Among the essential factors to consider when starting a business are the various tax implications associated with different entities. Understanding this will help you fast-track the launch of your business and ensure it complies with tax requirements.
Some taxes applicable to the various entities include income tax, estimated tax income, and self-employment. The online sales tax was also recently introduced to coincide with the increase in e-commerce business. Online sales tax is a requirement imposed on businesses with physical shops for their online customers. However, if your business doesn’t have a physical presence, it’s exempt from this tax.
However, the requirements for online sales tax vary from state to state. These, like other tax requirements, vary. But if you live in California, here are a few key pointers on California online sales tax every online business owner should note.
This article looks at the tax implications of starting a business. It’s a wholesome review, not just online sales tax. Keep reading to learn more.
Understanding Business Taxes
Business taxes are divided into four categories: income tax, self-employment tax, estimated taxes, and sales taxes.
The Internal Revenue Service (IRS) requires all businesses, save for partnerships, to file annual income taxes. It’s in addition to annual individual income tax returns filed using IRS Form 1040. This form is one of the official tax documents that taxpayers in the United States use to file yearly income tax returns.
Secondly, businesses with hired personnel are mandated to disclose and deposit various taxes. These include social security and medical taxes combined into the FICA tax, the federal unemployment tax (FUTA), and federal tax withholding.
Sole proprietors, limited liability company members, and general partners must pay self-employment taxes, which cover Social Security and Medicare taxes.
Lastly, estimated taxes apply to businesses quarterly. These taxes offset income tax that isn’t subject to self-employment tax or withholding. Collection and remission of sales taxes are also necessary for companies in the states where they operate.
Tax Implications Of Establishing A Business
The tax implications of a business vary depending on its structure. As a result, if you’re starting a business, you should first decide what kind of business you want. Following that, you can learn about the tax implications of your business. It also helps when you hire a tax attorney to help you understand and navigate your business tax obligations.
Below are the tax implications for different business structures.
1. Sole Proprietorships
Sole proprietors earn a personal income from their businesses. Nonetheless, this doesn’t exempt the income from being taxed as business revenue. As such, sole proprietorships are subject to considerable tax implications.
For starters, sole proprietors pay self-employment tax to fund Social Security and Medicaid. That’s because, unlike other businesses, sole proprietorships have no payroll systems where deductions can be made for Social Security and Medicaid.
Self-employment tax is calculated based on the income recorded under Schedule C in form 1040. In this schedule, sole proprietorships record profits or losses from their operations. The tax amount is then calculated on Schedule SE of the same form and filed together with your taxes. Schedule SE is the section where the taxes self-employed taxpayers owe are figured based on their net earnings. The details on this form are used to calculate a sole proprietor’s benefits subject to the social security program.
In addition, the profits or losses are recorded in form 1040. The amount recorded is a deduction of business expenses such as labor, cost of materials, and employee benefits from the total revenue. The remaining amount is the net profit you file in Schedule C. If your business experiences losses, your deductions are covered by your future taxable income.
Sole proprietors who work from home also qualify for the home office tax deduction. It entails adding up all the costs of operating your business from your home workspace regularly and exclusively. It’s worth noting that the total deductible expenses should be within your business’s income.
2. Limited Liability Companies (LLCs)
This business structure is known for the personal liability it offers its members. It implies that if the company falls into debt, the personal assets of owners are only in danger of being seized if the partners agree on it as a means of financing the business.
The IRS considers LLCs as pass-through entities because any tax liabilities and requirements flow through the business to the personal income tax returns of the members. The good thing about an LLC’s tax structure is its flexibility. LLCs can be taxed as sole proprietorships, corporations, and partnerships. This flexibility allows the companies to retain much of the accrued profits.
As per the IRS, single-member LLCs are taxed as sole proprietorships, while multi member LLCs are taxed as partnerships. The IRS also requires LLCs to file Form 1065 to ensure the income reported by its members is accurate. This information is recorded in schedule K1 of the form and includes the profits and losses of the business.
Taxation for partnerships is done at the individual level. Similar to LLCs, the IRS also considers partnerships as pass-through entities. While partnerships are required to file informational tax returns, they aren’t taxable entities.
General partners are liable for this entity’s debts. However, some organizations aren’t classified under Form 8832 for federal tax purposes. These include real estate investment trusts, insurance companies, and tax-exempt organizations formed after 1996.
Partnerships have tax advantages over other business structures. For one thing, they distribute cash flow and income among partners yearly based on suitability and proportionality. In addition, partnerships are exempt from double taxation because only the individual partners’ incomes are taxed.
Further, besides their relatively easy dissolution, partnerships have the benefit of liquidating tax-free, unlike corporations.
Corporations are divided into C and S corporations. These business structures are complex, as they require the distribution of official resolutions, the drafting of bylaws, and the scheduling of director meetings. Setting up these entities is also time-consuming and expensive compared to other structures.
However, this complexity is what offers tax liability protection to the owners. As such, the personal liabilities of shareholders aren’t threatened in case the corporations encounter losses.
The way C-Corps and S-Corps file their taxes differs significantly. On the one hand, C-Corps file their taxes using corporation tax returns. Included on IRS Form 1120, a corporate tax return contains details about a corporation’s profits and expenses, which are used to calculate the tax owed.
Other business entities, such as LLCs that choose to be taxed as corporations, also use this form to report their taxes. These corporations are liable for double taxation if the shareholders receive dividends from profits earned.
On the other hand, S-Corps aren’t required to use corporation tax returns to file taxes, saving them both time and money. Moreover, unlike C-Corps, S-Corps aren’t subject to double taxation.
The four above are the business structures you may have to consider. Under each business structure is a conclusive discussion of your expected tax obligations.
To Wind Up
Comprehending the tax implications of different business entities before establishing your business is crucial to avoid penalties and enhance compliance. For instance, while sole proprietors earn a personal income, they’re still subject to taxation. Similarly, LLCs have a flexible tax structure that allows them to choose how they want to be taxed.
Furthermore, partnerships are categorized as pass-through entities like LLCs but with more tax advantages. For example, they liquidate tax-free and aren’t subjected to double taxation. More notably, corporations have different tax implications. Unlike S-Corps, C-Corps are liable to double taxation and are required to use the corporate tax return form to file taxes. It’s essential to consult a tax professional before starting your business to ensure you’re on the right track tax-wise.
Sara Palmer is a tax consultant with over 15 years of experience in tax planning, solving tax disputes, and preparing and filing tax returns for businesses and organizations. Her current work entails helping companies file tax returns, ensure compliance with tax regulations, and minimize tax liabilities. She enjoys writing blogs and articles to advise and support businesses and organizations with tax issues during her free time.