What is my tax classification?
Many of you have been thinking about starting your own businesses or just being self-employed in general. There is a certain appeal in being your own boss.
Before you take your first step into the world of entrepreneurship, there are several factors you will need to consider in order to avoid potential tax problems.
Remember, if you start your business on the wrong tax compliance footing, you may encounter problems that may be very costly to resolve in the future.
After acquiring the requisite start-up capital and having put forth a good business plan, it is time to venture into the entrepreneurship realm. You will need to decide on the business structure.
The business structure you choose influences everything from day-to-day operations to taxes, to the paperwork you need to file, to your personal liability. You will need to choose a business structure before you register your business with the state.
Most businesses will also need to get a tax ID number and file for the appropriate licenses and permits. You should choose a business structure that gives you the right balance of legal protections and tax benefits.
Who is eligible to pay tax?
The first thing you need to know is the legal and tax classification of your entity. Different entities have different business structures and are taxed differently by the Internal Revenue Service. The most common ones are
- The Sole Proprietorship
- The Single Member Limited Liability Company (or simply Single Member LLC),
- The Partnership,
- The C-Corporation (or simply Corporation).
- The Small Corporations (or simply the S-Corp) and
Each entity has different tax reporting obligations and therefore, each has different record keeping requirements.
The American tax system is based on the honor system. This means that the IRS depends on you to honestly declare all your gross income, deduct all your allowed expenses, and pay a percentage on your net income.
Declaring your income and the related expenses is called “Filing your Tax Return”. You will do this every year for all incomes earned between January 1st and December 31st of each year.
Everyone with taxable income files their tax annual returns on IRS Form 1040.
There are various versions of this form depending on your immigration status in America. For instance, a non-resident will file IRS Form 1040-NR. Senior citizens may file Form 1040-SR.
Which business structure suits me best?
The Sole proprietor:
A sole proprietorship is easy to form and gives you complete control of your business. You’re automatically considered to be a sole proprietorship if you do business activities but don’t register as any other kind of business.
Sole proprietorships do not produce a separate business entity. This means your business assets and liabilities are not separate from your personal assets and liabilities. You can be held personally liable for the debts and obligations of the business.
Sole proprietors are still able to get a trade name. As a sole proprietor, in the eyes of the IRS, there is no difference between you (the Person) and your business. Your business income and expenses should be reported on Schedule C.
You will be responsible for paying self-employment taxes—such as Social Security and Medicare. Sole proprietorships can be a good choice for low-risk businesses and owners who want to test their business idea before forming a more formal business.
The Single Member LLC:
You may start a Limited Liability Company by yourself and be the only member of the LLC. This is also called a Single Member LLC.
In the eyes of the IRS, the Single Member LLC is considered a disregarded entity and as such, there is no difference between a Sole Proprietorship and a Single Member LLC. They are all taxed in a similar way.
A single-member LLC does not pay federal income taxes. Any profits reported by the Single Member LLC are passed wholly to the sole member who in turn declares these profits on his personal Form 1040. This is why it is referred to as a “Pass-Through Entity.
The Single Member LLC is a step above the Sole Proprietorship in that it established a separate legal business entity. This means your business assets and liabilities are separate from your personal assets and liabilities for legal purposes (not for IRS purposes).
You cannot be held personally liable for the debts and obligations of the LLC (unless you “pierce the corporate veil”).
If you have a business partner, you are required to report your incomes and expenses on IRS Form 1065. A partnership does not pay federal income taxes. Any profits reported by the partnership are divided amongst the partners according to their Profit-Sharing Ratios.
This leaves a balance of zero and this is why they do not pay federal income taxes themselves.
This is also why it is referred to as a “Pass Through Entity. The share of income is reported on Schedule K-1 and the partner is then required to report this income on their personal income tax return (Form 1040)
These are legal entities that are separate and distinct from their owners. Corporations enjoy most of the rights and responsibilities that individuals possess. They can by themselves enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets, and pay taxes. They are also referred to as “legal persons.” Any acts of the corporations are considered the acts of the corporations and not the acts of the members of the corporation.
Unlike sole proprietors, single member LLCs, partnerships, and S-Corps, Corporations pay income tax on their profits. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns.
C Corps file their taxes on IRS Form 1120 and report the Members share of profits on Schedule K-1 just like the partnerships.
The Small Corporations (or simply the S-Corp)
An S Corporation is a special type of corporation that’s designed to avoid the double taxation drawback of regular C corps. It is a Sole Proprietor and a Corporation hybrid. S corps allow profits, and some losses, to be passed through directly to owners’ personal income without ever being subject to corporate tax rates.
Not all states tax S corps equally, but most recognize them the same way the federal government does and taxes the shareholders accordingly.
Some states tax S corps on profits above a specified limit and other states don’t recognize the S Corp election at all, simply treating the business as a C corp. S corps also have a separate legal existence just like C corps.
If a shareholder leaves the company or sells his or her shares, the S Corp can continue doing business relatively undisturbed. S corps can be a good choice for businesses that would otherwise be a C Corp, but meet the criteria to file as an S corp. S-Corps file their taxes on IRS Form 1120-S and report the Members’ share of profits on Schedule K-1 just like the partnerships. They are also “Pass-Through Entities”.
What do I require to start a business?
Every eligible citizen or legal resident of the US has a Social Security Number. This number was initially designed to facilitate paying taxes and getting social security benefits. It was never intended to be an identifying tool but is now commonly used for identification purposes.
When you start a business, your business needs a number to be able to file the various business information returns. It needs a number similar to the Social Security Number. This number is referred to as the Federal Employer Identification Number (or simply the EIN).
Likewise, this number has evolved into an identifying tool. Registering a business is a two-part process. Register your business with your state (usually with the Secretary of State Department) and then file with the IRS to get a EIN.
Can I lie on my taxes?
Remember, it is totally upon your honor to declare your gross incomes, deduct all allowable expenses and pay taxes on your Net Profit. Taxes are dependent on the Net Profit and not on the Gross Revenues. If your profits are small, your tax liability will be small. Being an honor system, the penalties for filing fraudulent (inaccurate) tax return are huge. They carry hefty jail terms.
The IRS conducts tax audits based on different unknown criteria and so for this reason, if you are found guilty, you may face penalties ranging from punitive penalties, fines, interest, and even repossession of personal property. Filing a false return or tax evasion is a felony and is the most serious type of crime.
That is because from the IRS’s perspective if a person intentionally or willfully seeks to evade tax, they are trying to steal money from the United States citizens by artificially reducing their tax liability, and the IRS wants and enforces payback. The maximum prison sentence is five years; the maximum fine is $100,000.
This is just a guide and should not be treated as legal tax advice. Always check with your local tax authorities on what is required in order to be able to file your taxes.