Now let’s take some time to consider the tax treatment for each one of the corporate entity structures discussed in the last article. Some tax issues affecting the choice of the entity involve tax years; pass-through issues; and compensation and payroll taxes.
Partnerships, S corporations and personal service corporations must conform their tax years to that of their owners, normally a calendar year, unless they can establish a business purpose for having a different tax year. Partnerships, S corporations, and personal service corporations may also elect on Form 8716 to use a tax year other than the calendar year. However, a payment is usually required to cover the tax on the income deferred when using a period other than a calendar year. A personal service corporation making such an election may have to limit the amount of deductions it may take for employee owners unless certain minimum distributions are made to them before the end of the calendar year.
Which tax year to adopt might influence your choice of an entity structure? You’ll probably want to avoid a year-end that falls around the busiest time for your company.
As I mentioned before, the sole proprietor reports business receipts and expenses directly on Form Schedule C as part of his or her Federal Form 1040, making estimated tax payments on a quarterly basis. This is as straightforward as it gets.
A partnership is considered a “pass-through” entity because the net income or loss of the business will flow directly to the personal returns of the partners based on the agreed-upon ownership percentage of income and losses. Each partner must make quarterly estimated tax payments. Even though the partnership itself doesn’t pay taxes, it must file an information return – Form 1065. This form sets out each partner’s share of the partnership’s profits or losses. The partnership must also provide a Schedule K-1, which breaks down each partner’s share of the business profits and losses and certain separately stated items of income and expense. Partners report this information on their individual income tax returns.
Typically, an S corporation is taxed like a partnership and the profits and losses and certain separately stated items of income and expense flow through to the federal tax returns of the shareholders in proportion to their stock ownership. They are still protected from the liabilities of the company. With an S corporation, it is important to check with the state tax division since some states tax an S corporation like a C corporation, instead of taxing the business profits on the shareholder’s personal returns.
Income from C corporations, on the other hand, can be subject to two levels of taxation. First, any taxable income of the company is taxed at graduated corporate rates. Then some dividends paid out to shareholders are potentially taxed again at the shareholder level, subject to the new, special tax treatment given to qualified dividends.
Qualified personal service corporations paying taxes cannot use the graduated tax rates for C corporations. The flat tax rate is the highest marginal rate (currently 35%).
It’s important that you keep excellent records to handle a more complicated corporate tax return effectively. To maintain your limited liability status, you must follow corporate formalities involving decision-making and record keeping.
Another key issue facing small businesses is the treatment of compensation and payroll taxes. A distinction must be made between wage income and self-employment income. Wage income is earned by employees who have their share of Social Security (FICA) and Medicare taxes withheld, along with federal and, if applicable, state and local income taxes. The business entity is also liable for its share of FICA and Medicare taxes on wages paid to employees. The employer must file wage tax reports and pay taxes throughout the year, which is a burdensome task. If payment for services is made to an individual who is not an employee of the entity, no Social Security or payroll taxes are withheld and it is up to the person, as a self-employed individual, to pay all Social Security taxes and file quarterly estimated tax payments.
As a sole proprietor, you report the net income of the business on your individual tax return. If you have employees, it may be advisable to incorporate and pay yourself compensation in the form of wages. An LLC is treated according to the tax treatment selected. If treated as a partnership, active members must pay quarterly estimated self-employment taxes, while inactive members are not subject to the tax.
Let me close by saying that determining the type of entity structure depends on a number of factors including taxation and liability. The place to start, however, is to discuss your objectives with your CPA. You can avoid a lot of problems and save considerable taxes by getting the right guidance at the beginning as opposed to playing catch up and fixing problems that might have become larger due to poor planning.