I’m not at all surprised that most business owners are easily confused by the US business tax system. CPAs, attorneys, and enrolled agents struggle with it also. The IRS code is long, complicated, and, yes, even fuzzy at times. But if you’re going to run your own business, it’s absolutely essential that you understand at least the basics of the way the system works.
Many new entrepreneurs, unsure whether their businesses will succeed or not, worry about putting their personal assets at risk. Consequently, they focus on the concept of limited liability when choosing the legal structure for their companies. While this is an important factor to consider, you must realize that your choice of business entity also determines which set of business tax rules you’ll have to follow.
Yes, there are several sets of rules and they can have vastly different effects on your tax bill.
Obviously, I can’t teach you everything you need to know in one blog post, but I do want to cover the main choices that you have.
Sole proprietorship
This is an unincorporated business run by one person. If you start a business by yourself and don’t create any formal legal organizational structure, you’re a sole proprietor. You’ll report the results of your business activities on a Schedule C and file it with your personal Form 1040.
Partnership
If you start your business with one or more other people and you don’t create any formal legal organizational structure, you’ll be considered as a partnership for tax purposes. You’ll report the results of your business activity on Form 1065. The partnership is NOT a taxable entity. What this means is that the various items of income and loss that the business has will pass through to the individuals who will then include them on their personal returns.
The business partnership pays no taxes. It files an information return which includes a Schedule K-1 for each partner, showing his/her share of partnership items. The amounts from the K-1 get included on each individual’s own personal Form 1040 on Schedule E.
Limited Liability Company (LLC)
LLC formation is regulated at the State level. To create an LLC, certain paperwork must be filed with the State. An LLC with one member is treated as a sole proprietorship and files a Schedule C with Form 1040. A multi-member LLC is allowed to choose if it wants to be taxed as a partnership or as a corporation.
I’ll discuss corporations in part 2 of this post.
