Tax Reporting for Sole Proprietors, Partnerships, LLCs, and Corporations
Paying taxes and reporting income for your company are very important jobs, and how you complete these tasks properly depends on your business’s legal structure. From sole proprietorships to corporations and everything in between, this discussion briefly reviews business types and explains how to handle taxes for each type. You also get some instruction on collecting and transmitting sales taxes on the products your company sells.
Finding the right business type
Business type and tax preparation and reporting go hand in hand. If you work as a bookkeeper for a small business, you need to know the business’s legal structure before you can proceed with reporting and paying income taxes on the business income. Not all businesses have the same legal structure, so they don’t all pay income taxes on the profits they make in the same way.
But before you get into the subject of tax procedures, you need to understand the various business structures you may encounter as a bookkeeper.
The simplest legal structure for a business is the sole proprietorship, a business that’s owned by one person. Most new businesses with only one owner start out as sole proprietorships. (If an unincorporated business has only one owner, the Internal Revenue Service automatically considers it to be a sole proprietorship.) Some of these businesses never change their statuses, but others grow by adding partners and becoming partnerships. Others add lots of staff and want to protect themselves from lawsuits, so they become limited liability companies (LLCs). Those seeking the greatest protection from individual lawsuits, whether they have employees or are single-owner companies without employees, become corporations.
The IRS considers any unincorporated business owned by more than one person to be a partnership. The partnership is the most flexible type of business structure involving more than one owner. Each partner in the business is equally liable for the activities of the business. This structure is slightly more complicated than a sole proprietorship (see the preceding section), and partners should work out certain key issues before the business opens its doors, including the following:
- How the partners will divide the profits
- How each partner can sell his or her share of the business if he or she so chooses
- What will happen to each partner’s share if a partner becomes sick or dies
- How the partnership will be dissolved if one of the partners wants out
Partners in a partnership don’t always have to share equal risks. A partnership may have two different types of partners: general and limited. The general partner runs the day-to-day business and is held personally responsible for all activities of the business, no matter how much he or she has personally invested in the business. Limited partners, on the other hand, are passive owners of the business and not involved in its day-to-day operations. If a claim is filed against the business, the limited partners can be held personally liable only for the amount of money that matches how much they individually invested in the business.
Limited liability companies (LLCs)
An LLC provides owners of partnerships and sole proprietorships some protection from being held personally liable for their businesses’ activities. This business structure is somewhere between a sole proprietorship or partnership and a corporation. The business ownership and IRS tax rules are similar to those of a sole proprietorship or partnership, but as with a corporation, the owners aren’t held personally liable if the business is sued.
LLCs are state entities, so the level of legal protection given to a company’s owners depends on the rules of the state in which the LLC was formed. Most states give LLC owners the same protection from lawsuits as the federal government gives corporation owners. But these LLC protections haven’t been tested in court to date, so no one knows for certain whether they’ll hold up in the courtroom.
If your business faces a great risk of being sued, the safest business structure for you is the corporation. Courts in the United States have clearly determined that a corporation is a separate legal entity and that its owners’ personal assets are protected from claims against the corporation. Essentially, an owner or shareholder in a corporation can’t be sued or face collections because of actions taken by the corporation. This veil of protection is the reason why many small-business owners choose to incorporate even though it involves a lot of expense (both for lawyers and accountants) and government paperwork.
In a corporation, each share of stock represents a portion of ownership, and profits must be split based on stock ownership. You don’t have to sell stock on the public stock markets to be a corporation, though. In fact, most corporations are private entities that sell their stock privately among friends and investors.
If you’re a small-business owner who wants to incorporate, you first must form a board of directors. Boards can be made up of owners of the company as well as nonowners. You can even have your spouse and children on the board; those board meetings undoubtedly would be interesting.
Tackling tax reporting for sole proprietors
The federal government doesn’t consider sole proprietorships to be individual legal entities, so they’re not taxed as such. Instead, sole proprietors report any business earnings on their individual tax returns; that’s the only financial reporting they must do.
Most sole proprietors file their business tax obligations as part of their individual 1040 tax return by using the additional two-page form Schedule C, Profit or Loss from Business. Download the latest version of Schedule C.
Sole proprietors must also pay the so-called self-employment tax, which means paying both the employee and the employer sides of Social Security and Medicare. That’s a total of 15.3 percent, or double what an employee would normally pay, and it’s a bummer for sole proprietors. The table shows the drastic difference in these types of tax obligations for sole proprietors.
|Type of Tax||Amount Taken from Employees||Amount Paid by Sole Proprietors|
Social Security and Medicare taxes are based on the net profit of the small business, not the gross profit, which means that you calculate the tax after you’ve subtracted all costs and expenses from your revenue. To help you figure out the tax amounts you owe on behalf of your business, use IRS Form Schedule SE, Self-Employment Tax. On the first page of this form, you report your income sources, and on the second page, you calculate the tax due. Download the most current version.
Under the tax law passed in December 2017, a new provision called the 20% Pass-Through Tax Deduction for small businesses became effective in 2018. This law provides a deduction for small businesses that report earnings on their personal tax return rather than a corporate tax return. To see whether your company qualifies, you can read the complicated rules. But, be sure to discuss whether your business qualifies with the person who prepares your tax return. This new benefit will end January 1, 2026, unless Congress extends it.
