Tax Reference for Starting a Small Business
Federal Tax Series Part One
Death and taxes are the two guarantees in life, and unlike death, taxes occur repeatedly. Arriving in the form of filing deadlines and bills due, both federal and state tax laws can be intricate for individuals as well as for businesses. It is not uncommon for individuals to turn to software programs for their tax needs, neither is it unusual for businesses to hire professionals to assist with company taxes. A small business, especially one just starting out, might not have the resources to procure a tax professional nor the ability to wade through tax requirements. In an effort to help, Distribution Center is presenting this first installment of a three-part federal tax series for small businesses. Sourced from the Internal Revenue Service (IRS) and other government organizations, this series will provide basic information for starting, operating, and closing a small business in regards to federal taxes.
WHAT TYPE OF BUSINESS IS IT?
When it comes to taxes, selecting the business structure for a new company has significant consequence. There are five different types of business structures — sole proprietorships, partnerships, corporations, S corporations, and limited liability companies (LLC). Take a look at what the IRS website had to say about each of these business structures.
1. Sole Proprietor
In simple terms, the sole proprietor is the only owner of an unincorporated business. The only name on the door is that one person who is doing all the work and writing all the checks. There is an exception to this rule according to the IRS, “If a person is the sole member of a domestic LLC, then they cannot be a sole proprietor if they elect to treat the LLC as a corporation.”
When two or more people join forces to work on a business, that is a partnership. Both contribute to the business and both stand to benefit from the business. Contributions include money, property, labor, or skill; and benefits include the profits, but do not exclude losses. This business structure is hallmarked with an equal share in the good, the bad, and the ugly.
The IRS notes that a partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax.
“Instead, it passes through any profits or losses to its partners,” said the website. “Each partner includes his or her share of the partnership’s income or loss on his or her tax return.”
Businesses that are corporations have shareholders. According to the IRS, prospective shareholders exchange money, property, or both for the corporation’s capital stock. More often than not, corporations have the same deductions as a sole proprietorship to figure its taxable income. It can also be afforded special deductions.
“For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity,” said the IRS. “A corporation conducts business, realizes net income or loss, pays taxes, and distributes profits to shareholders.”
The corporation pays taxes on its profits when earned, and shareholders pay taxes on their dividends when received. Corporations do not get a tax deduction when distributing dividends to shareholders, and shareholders cannot deduct the corporation’s losses.
4. S Corporation
According to the IRS, corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes are considered S corporations. Instead of being double taxed, as in the corporation structure, shareholders of the S corporation report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.
“This allows S corporations to avoid double taxation on the corporate income,” said the IRS. “S corporations are responsible for tax on certain built-in gains and passive income at the entity level.”
To qualify as an S corporation, a company is required to be a domestic corporation, have no more than 100 shareholders, and have only one class of stock. It must also have the correct types of shareholders; for example, individuals, certain trusts, and estates. Partnerships, corporations, or non-resident alien shareholders are considered allowable. The final qualification looks at the type of corporation seeking this status. The IRS notes that certain financial institutions, insurance companies, and domestic international sales corporations are ineligible.
5. Limited Liability Company (LLC)
An LLC is a business structure allowed by state statute. Different regulations often stem from each state. Those looking to choose LLC status are encouraged by the IRS to check with the state of interest for details.
Those who own the LLC are referred to as members. In many states members are not limited to certain types of people or entities. Instead, individuals, corporations, other LLCs, and foreign entities can be members and have a stake in ownership. This does not apply across the board. Single member LLCs are ordinarily permitted in many states. As for a limit on members, there is no maximum.
WHAT DATA SHOULD BE TRACKED?
Choosing a business structure may have significant consequence on a company’s taxes, but so does keeping track of what happens financially in a business. One of the first steps to efficiently keeping track of financial and tax data in a company is to apply for an employer identification number (EIN). Also known as a federal tax identification number, this string of digits identifies a business much like a social security number identifies a person. Tax filings and other government documents cannot be filed without being issued an EIN. The number is good for the life of the business. A new one does not need to be issued unless company ownership or structure changes. The number can be applied for via paper forms, but the IRS explains that it is faster to apply online.
“Good records will help you monitor the progress of your business, prepare your financial statements, identify source of receipts, keep track of deductible expenses, prepare your tax returns, and support items reported on tax returns,” said the IRS. “You may choose any recordkeeping system suited to your business that clearly shows your income and expenses. Except in a few cases, the law does not require any special kind of records. However, the business you are in affects the type of records you need to keep for federal tax purposes.”
When a business has employees, it is required to pay certain tax responsibilities and file forms for these employees and the payments. Employment taxes include social security and Medicare taxes, federal income tax withholding, and federal unemployment tax.
Employment tax records must be retained for four years, according to the IRS. As for the rest of the data gathered and filed, how long it is kept is not regulated. The government does warn, however, that the burden of proof, when it comes to taxes, lies with the business and not with the government.
“The length of time you should keep a document depends on the action, expense, or event that the document records,” said the IRS. “You must keep your records as long as they may be needed to prove the income or deductions on a tax return.”
Watch for the next installment of this series that covers operating a small business in the Aug. 2014 issue of Distribution Center. This article should be used for informational reference only and should not be considered a substitute for consulting a tax professional.
Visit www.irs.gov for more information.
Ten Steps to Starting a Business
Starting a business involves planning, making key financial decisions, and completing a series of legal activities. These 10 steps could help you plan, prepare, and manage a business.
Step 1: Write a Business Plan
Use these tools and resources to create a business plan. This written guide will help you map out how you will start and run your business successfully.
Step 2: Get Business Assistance and Training
Take advantage of free training and counseling services, from preparing a business plan and securing financing, to expanding or relocating a business.
Step 3: Choose a Business Location
Get advice on how to select a customer-friendly location and comply with zoning laws.
Step 4: Finance Your Business
Find government backed loans, venture capital, and research grants to help you get started.
Step 5: Determine the Legal Structure of Your Business
Decide which form of ownership is best for you: sole proprietorship, partnership, Limited Liability Company (LLC), corporation, S corporation, nonprofit, or cooperative.
Step 6: Register a Business Name (“Doing Business As”)
Register your business name with your state government.
Step 7: Get a Tax Identification Number
Learn which tax identification number you’ll need to obtain from the IRS and your state revenue agency.
Step 8: Register for State and Local Taxes
Register with your state to obtain a tax identification number, workers’ compensation, unemployment, and disability insurance.
Step 9: Obtain Business Licenses and Permits
Get a list of federal, state, and local licenses and permits required for your business.
Step 10: Understand Employer Responsibilities
Learn the legal steps you need to take to hire employees.
SOURCE: The U.S. Small Business Administration www.sba.gov