Ken Boyd from Accountinged.com, wrote this great piece for the Intuit/QuickBooks Blog, we compiled all the 8 pages into a single document to make it easy to print!
An Introduction to the Pass Through Concept
To understand the differences between business structures, it’s important to consider how a particular structure impacts your taxes. Some businesses are pass through entities, and others are not.
These entities pass through profits and losses directly to a single owner. Assume, for example, that Bob owns a gift shop as a sole proprietor. The gift shop profits pass through to Schedule C of Bob’s personal tax return (Form 1040).
The business profit on Schedule C is added to other income on Bob’s personal return, and that total goes into the tax calculation. Let’s say that Bob files a joint tax return with his wife Sue. Bob’s gift shop business generates net income of $50,000 for the year, and Sue receives a W-2 form with gross wages of $60,000 from her job. Bob and Sue also earn $2,000 in interest and dividend income. All of these amounts are included as income on Bob and Sue’s joint tax return.
S Corporations (S corps), Limited Liability Companies (LLCs) and Partnerships
These businesses are also pass through entities. The terms differ slightly between each type, but all three entities pass through profit and losses directly to the owners. LLC owners are referred to as members, S corp owners are described as shareholders, and partners have ownership rights in a partnership. Ultimately, the profits generated by all of these businesses flow through to the owners.
C Corporations (C Corps)
When most people think of a “corporation”, they’re referring to a C corporation (C corp). C corps are not pass through entities. Instead of a sole proprietorship, assume that Bob owns 80% of a chain of gift shops that operates as Openmeadow Gifts, a C corporation. Openmeadow files a tax return and pays taxes on the profits generated by the corporation.
Let’s assume that Openmeadow earned $100,000 last year and paid $20,000 in corporate income taxes. Keep in mind that the tax rate schedule for corporations is different from the tax tables used for individual income taxes. Say that Bob receives $40,000 in dividends on Openmeadow’s profits. The $40,000 is posted as income to his individual tax return, and Bob will pay ordinary income tax on the dividends.
It’s important to understand that C corp earnings are taxed twice, while the profits on sole proprietors, S corporations and partnerships are only taxed once.
The Pros and Cons of Every Business Structure
There are pros and cons to each type of business structure, and it’s important for every business owner to understand the benefits (and possible drawbacks) of each entity.
The Risks of Sole Proprietorships
This form of ownership is for a single owner who wants to start a business. A sole proprietorship is the simplest business structure, because it does not require the owner to set up a separate legal entity (although you should create a fictitious name). The profits and losses pass through directly to the owner’s personal tax return, using Schedule C.
The sole proprietor structure has some drawbacks, however. To grow your business, you’ll probably need to raise more capital, and it’s difficult to raise additional capital as a single owner. If your intention is to grow your business into a large operation, a sole proprietorship is not the best structure for you.
This structure also exposes the owner to unlimited personal liability for business risks. While a sole proprietorship allows you to get up and running quickly, you’re legal risk is higher than any other type of business structure.
LLCs: Are They Worth the Investment?
To avoid the unlimited liability issues of operating a sole proprietorship, many owners set up limited liability corporations (LLCs). LLCs pass through profits to the owner, but also limit the owner’s legal liability. You can have an unlimited number of members in your LLC, which makes it easier to raise capital and expand your business.
You will incur costs to setup your LLC with your state and maintain your LLC status. Setting up an LLC is more complex, because your have to choose a tax status and create an operating agreement. However, many business owners feel that the flexibility offered by an LLC is worth the extra time investment.
Is Your Business Ready to Be an S Corp?
When you form an S corp, you issue stock to each of the owners, who are referred to as shareholders. Since the S corp is a business entity, its shareholders are protected from many forms of business legal liability. Profits pass through to the shareholders, and each shareholder has the right to sell their shares. This type of corporate structure makes it easier to raise capital, and an S corp has an unlimited life.
There are some limitations to the S corp structure. Current tax law limits the number of shareholders to 75, and only one class of stock can be issued. An S corp must also consider the amount of compensation paid to the managers who operate the S corp. The IRS has rules regarding reasonable compensation paid to S corp business managers.
Forming an S corp is complex, and the tax reporting requirements to maintain your S corp status can be extensive. If you choose this type of corporate structure, hire a CPA or an attorney to help you with the paperwork.
Partnerships Come in Different Shapes and Sizes
In a partnership, two or more people operate a business using a partnership agreement. The partnership can take several forms, but the most common arrangement requires at least one general partner and possibly a group of limited partners.
A general partner is typically involved in the management of the partnership. As an example, many law firms and accounting firms are partnerships, and are managed by general partners. General partners have unlimited legal liability, and that liability extends to their personal assets. In addition, every partner is liable for the actions of other partners while conducting work for the partnership.
