When you start a new business the IRS will put you into one of four tax classes. Do you know the differences?
While you don’t need to be an expert, you should understand the differences in these tax classes to make sure you are compliant with tax laws. Sometimes you must stick with the default, but other times you can elect a different class. Below is a recap of your options.
1. Sole Proprietorship Taxation
Being taxed as a sole proprietorship is the easiest – the IRS will treat all your income and loss as personal, which means you don’t have to file a business tax return. Rather, you report the income/loss on your personal tax return using Schedule C. Sole proprietors should make estimated tax payments quarterly and will owe taxes on profits, even if they are not distributed to your personal bank account.
Who can elect sole proprietorship taxation?
- Sole proprietors (freelancers) operating without a formal business entity
- Single-member LLCs
2. Partnership Taxation
Much like sole proprietorship taxation, partnership taxation will “pass through” income and loss to the personal returns of the partners using a K-1. The partnership itself won’t owe taxes but it does have to file an informational return with the IRS. And just like sole proprietors, partners should make estimated tax payments quarterly and will owe taxes on profits, regardless if they are distributed.
Although it seems simple, partnership tax is very complicated and you should get professional tax help if your business is taxed as a partnership
Who can elect partnership taxation?
- Partnerships (all forms of partnerships, including accidental partnerships)
- Multi-owner LLCs
3. Corporate Taxation
It is often said that corporations are subject to “double tax” because they are taxed twice. The corporation will file its own tax return and pay income taxes on profits. Then, if profits are distributed to the shareholders, the shareholders will pay taxes on those dividends. This is one of the biggest drawbacks of being a corporation, however, corporations can make an S-Corp election (see below) to minimize the tax burden to some extent.
Who can elect corporate taxation?
- Single-owner LLCs (although this is rare)
- Multi-owner LLCs (this is rare too)
4. S-Corp Taxation
An S-Corp technically isn’t a business entity, it is just a tax classification (under Subchapter S of the IRS Code). If your election is approved, the IRS will “pass through” your income and losses to your personal return, even if you are a corporation. Not only does this do away with corporate level taxes, but you can also reduce your tax burden even more in certain situations.
However, you shouldn’t make an S-Corp election without careful planning since there are limitations on S-Corp ownership. To learn more, check out our S-Corps 101 Series.
Who can elect S-Corp taxation?
- Single-owner LLCs
- Multi-owner LLCs
*This article is very general in nature and does not constitute legal advice.