As a sole proprietor, you can choose to file as a corporation even if you aren’t legally incorporated. You may want to do so because corporations have more allowable deductions and you can pay yourself a salary, but this practice requires a lot of extra paperwork, and your accountant’s fees will be much higher if you decide to file as a corporation. Because corporations pay taxes on the separate legal entity, this option may not make sense for your business. Talk with your accountant to determine the best tax structure for your business.
If you do decide to report your business income as a separate corporate entity, you must file Form 8832, Entity Classification Election, with the IRS. This form reclassifies the business — a step that’s necessary because the IRS automatically classifies a business owned by one person as a sole proprietorship. Download the most current version of the form.
As the bookkeeper for a sole proprietor, you’re probably responsible for pulling together the Income, Cost of Goods Sold, and Expense information needed for this form. In most cases, you hand off this information to the business’s accountant to fill out all the required forms.
Filing tax forms for partnerships
If your unincorporated business is structured as a partnership (meaning that it has more than one owner), it doesn’t pay taxes. Instead, all money earned by the business is split among the partners.
As a bookkeeper for a partnership, you need to collect the data necessary to file an information schedule called Schedule K-1 (Form 1065), U.S. Return of Partnership Income for each partner. The company’s accountant will most likely complete the Schedule K-1 forms. The entire information filing for the company is called Form 1065, U.S. Return of Partnership Income.
Any partner who receives a Schedule K-1 must report the recorded income on his or her personal tax return — Form 1040 — by adding a form called Schedule E, Supplemental Income and Loss. (Schedule E is used to report income from more than partnership arrangements; it also has sections for real estate rental and royalties, estates and trusts, and mortgage investments.) Find the most current version of this form.
Unless you’re involved in a real estate rental business, you most likely need to fill out only page 2 of Schedule E. Pay particular attention to Part II, Income or Loss from Partnerships and S Corporations. In this section, you report your income or loss as passive or nonpassive income — a distinction that your accountant can help you sort out.
Partnerships also may qualify for the 20% Pass-Through Tax Deduction. Be sure to check with your accountant regarding this new tax benefit.
Paying corporate taxes
Corporations come in two varieties: S and C. As you might expect, each variety has unique tax requirements and practices. In fact, not all corporations even file tax returns. Some smaller corporations are designated as S corporations and pass their earnings on to their stockholders.
Check with your accountant to determine whether incorporating your business makes sense for you. Tax savings isn’t the only issue you have to think about; operating a corporation also increases administrative, legal, and accounting costs. Be sure that you understand all the costs before incorporating.
Reporting for an S corporation
An S corporation must have fewer than 100 stockholders. It functions like a partnership but gives owners more legal protection from lawsuits than traditional partnerships do. An S corporation is treated as a partnership for tax purposes, but its tax forms are a bit more complicated than a partnership’s. All income and losses are passed on to the owners of the S corporation and reported on each owner’s tax return, and owners also report their income and expenses on Schedule E.
S corporations also may qualify for the 20% Pass-Through Tax Deduction mentioned earlier in this chapter. Be sure to check with your accountant regarding this new benefit.
Reporting for a C corporation
The type of corporation that’s considered to be a separate legal entity for tax purposes is the C corporation — a legal entity formed specifically for the purpose of running a business.
The biggest disadvantage of structuring your company as a C corporation is that your profits are taxed twice — once as a corporate entity and again on dividends paid to stockholders. If you’re the owner of a C corporation, you can be taxed twice, but you can also pay yourself a salary and therefore reduce the earnings of the corporation. Corporate taxation is very complicated, with lots of forms to be filled out, so there’s not enough room here to go into great detail about how to file corporate taxes. Before the new tax law went into effect on January 1, 2018, corporate tax rates ranged from 15 to 38 percent. On January 1, 2018, the flat corporate tax rate is 21 percent.
You may think that C corporation tax rates look a lot higher than personal tax rates, but in reality, many corporations don’t pay any tax at all or pay taxes at much lower rates than you do. As a corporation, you have plenty of deductions and tax loopholes to use to reduce your tax bites. So even though you, the business owner, may be taxed twice on the small part of your income that’s paid in dividends, you’re more likely to pay less in taxes overall.
Taking care of sales tax obligations
Even more complicated than paying income taxes is keeping up to date on local and state tax rates and paying your business’s share of those taxes to the government entities. Because tax rates vary from county to county, and even from city to city in some states, managing sales taxes can be very time-consuming.
Things get messy when you sell products in multiple locations. For each location, you must collect from customers the appropriate tax for that area, keep track of all taxes collected, and pay those taxes to the appropriate government entities when due. In many states, you have to collect and pay local (city or county governments) and state taxes.
An excellent website for data about state and local tax requirements is the Tax and Accounting Sites Directory. This site has links for state and local tax information for every state.
States require you to file an application to collect and report taxes even before you start doing business in that state. Be sure that you contact the departments of revenue in the states where you plan to operate stores before you start selling products or services and collecting sales tax.
All sales taxes collected from your customers are paid when you send in the Sales and Use Tax Return for your state; you must have the cash available to pay this tax when the forms are due. Any money you collected from customers during the month should be kept in an account called Accrued Sales Taxes, which is a Liability account on your balance sheet because it is money owed to a governmental entity.