Limited partners, on the other hand, are not involved in the management of the partnership, and their liability is limited to their investment in the partnership.
Partnerships are pass through entities, so each partner’s share of profits is included on his or her personal tax return. The process of filing a partnership return may be complex, however. The partnership must file a tax return that lists each partner’s share of profit, and the dollar value of each partner’s ownership share (basis).
C Corps Offers More Protection, More Taxes
A C corporation (C corp) is not a pass through entity, because the corporation files a tax return and pays taxes as a corporation. If you choose to form a C corp, you must follow the incorporation rules for your particular state, and you’ll be required to file annual financial statements. Earnings are taxed at both the corporate level and on the owner’s personal tax return.
Your legal liability as a C corp shareholder is limited to the dollar amount of equity you own. A C corp offers the strongest level of legal liability protection for the owners. Also, a C corp is the best way to raise capital, since you can continually issue more shares of stock, and your business has an unlimited life.
Your C corp requires more legal and regulatory reporting than any other type of business structure, and you must file a corporate tax return.
What Is Ownership Basis?
The most misunderstood tax concept for business owners is the concept of basis. Basis refers to an owner’s investment in a particular business, and basis must be tracked accurately for annual tax reporting. When an owner sells his or her business interest, the profit on the sale is calculated as (sales proceeds received) less (basis).
Here’s an example of calculating basis:
- Bob invests $50,000 in cash and $10,000 in furniture and fixtures into Openmeadow Gifts. The equity section of the company’s balance sheet will list $60,000 in capital contributed by Bob, which is his basis of ownership.
- An owner’s share of company profits increases basis. Think about basis as a bucket: Bob put money into the bucket when he contributed cash and other assets into the business. Assume that Bob’s share of profits for the first month is $5,000. Bob will be taxed on his share of the profits, but that $5,000 also increases his basis to $65,000.
- An owner’s share of company losses decreases basis, along with any withdrawals. Assume that the company loses money in month two, and Bob’s share of the loss is $3,000. During month two, Bob also takes a withdrawal of $5,000. His basis declines to ($65,000 – $3,000 losses – $5,000 withdrawal) = $77,000.
Basis is most important when an owner decides to sell all or part of a business interest. Basis in a business interest is similar to cost basis for an investment. If you were selling 100 shares of IBM stock at $50 per share, for example, you’d need to know that your cost basis is $30 per share to calculate a $20 gain per share.
In the same way, Bob cannot calculate his gain or loss on the sale of his business interest if he doesn’t know his basis. In many instances, a company will not keep close track of an owner’s basis, and the business must catch up its accounting records to compute an owner’s gain or loss on a sale.
Let the Paperwork Begin: 4 Steps to Forming a New Business
Dealing with paperwork can be frustrating, particularly when you form a new company. The task is more difficult if you’re trying to decide on a particular business structure. Follow these steps to set up your company, regardless of which business structure you choose.
1. Choose a Fictitious Business Name
The fictitious name of your business is different from your personal name. This name is also called a “doing business as”, or DBA name. You need to choose a fictitious name, and use the name on all government forms and applications, such as your employer tax ID and any licenses that your business requires.
Check with your county or state government to determine how to file your fictitious name. In many cases, a state’s secretary of state’s office handles this task.
2. Register for an Employee Identification Number (EIN)
The IRS issues employee identification number (EIN) numbers. This number is used on federal and state tax filings, including payroll tax reporting documents. You can apply for an EIN through the IRS website. You’ll need to register your fictitious name first so that the name can be used to apply for an EIN number.
3. Create a Business Checking Account
Once you register your fictitious name and get an EIN number, you should set up a business bank account. No business owner should operate a company using a personal checking account even if their tax liability passes through their business structure. There are several reasons why:
- Financial reporting: If you don’t separate your business and personal bank transactions, it’s difficult to track your company activity and generate financial statements. Also, it’s much more likely that you’ll make a mistake and include personal transactions in your business records.
- Legal liability: If your business is sued, it will be more difficult to prove that your business is a separate entity from you personally. If you handle business and personal transactions through the same bank account, you may be putting your personal assets—like your home and retirement savings—at risk if your business is sued.
- Additional capital: At some point, you may need to add new owners to your firm to raise more capital. Keeping your business records separate demonstrates that you take your business seriously. An investor is more likely to purchase ownership in your business if you keep company bank activity in one unique account.
Set up a business bank account and keep your company records separate from personal transactions. Do this right from the start.
4. Get Your Documents and Licenses in Order
You may be required to create a number of other documents, depending on what type of business you form:
- Article of organization, operating agreement: LLCs are required to file these documents, which explain who the LLC members are, and how the LLC will be operated. Partners create a partnership agreement that is used to operate the entity. Both forms are filed with taxing authorities and regulators.
