Federal income taxes
Whether you're an employee, a consultant or a business owner, you will have to file an individual federal tax return and pay federal income taxes. Your tax liability will vary depending on your business's structure, your income and other sources of household income for the year. For more information, see details below according to different business types and consult the IRS website's small business and self-employment page.
If you haven't created a separate business entity and are running your company as a sole proprietorship, you don't have to file a separate business income tax return — all business revenue and expenses get reported on your individual tax return. You'll still want to keep precise business records, as you'll record your business income and expenses on Schedule C, which is part of your individual tax return.
Once your business is operational, you might still be eligible for a variety of tax credits or deductions that can help lower your tax liability.
For example, you could get a deduction for the business percentage of your auto expenses (or take the 2019 standard mileage rate of 58 cents per mile) when you use your vehicle for business purposes, and you might be able to deduct a portion of your home's mortgage interest, real estate taxes, insurance, utility bills and repairs if you have a home office that qualifies for the home office deduction.
All profits from the business are subject to income taxes as well as “self-employment tax,” which are the employee and employer halves of Social Security and Medicare. Because no payroll is being run (as would be the case if you were an employee), the IRS wants to collect these taxes on your “earned income.”
Even if you regularly file your own tax return, you may want to hire an accountant who is familiar with your industry to review your return and explain which tax deductions or credits you can claim. You may also qualify for free tax preparation through the IRS's Volunteer Income Tax Assistance (VITA) program.
Partnerships are similar to sole proprietorships in that the tax responsibility “passes through” to the business's owners. Unlike a sole proprietorship, the business needs to file an information return with the IRS, Form 1065 U.S. Return of Partnership Income, also known as a partnership tax return.
The information return tells the IRS about your partnership, such as its revenue, expenses and tax credits for the year. But the partnership doesn't submit a tax payment with the partnership tax return because the profits pass through to the partners, who will then pay taxes on their individual tax returns.
The partnership return generates Schedule K-1s, which it must send to each partner showing his or her portion of the partnership's profits or losses. A copy of each Schedule K-1 also gets sent to the IRS as part of the partnership return. The partners will need this information to file their individual tax returns, where they'll determine how much tax they owe on their portion of the proceeds.
C corporations must file a corporate income tax return, Form 1120, and pay a flat 21 percent federal corporate income tax on the profits. This is much less than the top individual tax rate of 37 percent. However, not only does the corporation pay tax on any profits, but individual shareholders also pay taxes on any dividends they receive. In addition, if you are actively involved in the operation of the small business, you're likely an employee as well as an owner of the corporation.
The company must pay you a salary for your work, and it should withhold income, Social Security and Medicare taxes (i.e., withholdings) from your pay and send the money on to the IRS. The wages and employer portions of tax payments (employer halves of Social Security and Medicare, as well as unemployment taxes) are all business expenses that can decrease the corporation's taxable income.
The corporation should send you and the IRS a Form W-2 reflecting your salary and withholdings for the year, in addition it should send the IRS and your state other payroll related forms, such as a Form W-3. You'll use the W-2 to complete your individual tax return.
As the owner of the corporation (i.e., a shareholder), you could choose to distribute corporate profits as a dividend. A dividend isn't a business expense, it simply means the corporation is giving its profits to the people who own the corporation. Because it's not an expense, corporations pay corporate income taxes on the money.
The company should provide a Form 1099-DIV with your dividend income and file one with the IRS. You'll need the form to complete your individual tax return as it is taxable income to you as an individual.
Corporations that elect for S corporation taxation are pass-through entities. Similar to partnership returns, they don't pay corporate income taxes. Instead, the income from the S corporation passes through to the individual shareholders and gets reported on the owners' individual tax returns. The owners have to pay taxes on their share of the income. However, S corps still have to file an 1120S information return to report the business's activity to the IRS.
To understand why some small business owners choose to use an S corporation, consider a simplified example where you are the sole owner and only employee of an S corporation that made $90,000 in profit last year.
You receive a $60,000 salary as an employee of the company, which you determine is a reasonable salary based on how much employees of similar companies in your area make. That salary is subject to Social Security and Medicare taxes of approximately $9,000.
However, as the sole owner of the company, you can then receive the remaining $30,000 as an owner distribution (which is described later), which is not subject to Social Security and Medicare taxes This is a major difference from sole proprietorships and partnerships, where the entirety of the profits are subject to Social Security and Medicare.
S corporations file an information return with Form 1120S, file Form W-2s and other appropriate payroll forms for employee wages and report owners’ shares of income and losses with a Schedule K-1s.
Limited liability companies
With an LLC, how you report and pay federal income taxes will depend on how you elected to have your LLC taxed and the number of members (i.e., owners).
You could elect to have the LLC taxed as either a C corp or an S corp and follow the rules for those types of entities. This requires a special election by sending in a Form 2553 to the IRS requesting this treatment.
Or, if you're the sole owner and don't elect for corporation taxation, your LLC will be taxed as a sole proprietorship. The LLC's income or losses will flow through to your individual tax return and be reported on a Schedule C.
By default, the IRS will treat multi-member LLCs as partnerships. You will have to file an information return for the LLC, but the LLC doesn't have to pay any corporate income taxes, as the IRS views it as a partnership. All the profits and losses get passed through to the owners.
In most states, if you own an LLC with your spouse, the LLC is taxed as a partnership. However, if you live in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), where one spouse's income or debt is considered both spouses' income or debt, you can choose whether you want the LLC to be treated as a partnership.