Any entity that earns income is subject to federal taxes. Depending on how you establish your enterprise, it will be taxed either separately or through your personal income. Corporations and limited liability companies (LLCs) are functionally distinct from you, so their income and yours are taxed individually.
Partnerships are separate from you, but they aren’t taxed directly. Instead, each member of the arrangement pays taxes on his or her share of the income. If you operate your business as a sole proprietorship or act as an independent contractor, your revenues will be taxed as your income because your enterprise activities are not considered distinct from you. What this means in practice is that you would incorporate profits and losses into your personal tax return.
Business taxes differ from regular income tax in that they are not withheld automatically from earnings. Because of this, commercial taxes are typically paid throughout the year as revenues come in. This helps prevent penalties being assessed at the end of the tax year due to underpayment of federal obligations. This kind of payment is called estimated tax because it’s based on projections of total yearly income derived from incomplete information. It’s paid quarterly.
A Closer Look at Organizational Types and Taxes
As mentioned before, there are several ways to structure a business (e.g., corporation or sole proprietorship). The way in which yours is set up will determine how you file your taxes:
- Sole Proprietorship — Unincorporated and individually owned, this is the simplest type of organization to start and operate. A proprietorship doesn’t exist apart from its owner and shares liabilities with him or her. The owner accepts liability and risk for all assets, whether used in the enterprise or not. Revenue and expenses from a sole proprietorship are included in the owner’s personal tax return.
- Partnership — An arrangement between two or more individuals to mutually engage in some commercial activity. Participants each contribute some portion of capital, property, skill and labor to the undertaking and each expects to share in the profits. A partnership is required to file an information return to report revenues, deductions and expenditures related to its operations, but it doesn’t pay income tax. Instead, any profit or loss is passed through to the members of the partnership, who would be responsible to report their respective shares of the business’ income on their individual tax returns.
- Corporation — Incorporating a company creates an entity that can stand apart from its owners and function independently of them. A corporation is created when principals exchange some combination of money or property for portions of ownership interest — or shares — in the resulting company. A corporation takes most of the same deductions as a sole proprietorship, but also may take certain special deductions. The corporation pays tax on profits as they’re earned, and shareholders pay taxes on dividends issued on their shares. Shareholders may not deduct any of the corporation’s losses.
- S Corporation — If eligible, a domestic corporation may opt to prevent the business and shareholders from being double-taxed through treatment as an S corporation. This type of organization is usually exempt from paying federal income tax except on certain capital gains and passive income. S corporation shareholders include on their tax returns their share of the enterprise’s separately stated income, deduction, loss and credit, as well as their portion of non-separately stated income or loss.
- Limited Liability Company — This kind of business is designed to insulate its owners from certain exposures. Participants in an LLC aren’t personally liable for debts it incurs. For tax purposes, an LLC may be classified as a partnership, a corporation or an entity disregarded as separate from its owners.
An Inevitability of Life
No matter the kind of business structure, taxes must always be paid on profits. Consider carefully the differences between the ways of organizing your enterprise and choose the style that best addresses your individual and commercial needs.
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