- Choose tax status: Some business structures require the company to choose how the entity will be taxed. An LLC, for example, may be taxed as an S corporation with a pass through tax structure.
- Licenses and permits: Finally, you need to apply for any licenses or permits required by your industry. A homebuilder, for example, needs city permits to renovate a home or build an addition. Attorneys and accountants must be licensed in their state to do business. Check with your city, county, state and federal authorities to determine the licenses and permits you need to operate.
Completing these steps is important, because these issues will have an impact on your business for years into the future.
Do You Have Employees, Independent Contractors or Both?
If you’re starting your first business, you may find it difficult to understand employment taxes from an owner’s perspective. If you worked as an employee, you were issued a W-2 and your employer withheld and submitted federal and state taxes on your behalf. You picked up the tax withholding amounts from your W-2 and posted them to your personal tax return.
This process is more complicated as a business owner, however. An owner must determine if each worker is an employee or an independent contractor. Business owners must also withhold taxes on employee wages, and deal with estimated tax payments on company profit.
1099 or W2? The Distinction Is Important
Many businesses have workers that are classified as employees and others who work as independent contractors. The distinction is important, because it affects how income taxes are withheld and paid.
The IRS requires employers to determine if a worker is an independent contractor or an employee. The guidelines address how much control the company has over the worker, such as control over what the worker does and how they perform their work. The less control a company has, the more likely it is that the worker is classified as an independent contractor.
Companies must withhold federal, state and other taxes from employee wages and submit those amounts to the proper taxing authority. Independent contractors, on the other hand, are responsible for their own federal and state taxes.
As an example, assume that Silverscreen Productions hires Julie as a freelance producer. Julie hires a cameraman, write scripts, plans video shoots and edits the video that is shot. Since the producer controls when and how the work is performed, Silverscreen’s CPA determines that the producer is an independent contractor, which means that no worker taxes are withheld by the company.
Silverscreen also hires Joe as an executive assistant for the company president. The president closely manages Joe’s work, and the firm’s CPA determines that Joe should be classified as an employee.
To make this determination as simple as possible, we created a 1099 vs. W2 wizard. Just answer a few simple questions and it will tell you how to classify your workers.
A Primer on Payroll Taxes
Any type of business that hires employees has to manage payroll taxes. Consider Joe, the executive assistant at Silverscreen. Joe fills out an IRS W-4 form to determine his federal income tax withholdings on his $40,000 annual income. Silverscreen follows these steps to process Joe’s payroll taxes:
- Based on his W-4 withholding documents, Silverscreen withholds 25% of Joe’s gross pay for federal taxes and 5% for state taxes.
- Silverscreen submits the tax amounts withheld to the IRS and to Joe’s state department of revenue.
- At year-end, Silverscreen issues Joe a W-2 form, which includes the total amounts withheld for taxes.
Joe includes the W-2 form with this personal tax return. The W-2 lists gross wages and the federal and state tax withholdings.
Managing payroll taxes is time consuming. Consider hiring an outside payroll company to calculate employee tax withholdings. You can give the payroll company access to your company bank account so that they can transmit the net pay to each worker’s bank account. These firms can also complete all payroll tax forms and transmit the forms and tax payments to the IRS and to your state revenue office. The cost of hiring a payroll company may be a huge time saver for your business.
FICA and Medicare Taxes
Employers withhold the worker’s share of FICA and Medicare taxes from gross pay, and also pay a company share of the taxes. Sole proprietors, on the other hand, must pay FICA and Medicare taxes using Schedule SE (self-employment tax) on their personal tax returns. Currently, sole proprietors pay a 15.3% tax rate for FICA and Medicare taxes, with one-half of those taxes posted as a business expense on Schedule C. The business deduction allows the sole proprietor to recover the “business paid portion” of the taxes as a company expense.
How and Why You Must Estimate Your Quarterly Tax Payments
Most people get taxes taken directly from their bi-weekly paychecks. This isn’t the case for business owners, who have to pay taxes on a quarterly basis year-round. It’s intimidating at first, but a few simple lessons will make this process simple. There are differences in how this works for businesses vs. self-employed individuals, so read each section carefully.
Estimated Taxes for Corporations
One way or another, every business person makes estimated tax payments on their income. If your business is a pass through entity, you make estimated taxes for your personal tax return. A corporation, on the other hand, pays taxes on its income and submits estimated business taxes periodically during the year. Here’s an example for a corporation:
Openmeadow Gifts, a C corp, earned $100,000 in year one and paid $20,000 in taxes. Bob, the majority owner of Openmeadow, works with his CPA to plan for estimated tax payments periodically during the year. Based on his profit estimates, Bob thinks that Openmeadow will earn $120,000 in year two and pay $24,000 in federal taxes.
