Self-employed, in the truest sense of the word, comes in the form of a sole proprietorship, or general partnership if you started your business with someone else. Sole proprietorships and general partnerships are the most basic business structures—there are no formal requirements needed to get started. No upfront fees, no permission needed from the government.
As you begin to explore your business idea, prove your concept, and test the market; you are most likely starting a sole proprietorship or general partnership. These minimal business structures are personal, both emotionally and legally.
Sole proprietorships and general partnerships are considered extensions of business owners by the IRS. In other words, the IRS will not tax a sole proprietorship or general partnership itself. Instead, the tax obligations for your business are due by you and your partners, the business owner(s). In fact, the net income from your business is reported on you and your partners’ annual tax returns—Form 1040, Schedule C for sole proprietorships and Form 1040, Schedule E for general partnerships.
The Tax Pros and Cons of a Self-Employment
In addition to the lean start available through the sole proprietorship/general partnership form, the business structures provide you significant tax benefits. Since your business tax and your personal tax become one in the same, you gain a large opportunity for tax-write offs. All business expenses become your personal expenses when calculating net income and income taxes. If your business operates at a loss, you can generally deduct the loss from your personal gross income. The IRS publishes helpful materials, like the Home Office Deduction page, for self-employed business owners trying to understand the tax implications of their businesses.
On the downside, being personally accountable for your business’ tax obligations is risky. If you don’t calculate your taxes correctly, or worse, you don’t pay your taxes at all, you are personally liable to the IRS and your state taxing authority. Your personal property can become subject to tax liens if tax liabilities are not satisfied.
In a less severe scenario, you might simply be caught off guard by your tax bill should your business knock it out of the park. As a business creator, chances are, tax calculations are not part of your daily routine. However, if you don’t account for anticipated tax payments, your personal 1040 could leave you with an unexpected surprise come April. To help the self-employed prepare for tax liability, the IRS offers the estimated tax method.
The estimated tax method allows a self-employed individual to pay Social Security, Medicare, and income tax on a quarterly basis. There are specific rules and exceptions regarding those who need to pay Estimated taxes. Check out the IRS’ Estimated Taxes site to learn more.
When Does It Makes Sense to Formally Organize?
While there are certainly benefits to staying self-employed under a sole proprietorship or general partnership form, at some point, it usually makes sense to formally organize under one the many formal business forms available (e.g. corporation, limited liability company, etc.).
The unifying element underlying most formal business forms is separating the business owners from the business itself. Unlike a sole proprietorship or general partnership, more formal business structures do not treat businesses as an extension of the business owners. Instead, a “veil” is inserted as a wall shielding business owners from business liabilities. To explain, we’ll consider two popular business forms: the corporation, and the limited liability company (LLC).
What Does It Mean to Be a Corporation?
From an organizational and tax perspective, corporations sit at the opposite end of the spectrum from a sole proprietorship or general partnership. To set up a corporation, you complete formal steps required by state statute. Various forms and rules vary by state, but a general list includes:
- Register a business name
- File Articles of Incorporation
- Pay a filing fee
- Draft and adopt Bylaws
- Hold a Board of Directors meeting
If you organize as a corporation, you are not responsible for your business’ taxes. Rather, you are only responsible for taxes due on the income you receive from the corporation through paychecks and any distributions/dividends that the corporation may grant you as an owner. The business income generated by the corporation is also taxed, but the corporation is responsible for paying this tax. Because income is taxed at both the corporate level and the shareholder/employee level, the term “double taxation” is used to describe the taxing structure of a corporation.
There are upsides and downsides to a corporation tax structure. Upsides include clarity and protection to the shareholder. A corporation clearly pays the corporate tax due on the income the business generates. The major downsides of a corporation tax structure is the double taxation concept previously mentioned, and the complexity involved. Corporate tax is one of most complicated areas of tax law, and experts should be used to ensure compliance.
What About an LLC?
An LLC allows you to take advantage of certain perks from both the sole proprietorship/general partnership form and the corporation form. From a tax perspective, the members (business owners) elect whether to be taxed as a general partnership (pass through taxation) or as a corporation (double taxation). You choose the taxing mechanism that best suits your specific situation. Although you choose your tax structure, you remain protected by the corporate veil that a corporation provides. While an LLC requires some formal filing requirements, they are much less than a corporation. Again, specifics vary by state, but general requirements include:
- Register a business name
- File Articles of Organization
The key consideration for understanding the tax consequences of your self-employment is understanding your business form. Each form has its pros and cons. Most likely, the ideal business form for your business will evolve as your business matures. Reorganizing into a new structure is quite common, and keeping the above pros/cons in mind when considering your situation should help you make the best decision.