When it comes to starting and running a business, understanding the different types of business entities and their associated taxation types is crucial. The choice of business entity can impact your tax obligations and liability. In this blog post, we will break down the various business entities and explore the different taxation types they are subject to.
Understanding Business Types
There are four main types of businesses:
1. Sole Proprietorship
Definition: A sole proprietorship is a business owned
and run by one person. This is the simplest form of a business
Examples: Think of freelancers, photographers, personal hairdressers, babysitters, tutors, and similar small businesses.
Taxes: Sole proprietors deal with income tax, self-employment tax, and
estimated taxes if they choose that method of payment.
2. Partnership
Definition: Partnerships form when two or more people come together to manage a business and share its profits.
Examples: If you and your best friend decide to go into a clothing business together. Starbucks and Target, or Apple Pay and Mastercard can be seen as partnerships.
Taxes: Partnerships can be subject to estimated taxes if they choose this method. General partners pay self-employment taxes on their business income. Limited partners may also be subject to self-employment taxes if they receive guaranteed payments for services provided to the partnership.
3. Corporation
Definition: Corporations are separate legal entities from their shareholders (owners).
Examples: Think of big companies like Amazon, Pizza Hut, or Apple.
Taxes: Corporations are subject to income tax, employment tax for their workers, and sometimes excise tax, depending on their activities. Excise tax can often be deducted as a business expense. It's important to note that corporations face double taxation, meaning profits are taxed both at the corporate level and again when distributed as dividends to shareholders.
4. S Corporation (S Corp)
Even though we included them under the business entities, S-Corporations are really a form of tax on their own
Definition: S Corporations pass their income, losses, deductions, and credits through to their shareholders, avoiding double taxation.
Examples: Any corporation can choose to become an S Corp if it suits its tax strategy.
Taxes: S Corps don't pay federal income tax as a business entity. As we previously stated, instead, shareholders report income or losses on their individual tax returns.
For more information on the fundamentals and processes of S-Corporations, you can check our previous blogs, "Payroll Compliance" and "LLC vs. S-Corp"
Navigating Tax Obligations
Now that we've covered the main business entities, let's explore the various tax types your business might encounter:
1. Income Tax
Description: Income tax is what businesses pay on their
earnings and profits.
Details: For most businesses, income tax is a significant part of their tax obligations. Partnerships do not pay income taxes at the entity level. Instead, profits are divided among the partners who report their share on their personal tax returns.
2. Self-Employment Tax
Description: Self-employment tax includes social security and Medicare taxes for individuals who work for themselves.
Details: You're subject to self-employment taxes if you earn $400 or more. Certain church workers may also need to pay self-employment taxes based on their employment and earnings.
3. Employment Taxes
Description: Employment taxes are deducted from employees' paychecks and cover Social Security, Medicare, and federal income tax.
Details: These taxes are deducted from employee wages and help fund programs like Social Security and Medicare. Employers also pay Federal Unemployment Tax (FUTA) to support state workforce agencies.
4. Estimated Taxes
Description: Estimated taxes are paid quarterly to cover income and self-employment tax.
Details: You have several ways to make estimated tax payments, including online options, electronic bank withdrawals, IRS Direct Pay, using debit/credit cards, or mailing a check with IRS Form 1040-ES.
5. Excise Tax
Description: Excise taxes are added to the sale of specific goods, services, or certain activities.
Details: These taxes apply to items such as fuel, heavy trucks, airline tickets, indoor tanning, and tobacco products. They can be imposed at different stages, such as import, manufacturer's sale, retailer's sale, or consumer use. Businesses involved in these goods often file Form 720 to pay excise taxes. The revenue from excise taxes typically funds related projects, like road maintenance or public health campaigns.
In this exploration of business entities and taxation, we've dissected the essence of entrepreneurship. We've classified the core business structures, from the simplicity of sole proprietorships to the complexity of corporations and S Corporations. Alongside, we've demystified the realm of income tax, self-employment tax, employment taxes, estimated taxes, and excise taxes.
As you trickle through the world of business, grasp the importance of choosing the right entity and complying with tax obligations. Remember, tax laws can be intricate and ever-changing. Seeking professional guidance ensures you're on the right path toward entrepreneurial success, financial security, and tax compliance.
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