At the end of year two, Openmeadow’s CPA calculates a tax liability of $25,600. The company records the $24,000 in estimated tax payments on the tax return, and pays the remaining $1,600 when the corporate tax return is filed
Estimated Taxes for Individuals
Pass through entities do not make tax payments. Because the income passes through to each owner, it’s up to the owner to plan their own tax payments. Owners in sole proprietorships, S corporations and partnerships make estimated tax payments for their personal tax returns.
As an example, Silverscreen Productions pays Julie $40,000 for her work as a producer in year two, and Julie also earns $20,000 from other clients. Julie works exclusively as an independent contractor, so her payments do not include any tax withholdings for year two.
In year one, Julie paid $10,000 in federal taxes on $50,000 in income, or a 20% tax rate. Based on a conversation with her CPA, she expects to pay the same 20% tax rate in year two, or $12,000 in taxes on $60,000 in income. Julie pays estimated taxes periodically during the year.
|Due (in 2017)
|January 16 (of the following year)
When her CPA prepares her year two tax return, the accountant calculates a $13,700 tax liability. The CPA posts the $12,000 in estimated taxes to her tax return, and Julie pays the remaining $1,700 in taxes when she files her return.
It’s critically important for both corporations and individuals to make estimated payments during the year. If not, the taxpayer may incur interest and penalties due to underpayment.
The estimated tax system allows the taxing authority to collect a large percentage of taxes due before tax returns are filed. This system applies to both federal and state taxes, and possibly for your city and county taxes as well.
What You Need to Know About Business Expenses and Tax Deductions
To minimize the amount of taxes you legally owe, it’s important to understand both business expenses and other tax deductions. If you don’t educate yourself on these issues, you may pay more tax than is necessary.
This discussion includes several business expenses that are misunderstood, and some common tax deductions that impact many businesses.
3 Misunderstood Business Expenses
The tax laws for business expenses are complicated and can change frequently. Some expenses require extensive documentation, and those records need to be monitored throughout the year. Here are some common business expenses that are misunderstood:
- Retirement accounts: Investors have several types of retirement accounts that can be set up and funded, but the rules are complex. Sole proprietors deduct their retirement plan contributions on Schedule C of their personal tax return. Generally speaking, the amount that a company contributes to an employee’s retirement plan is a business expense.
- Health insurance: The premiums for health insurance are also deductible as a business expense. Many sole proprietors find that paying for their own health insurance is far more expensive than the cost they pay as an employee in a large organization. If you’re considering a sole proprietorship, take a hard look at the cost you’ll incur for health insurance.
- Home office expenses: Be careful here, because the IRS may closely review any deduction you take for a home office. Using this deduction requires careful recordkeeping. If you don’t spend a large amount of your time working in a home office, don’t use this deduction.
Work with a CPA to get a clear understanding of these expenses. A tax professional can explain how each expense applies to your personal situation.
Tax Deduction Lessons for Every Business
Corporations pay taxes using a set of corporate tax rates, and those rates are different from individual income tax rates. On the other hand, if your business is a pass through entity, you’ll pay tax on your company profits based on your personal tax rates. Here are some common tax issues that businesses of all types must address:
- Depreciation expense: If you own an asset that you’ll use in your business for more than a year, that asset should be capitalized. Rather than expense the cost of office furniture, for example, you create an asset account for office furniture and depreciate the cost over the asset’s useful life. Consult with a CPA to determine the useful life and rate of depreciation for your asset purchases.
- Cost of sales vs. operating expenses: The cost to produce a product is posted to cost of sales expense when the items are sold. The same rule applies when a company purchases inventory and sells items to a customer. Other costs, such as shipping and storage costs, are also posted to cost of goods sold. Costs not directly related to the product, such as utility costs, are expensed as operating costs as they are incurred.
- Income vs. capital gains: When you’re paid a dividend as a shareholder, or you take a distribution of company profit, you generally pay ordinary income taxes on the dollars you received. If, on the other hand, you sell your ownership interest, you may incur a capital gain or loss on the sale. There may be different tax rates for ordinary income and capital gains, depending on your personal tax situation.
- Salary vs. profit distribution: Some business owners earn a salary and also receive a share of profits and losses at year-end. The business must withhold federal and state taxes from salary, along with FICA and Medicare taxes. When an owner receives a profit distribution, however, the owner must plan for any required estimated tax payments on the distribution. This can be challenging, since the income tax bracket is based on total income, which includes both the salary and any profit distributions. Find an expert to estimate your total earnings and plan your estimated tax payments.
With careful planning, you can file an accurate tax return and avoid any interest, penalties and fees.
Get Help and Plan Ahead
Starting a business requires many important decisions. When it comes to accounting and taxes, get some help. An accountant and a cloud-based accounting tool will go a long way towards reducing the administrative overhead of running your business.