Last year, the tax reform changes had a dramatic impact on your business. The impact was even more extreme, depending on the type of business entity you filed as on your tax return. We are going to discuss what a business entity is, define each entity, and get a refresher on what the changes were.
If you’re new or unsure what a business entity is, let’s start with the basics. What is a business entity? A business entity is the type or structure of your business. Typically, this is established when filing with your state’s Secretary of State.
Types of business entities include corporations, partnerships, limited liability companies, limited liability partnerships.
Then your business entity is broken down even further into two categories deciding how they will be taxed: pass through and double taxation.
Pass-through entities include Sole Proprietorships, Partnerships, LLCs and S Corporations.
C Corporations are the only entity that classifies as double taxation.
It’s important to figure out what the right scenario is, not only for your business but also for your household income. Choosing the wrong one could result in an unnecessary increase in your tax liability.
A sole proprietor is someone who owns an unincorporated business by themselves. Sole proprietorships require the least formalities and the owner is personally liable for all the business’s debts and obligations.
If you decide to operate your business as a sole proprietor, you may want to file a trade name application. Registering your trade name gives you certain statutory rights, including the right to bring a civil action for misuse of your trade name and the right to bring a civil action to stop the use or sale of any counterfeits.
Business income and expenses for a sole proprietorship are reported on a federal Form 1040, on Schedule C.
A Limited Liability Company (LLC) is a hybrid business entity that gives the owners the option to be taxed as a partnership or a corporation.
An LLC is similar to a corporation because the owners (members) have limited personal liability for the debts and actions of the company, but it can have the tax advantages of a partnership or S-Corp in that the profits and losses of the company can be passed through to the owners.
Generally, LLCs have fewer formal requirements than corporations and more freedom in the management of the company.
Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC owner’s tax return (a “disregarded entity”). By default, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes and an LLC with only one member is treated as a disregarded entity. If you would like to change this, you must file Form 2553 Election by a Small Business Corporation and affirmatively elect to be treated as an S Corporation for tax purposes.
Partnerships are basically self-explanatory. A partnership is an association of two or more people carrying on as co-owners of a business. The partners are personally liable for all debts and obligations related to the business. Each person contributes money, property, labor or skill, and expect to share in the profits and losses of the business. A partnership must file an annual return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its individual partners, via K-1, who then report his or her share of income and losses on their own individual tax returns.
While forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. The owners in this scenario are called shareholders. They have limited personal liability for the debts and obligations of the corporation.
The corporation must meet the following requirements to qualify for an S-Corp:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
S Corporations file their taxes on the Form 1120S and, like Partnerships, S-Corps pass most income and losses to shareholders via K-1, who report this information on their individual tax returns.
Special Deduction for Pass-Through Entities
The new tax laws gave all pass-through entities a special 20 percent deduction on net profit called Qualified Business Income (QBI) deduction. We will be discussing this topic in more detail in a future post.
Double Taxation Entity
For federal income tax purposes, a C Corporation is recognized as a separate taxpaying entity. This is the least common business entity that new business owners consider because C Corporations are subject to double taxation.
The C Corporation files a Form 1120, where it reports all income and deductions. A C Corporation is then taxed on their net profits for the year, without regard to how much was paid out to shareholders as dividends. The corporation does not get a tax deduction when it distributes dividends to shareholders and the shareholders report the dividends as income on their personal tax returns. Therefore, this is what creates a double tax. On top of this, shareholders are not able to deduct any losses of the corporation.
If you are still unsure which entity to file your business under, we can solve that problem. Contact Verdant to discuss your best strategy. Choosing the right entity is very important in order to reduce tax liability for your business and possibly your family.
Verdant Accounting assists with much more than taxes, we have services to help start, maintain and leave or pass down your business. Schedule an appointment with us today to plan your business ventures. Your first consultation is always FREE.
Source: IRS.gov (follow the link for detailed lists of all forms needed to file for each entity)