June 14, 2016
The most basic thing that all companies must do before they can start working on their taxes, scratch that… The first thing a company needs to do before they can accurately keep their books is decide which type of business entity to register as. While this does not stop you from operating your business, knowing what type of business entity you are going to file as will allow you to track revenues and expenses accordingly, which will minimize your tax liability and minimize the income tax preparation fees and the amount of hours you spend laboring over your taxes at the end of the year! So, lets talk types of businesses (or, at least, the most common types of small businesses):
Most small business are a type of Flow Through Entity. These are business that operate and the money ‘flows through’ the business into the owner’s accounts (in one fashion or another). Sometimes this happens literally, like when a photographer or musician or babysitter receives revenue and this is their actual, take-home income. While other times this only happens for tax purposes, as in when partners in a partnership or an individual business owner does not take all profits from a company as their take-home income, but rather they leave this money in the company so that the company can continue to grow. Regardless of the situation, the company is not the entity responsible for the taxes on the profits, the owner(s) of the company will report the profits as income and pay self-employment tax. The following are types of flow-through entities.
If you file as a Sole Proprietorship, and you are going to turn a profit this tax year, then quarterly estimated tax payments will help you to avoid late payment penalties and fees. The biggest benefit of this type of company is that it allows the owner to operate the company with as little hassle as possible. The drawback is that, unless incorporated as an LLC filing as a Sole Proprietorship, there is very little personal protection from business and legal liabilities, and it is high on the list of IRS audit targets.
This eliminates the business and legal libility risks that the owner of a Sole Prop may take (if the company is not an LLC filing as a Sole Prop). It also means that an owner can be a W-2 employee. An S Corp is the other type of entity that owner(s) with an LLC can choose to file as.
This is why the above two entities mentioned that an LLC can elect to file taxes as either type. Before the IRS can determine tax liability, it must first know which type of entity a company is filing as. The biggest difference between a Sole Prop and an S Corp is that the owner of a Sole Prop cannot be considered a W-2 employee in the company. Thus, the entire profit of the company (including anything that the owner may have taken home as ‘wages’) is subject to self-employment tax as well as the commensurate income tax for the owner’s tax bracket. The owner of an S Corp can be a W-2 employee, which means that his or her wages are an expense for the company, which lowers the net profit, providing less taxable income for the company. The W-2 wages are taxed at individual tax rates, and the employer portion of the employment taxes comes out of the profits of the company. However, since an S-Corp is considered as a separate entity from its shareholders and officers, the net profits reported on K-1 form, which can be taken as a distribution by the owners, are exempt and not subject to self employment tax, providing a considerable tax saving for many St. Louis small business owners.
Each owner contributes something of value to the company. This can operate in much the same way as a Sole Prop, with the main distinction being that has multiple owners, not just one. As in the Sole Prop, partners should make estimated quarterly tax payments, if they think they will turn a profit. Additionally, partners cannot be a W-2 employee in the company, so they pay self-employment taxes on their portion of the profits. One way to shield a partner from incurring too much tax-liability is to make that person a limited-partner. In cases such as these, that partner is only taxed on the guaranteed payments. However, each Partnership must have at least one general partner, or partner who is responsible for paying taxes on the profits.
There you go! I tried to keep it short for you, so I have included some helpful sites that you can link to for additional information. Or if you want to talk to a live individual about these topics we are always happy to help!
https://www.irs.gov/businesses/small-businesses-self-employed/business-structures
https://www.irs.gov/uac/choosing-a-business-structure
https://www.sba.gov/starting-business/choose-your-business-structure/partnership
Sincerely,
Chelsea Auton
The Volpe Consulting & Accounting Team
