It’s crucial to understand your business entity’s unique tax requirements to make sure you’re making the right payments and following the law. A sole proprietorship is the most straightforward. Conversely, a corporation is particularly more complex when it comes to business taxes.
Let’s look at the basics of each business type and its tax situation.
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The Internal Revenue Service (IRS) defines several types of businesses, but states can put their spin on things, too.
Regardless, there are a few hallmark business types that most people deploy, and the four most common entities are listed below.
| Type | Key features | Drawback | Examples |
|---|---|---|---|
| Sole proprietorship |
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| Limited liability company (LLC) |
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| Partnership | |||
| Corporation |
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A sole proprietorship allows individuals to run a simple business with minimal formalities. A common example is someone regularly selling at a swap meet or online auction site. Most people can start selling goods and services immediately without needing an attorney or excess bureaucracy.
Indeed, this simplicity means anyone can quickly launch a business hassle-free. But there is a significant drawback. There’s no legal distinction between the owner and the business in a sole proprietorship. This blurring of boundaries means you’re personally responsible for all aspects, including your business’s debts, liabilities and legal obligations.
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A limited liability company (LLC) is better if a sole proprietorship feels too risky. It is more complicated to set up, but part of what makes it appealing is how it typically separates your personal assets from the company. Your house and car can’t usually get seized to pay off business debts, for example.
Every state sets its own policies for LLCs. This variance means you must pick the legal environment most conducive to your needs. Specifically, you’ll want to consider under what circumstances your personal assets may get exposed to business liabilities. This exposure, called “piercing the corporate veil,” can occur differently per state.
A partnership is an option if you’re going into business with someone else. As the name implies, this type involves two or more people owning and operating the business. A written partnership agreement outlines each person’s responsibilities, income share, liabilities and other terms.
Unfortunately, partnerships don’t have the same protection LLCs do, so your personal assets are fair game.
Still, this business entity is somewhat easy to launch and informal. Unlike an LLC, a partnership boasts reduced bureaucracy and fewer long-term requirements. You’ll get to focus more on turning a profit and less on filing the correct forms and such.
Bottom line, if you have a good relationship with your business partner and prefer a simpler operation, a partnership is worth considering.
A corporation is a legal entity that is entirely separate from its owners, known as shareholders. It’s the preferred choice if you have big dreams that involve raising capital, taking on many owners and staff and mitigating large amounts of liability. You’ll have less control over the business but you’ll also have the least amount of personal liability.
If you’re the founder of a corporation, you must feel comfortable with a board of directors having authority over you. This type of business requires an open mind and willingness to hand over the reins to others.
One unique element of a corporation is its perpetual existence. The business will continue to run when you and other founders move on. In this situation, the board of directors exerts its authority to find your replacement.
If you’re okay with relinquishing authority over your business, then you can reap a corporation’s benefits. Namely, you can raise money from investors to grow the business, and this capital can afford you growth far beyond other business entities.
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Each business entity has distinct advantages come tax time. Let’s dive into these defining traits.
When it comes to taxes, a sole proprietorship upholds its theme of simplicity. You report business income and expenses on your personal tax return using the IRS’s Schedule C form (Profit or Loss from Business). You’ll file this along with your regular Form 1040 tax return document.
You’ll also need to pay self-employment tax. This levy covers your contribution to Social Security and Medicare. Employers deduct it from employee paychecks in traditional workplaces, but since you’re your own boss, you’ll need to hand it over to Uncle Sam on your own.
Finally, depending on your specific situation, you may need to file additional tax forms. A common one is Form 4562 (Depreciation and Amortization). This form accounts for depreciation in the value of your business assets. Another popular document is Form 8829, which details a tax deduction if you use part of your home as your business’s office.
If this feels confusing, don’t worry. Most online tax software titles, like TurboTax, support these forms. And this is still a fraction of the complexities involved in other business entities.
LLCs boast another unique perk: Choice over how you’re taxed. You get to tell the IRS how to charge taxes on your business.
That flexibility is because the IRS doesn’t recognize LLCs as a distinct tax category. Instead, you’re taxed as a sole proprietorship, partnership or corporation. Each has its pros and cons. A tax professional can help you nail down the right choice.
If you pursue taxation as a sole proprietorship or partnership, each member will report their share of income and expenses on their personal tax return. The business will not file its own return. This arrangement is known as a “pass-through entity.”
On the other hand, things are tricky if you opt for the corporation route. For starters, your LLC will file its own tax return separate from your personal filing. You’ll also need to consider if your business is a C corporation or an S corporation. There are many technical differences between the two, so consult with a tax advisor for details.
Again, a partnership is a pass-through entity. Each partner reports their share of income and expenses on their own personal tax return. The partnership agreement, created at the start of the business, determines how much each partner receives.
The partnership entity must file an informational return with the IRS using Form 1065 (U.S. Return of Partnership Income). This document details the partnership’s income, deductions, credits and other financial information. Still, this only alerts the IRS about what to expect from each partner’s personal returns.
Unlike the other entities above, a corporation is entirely independent of its owners, known as “shareholders” in this case.
The corporation files its own tax returns using IRS Form 1120 (U.S. Corporation Income Tax Return). Due dates depend on when the business was founded — the IRS expects a return by the fifteenth day of the fourth month following the close of the corporation’s tax year.
Profits are either reinvested in the business or distributed to shareholders in a payment known as a “dividend.” This lump sum issuance creates double taxation because both the corporation and the shareholder are charged tax on the amount.
This business entity is the most complex of all. There are far more nuances involved than with other types. For example, some corporations must pay taxes quarterly instead of annually. Missing a deadline results in harsher penalties than those for sole proprietors. Bottom line, it’s best to consult with an attorney or tax professional to meet all requirements.
The IRS and state tax authorities treat each business according to its legal entity type. A sole proprietorship is the easiest and simplest option, but it’s severely limited in protection. Meanwhile, other types of operations, such as corporations, provide lots of opportunities but also require a tremendous amount of effort and money to start.
If you’re in charge of filing taxes for your business, pay close attention to the legal structure. Then determine the IRS forms needed for your specific type. Software, such as QuickBooks, can help with this task.
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