Starting a small business is hard enough without adding taxes to the mix. Taxes don’t have to be as challenging (or painful) as they’re cracked up to be though, especially if you put in the work during the setup phase.
We’ve written an article focusing on the nitty-gritty of getting the right business licenses and permits based on your location; this article focuses specifically on taxes.
Taxes Start with Your Business Structure
The structure of your business — whether you choose sole proprietorship, partnership or LLC — influences your tax status. If you haven’t already decided your business structure, think about taxes before making your choice.
The simplest business structure is the sole proprietorship. A sole proprietor reports income and losses from the business on Schedule C attached to their individual income tax return, Form 1040. Creating this type of entity does not require the services of an attorney.
If a sole proprietor’s business runs into financial trouble, creditors can bring a lawsuit against the business, and if the suit is successful, the owner would have to pay the business debts with their own money.
Sole proprietors can deduct expenses that are “ordinary and necessary” for conducting their trade or business. Ordinary expenses are ones that are common and accepted in your trade or business. Necessary means the expense is helpful and appropriate.
For example, an ordinary and necessary expense would be purchasing business cards and attending networking events to promote your business and generate new clients. An unreasonable business expense could be chartering a helicopter to take you to a networking event in a nearby city.
While the IRS does not provide a comprehensive list of the types of business expenses that can be deducted, you can find more discussion and general rules in the IRS Publication 535.
Although your business income and losses are reported on your personal tax return, keeping your business accounts separate from your personal accounts, while not technically required, is a good idea. This way, it’s easier to track your business expenses when they aren’t mixed in with personal expenses. Having a separate business checking account can help increase the credibility of your business and avoid the IRS’s hobby loss rules. Hobbies have limitations on the amount of expenses that can be deducted.
A partnership is similar to a sole proprietor, but it consists of two or more partners. Income or losses from the business are reported on an informational return, Form 1065. The partnership doesn’t pay income taxes directly. Instead, partners are taxed on their share of partnership income, regardless of whether they take money out or reinvest it back into the business.
Say a partnership is formed by two individuals and they purchase property to rent out to a tenant. During their first year of business, they earn a net income of $20,000. Rather than split the profits 50/50, the partners agree to use the $20,000 as a down payment on a second rental property for the business. Even though they’ve reinvested their share of profits back into the business, each partner has to pay taxes on their share of the $20,000. Like a sole proprietorship, partners have personal accountability for business debts.
A limited liability company (LLC) is a business structure allowed by state statute but the IRS can treat an LLC as either a corporation, partnership or, in the case of a single-member LLC, a sole proprietor.
An LLC has the benefit of allowing business owners to operate like a traditional partnership, distributing income to the partners to report on their individual tax return, but offers the personal protection from business debts.
Consider the example of the partnership that purchased the rental properties. If that partnership elects to be an LLC, the owners will be taxed on their share of net income, regardless of whether they reinvest the profits back into the business.
The advantage of an LLC structure is the legal protections that come with it.
If the partnership ran into financial trouble, the financial exposure of the members would be limited to their investment in the business. Creditors couldn’t come after them personally for business debts (unless the partners personally guaranteed the loans).
S-corporations and C-corporations get a lot more complicated and are in a whole different league as far as taxes are concerned. If you’re starting a business from scratch, establishing yourself as a corporation isn’t a good option, since these entities require you to have shareholders and a board, and also require corporate taxation.
If you’re a new owner and are unfamiliar with the corporation tax structure, but are taking over an already established corporation, consider working with a professional to avoid any missteps.