The form that your business is categorized as is a very important decision that you should not take lightly. As you start your business and set the stage for your company's future, you will operate as either a sole proprietorship, partnership, limited liability company, corporation, or pass-through or corporate entity.
While the type of business matters in many ways, one of the most important aspects of how you categorize your business will be the taxes that you pay. Keep reading to better understand the IRS situation you'll find yourself in from day one depending on the type of business you operate.
Sole proprietorships are unincorporated businesses. If you have this type of business, your tax responsibilities may include income tax withholding, Social Security taxes and Medicare taxes in addition to the usual federal unemployment tax and income tax.
A partnership in the business sense is a relationship between two or more people with the intention of doing trade or conducting business in situations where each person contributes money, property, labor or skills while also sharing in the profits and losses of the business.
With a partnership, you must report your business's income, including gains, losses and all deductions, via the annual information return. Each business partner is required to report their share of the losses and income from the partnership via each individual's personal tax return. The partnership must report all its tax-related finances on Schedule K-1.
In a partnership, each individual may need to file the following forms and information:
LLCs are business structures permitted by state statute. However, for the sake of federal tax purposes, this classification is considered either a corporation or a partnership.
When you form a corporation, those who are considered prospective shareholders are the people who exchange money and property, if not both, for the corporation's stock. A corporation will generally take the same deductions that a sole proprietorship does. However, a corporation can take special deductions on top of those associated with sole proprietorships.
S corporations cannot have more than 100 shareholders. While not all businesses are eligible for the S corporation designation, those that are can take advantage of benefits such as pass-through corporate income, losses, deductions and credits attributed to shareholders for the sake of federal tax.
Shareholders must report flow-through income and losses as part of their personal tax returns. These reports will be assessed in terms of tax owed at their individual income tax rates, meaning they can avoid having to pay double the amount of taxes on their corporate income too. Additionally, S corporations are responsible for paying taxes on built-in gains and passive income at entity levels.
Here are the forms that each type of business must fill out and file:
Pass-through and corporate entities
Pass-through businesses are small businesses that are similar in structure to S corporations, LLCs, sole proprietorships and partnerships. In fact, pass-through businesses are so common that they account for about 95% of all U.S. businesses.
Tax reform laws and standards
In 2017, a tax reform law offered a deduction worth 20%, but new standards in 2022 phased out the 2017 tax reform law in terms of taxable income levels ranging from $170,050 to $220,050 for single filers. The income levels are adjusted to a minimum of $340,100 and a maximum of $440,100 for those who file jointly. As of 2023, phase-out limits are currently set at $182,100 for those filing as single filers and $340,100 for those who file jointly.
While these limits are in place at the moment, these values are set to expire in 2027. Since the 2017 tax law has been temporarily suspended, businesses cannot deduct total losses greater than $540,000 per year for those who are married and filing jointly. The deduction limit for single filers is $270,000.
This information applies to all business-related income and losses. The income and losses of both Schedule C and pass-throughs are included in this. But if you have losses that exceed the annual limits, you are permitted to carry these losses with you into the next year as a way of lowering your taxable income in future years.
Business losses are no longer permitted to offset W-2 wages. Furthermore, spousal income is taxed separately, and because of this, spousal income might result in a subsequent tax bill regardless of whether the business losses exceed the total spousal income. Also, small-business owners who were the recipients of more than $600 from third-party digital platforms, like Amazon, Etsy or eBay, will receive Form 1099-K as a means of reporting this type of income in 2023 and beyond. Not only do small-business owners have to report this income, but platforms must also do so. That said, pushback from taxpayers and businesses resulted in a postponement of 2023 Form 1099-K until 2024.
Keep in mind that this article is simply an overview of what is a complex topic that involves very hard decisions. Make sure you work with financial and legal professionals who can help you answer your business-specific questions.
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