One of the most important decisions you must make as you start your journey toward self-employment is determining what your business structure will be.
Whether your company will be a sole proprietorship, an LLC, a partnership, an S-corporation, or C-corporation will affect how your taxable income flows through to your personal tax return, said Phoenix-based certified financial planner Dana Anspach.
If you are a sole proprietor, your business income and expenses should be reported on Schedule C, Anspach said. You’ll be responsible for paying self-employment taxes -- such as Social Security and Medicare.
“If you have a business partner, you will file as either a partnership or as a corporation,” she explained. “A partnership must file an information return, but it does not pay income tax.”
Information returns are tax documents (the most common being Form W-2) that businesses and taxpayers must file to report certain business transactions to the Internal Revenue Service. You use Form K-1 to report partnership income to the federal government.
Choosing to file as a C-corporation would be highly unusual for a start-up. Anspach says she can only see a new business owner choosing this organizational structure if a personal accountant or CPA recommended it for advanced tax benefits.
“Unlike a sole proprietorship or a partnership, a C-corporation is recognized as a separate tax-paying entity for federal tax purposes,” she said. That means the corporation may take special deductions, she explained. It also means the profit it earns is taxed at the corporate level, then taxed again when it is distributed as a dividend to shareholders.
S-corporations are similar to partnerships in that your income flows through to your personal tax return, Anspach noted. But they are like C-corporations in that you may set a salary and withhold payroll taxes at the corporate level. Some or all of your income may be reported to you on a Form W-2 at the end of the year.
One of the advantages of being an S-corporation is the taxpayer’s ability to choose a salary, subject to reasonable guidelines, she said. But Anspach cautioned entrepreneurs to consult an experienced CPA or accountant: There can be serious tax ramifications should a person severely underpay himself when the business is making money, because wages are the only taxable income the IRS can subject to payroll taxes.
Although an LLC is a legal business structure, it is a state-level designation that is not recognized for federal tax purposes, Anspach said. It must file as a corporation, partnership or sole proprietorship.