There are essentially two ways the IRS taxes businesses and entrepreneurs. We’ll explain them in as few words as possible in this post.
The two primary tax structures
- Pass-Through Taxation: Most businesses are taxed as “pass-through” entities. This means the profits and losses of the company are passed through to the owners’ individual tax returns. Thus, the company does not have any tax liability. Unless you elect otherwise, the following entities are taxed as pass-through business structures: (1) Sole Proprietors; (2) Partnerships; and (3) LLCs.
- Double Taxation: A small number of businesses are taxed twice–mostly corporations. The first tax is paid by the business itself when it recognizes income. The second tax is paid by the business owners when they receive profit distributions. Corporations are taxed like this by default. And while uncommon, LLCs can also elect this tax status.
(What about S-Corps? An S-Corp is just a tax election. When you make this election, you are electing to be taxed under special tax rules. And in certain situations, you can reduce your tax liability by thousands of dollars. You can read more about S-Corps in this three-part blog post series.)
How to report and pay taxes
There are a number of factors that will dictate how you (and sometimes your company) will actually pay your taxes.
Here’s a quick summary:
- Sole Proprietors. Paying taxes as a sole proprietor is the easiest. All income and losses will “pass- through” to your personal tax return and the “business” doesn’t have to file a tax return. There are two parts to paying taxes in this situation: (1) you should pay estimated taxes quarterly to cover your anticipated tax liability (an accountant can help you determine your estimated payments); and (2) you must complete and attach a Schedule C to your personal income tax return where you’ll report your annual profits or losses (you may owe additional taxes or you may get a refund if you overpaid).
- Partnerships. If you are taxed as a partnership, then all of your profits or losses will “pass-through” to the individual tax returns of each partner based on their ownership percentage. There are four parts to paying taxes in this situation: (1) each partner should pay estimated taxes quarterly to cover their anticipated tax liability from their share of the company’s profits; (2) the company must give each partner a K-1 annually to let her know how much profit or loss was allocated to her; (3) the company must file an informational return with the IRS; and (4) each partner must attach her K-1 to her personal income tax return where she will report her annual share of the company’s profits or losses (she may owe additional taxes or she may get a refund if she overpaid).
- LLCs. LLCs are unique and there is not a tax class for LLCs. Rather, the LLC must elect one of the other tax structures. Unless you elect otherwise, single-member LLCs will be taxed like a sole proprietor, while multi-member LLCs will be taxed as a partnership.
- Corporations. If you are taxed as a corporation, then both you and your company will report and pay income taxes. Because this is less common for small businesses we won’t get into the details here. But in short, the corporation will file a corporate tax return and will pay income taxes on its profits. If it distributes money to its shareholders, then the shareholders will report that income on their personal tax returns and they must pay income taxes on those profits.
*This article is very general in nature and does not constitute legal advice.