An important consideration when you're deciding what type of business to form is how each one of them pays income taxes. The process is different for each, sometimes markedly so, and types of business taxes can have a significant impact on your personal tax return.
Some businesses pass their earnings and losses to their owners, who pay income taxes on their share of the business's taxable income. These are called "pass-through" taxes.
Businesses that are pass-through tax entities:
- Sole proprietorships
- Limited liability companies
- S corporations
Corporations are not pass-through businesses. The corporation pays income taxes on its earnings, and the individual shareholders (owners) pay income tax on dividends they receive.
Here's an explanation of how pass-through taxes work:
- The business gathers information about its income, deductions, tax credits, and other information and prepares its tax return.
- The net income from that return is the result of that calculation.
- The income tax on the net income is divided between the owners based on their share of the business. One-owner businesses (sole proprietors and single-member LLCs) are taxed on the entire amount of net income.
- The amount of taxable income is included on a special report form. This form is different for each type of pass-through business.
- This business tax amount from the form is included on the individual owner's tax return, along with other income and expenses.
Self-Employment Tax for Business Owners
Owners of pass-through businesses also must pay self-employment tax (Social Security/Medicare tax) on their business income. S corporation owners are an exception; they don't have to pay self-employment tax.
How a Sole Proprietor Pays Income Tax
A sole proprietorship is the simplest form of business in the U.S. You're a sole proprietor if you're self-employed or an independent contractor unless you've registered as another form of business entity. A sole proprietorship is more or less formed by default when you don't take steps to register as another type of enterprise but you're in business for yourself.
Sole proprietors complete Schedule C to determine their taxable business income after deductions. The income resulting from Schedule C is transferred to the owner's personal tax return and tax is paid at the owner's personal tax rate.
Sole proprietors must also file Schedule SE and pay the self-employment tax—the equivalent of the Medicare and Social Security taxes that would otherwise be shared with their employer if they worked for someone else.
You should make quarterly estimated tax payments throughout the tax year if you're a sole proprietor because the IRS prefers that you pay as you earn. This involves filing Form 1040-ES.
How a Partnership Pays Income Tax
A partnership is the result of two or more individual taxpayers joining together for business purposes, and they share in both the profits and the losses of the business. Partnership businesses don't pay income tax directly to the IRS. Their partners are taxed on their shares of the partnership's income.
Business income or loss is calculated on Form 1065, and the individual partners then receive Schedules K-1 showing their shares of this income. Schedule K-1 is included with the owner's personal tax return and taxes are paid at the owner's personal tax rate, just as they would be if they were sole proprietors.
Partners must also pay the self-employment tax and make quarterly estimated tax payments.
How a Limted Liability Company (LLC) Pays Income Tax
A limited liability company (LLC) isn't recognized by the Internal Revenue Service as a business entity for tax purposes, so LLCs are taxed as other business entities. This can depend on how many owners the business has (referred to as members). Members can be individuals or other business types, such as a corporation.
A member in a single-member LLC files taxes as a sole proprietor does, using Schedule C and Schedule SE. As with a sole proprietorship, the income of the business is transferred to the member's personal tax return. LLC members should also pay quarterly estimated taxes.
A multiple-member LLC files taxes as a partnership, with individual member shares reported on Schedule K-1. It can also file Form 8832 and elect to be treated as a corporation for federal tax purposes.
A corporation is its own separate tax entity, and it pays income tax at the corporate tax rate. The owners of the corporation are shareholders, and they receive income in the form of dividends. They pay taxes on this income at the dividend rate.
This can result in double taxation. The business is paying taxes on its earnings at the corporate level, and shareholders are again paying taxes on the dividends they receive. Capital gains on the sale of shares can also be taxed at the individual level.
Some shareholders might also be executive employees of the corporation. These employees receive a salary and this income is taxed just as it would be for any other employee.
A corporation reports and files its taxes on Form 1120.
How an S Corporation Pays Income Tax
An S corporation is a type of corporation that pays taxes at the personal tax rate of the owners. It passes income, taxes, credits, and deductions down to its owners. The S corporation does not itself pay taxes, unlike a corporation, so there's no double taxation.
The tax paid by the owners/shareholders is determined by the total amount of the tax that would be owed by the S corporation were it required to pay taxes. This total is then divided among the shareholders based on their percentages of ownership.
The corporation files a tax return using Form 1120-S to report income passed down to shareholders, and individual owner shares are reported on Schedule K-1.
If One Business Owns Another Business
One business can own another business. For example, a corporation can own all or part of an LLC, or one LLC can own another LLC.
The owner pays the taxes if the company being taxed is a pass-through business entity—a partnership, LLC, or S corporation that passes its tax down to its owners. For example, the tax for an LLC would be calculated and the tax would be reported by the corporation if the corporation owned the LLC.
The corporation itself pays the tax if the business owned by another business is a corporation; the owners don't.