Business Taxation

The United States federal income tax system is a “pay-as-you-go” arrangement. It is common to hear a phrase “I have to file and pay my taxes so that I don’t get in trouble with the IRS.” However, it is important to remember that while filing a return is the annual event; payment of income taxes is supposed to happen throughout the entire year.

Taxpayers must pay the tax as they earn or receive income during the year. There are two ways for taxpayers to pay as they go:

  • Withholding. When income taxes are withheld from the taxpayers’ pay.
  • Estimated tax payments. If you do not pay your tax through withholding, or do not pay enough tax that way, you might have to pay estimated tax.  If you are not required to make estimated tax payments, you may pay any tax due when you file your return. Self-employed individuals and contractors are required to make periodic estimated income tax payments throughout the year.

All businesses except partnerships must file an annual income tax return.  Partnerships file an information return.  The form you use depends on how your business is organized. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute.

SOLE PROPRIETORSHIP. A sole proprietor is someone who owns an unincorporated business by himself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

PARTNERSHIPS. A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his share of the partnership’s income or loss on his tax return.

Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.

CORPORATIONS. In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.

The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.

S CORPORATIONS. S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.

To qualify for S corporation status, the corporation must meet the following requirements:

  • Be a domestic corporation
  • Have only allowable shareholders
    • including individuals, certain trusts, and estates and
    • may not include partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders.

LIMITED LIABILITY COMPANY (LLC). An LLC is a business structure allowed by state statute. Each state may use different regulations. Owners of an LLC are called members. Most states do not restrict ownership, and so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner.

A few types of businesses generally cannot be LLCs, such as banks and insurance companies.

Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation.

An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it files Form 8832 and affirmatively elects to be treated as a corporation.

EMPLOYMENT TAXES. When you have employees, the employer has certain employment tax responsibilities that the employer must pay and forms must file.  Employment taxes include the following:

  • Social security and Medicare taxes. Employers generally must withhold part of social security and Medicare taxes from employees' wages and you pay a matching amount yourself. To figure out how much tax to withhold, use the employee’s Form W-4.
  • Federal income tax withholding. Employers generally must withhold federal income tax from employees' wages. To figure out how much tax to withhold, use the employee’s Form W-4.
  • Federal unemployment (FUTA) tax. Employers report and pay FUTA tax separately from Federal Income tax, and social security and Medicare taxes. You pay FUTA tax only from your own funds. Employees do not pay this tax or have it withheld from their pay.