Tax Considerations
I always used to tell my clients, the IRS is like an owner in your business – It gets a cut of the profits too. How much of a cut can depend on the entity and of course the circumstances. I will talk about federal income tax and deductions in this section and save a brief discussion on self-employment taxes for the next section.
| Business Entity | Taxation |
|---|---|
| C-Corporation | Corporate Taxation IRC Sub. C |
| Partnership | Pass Through via IRC Sub. K |
| Limited Liability Company (LLC) | Pass Through via IRC Sub. K |
| Sole Proprietor | Owner |
| S-Corporation | Pass Through via IRC Sub. S |
Sole Proprietorships
Remember that sole proprietorships are not entities separate from their owners. As such, the owner reports all business-related tax items on their personal federal income tax Form 1040 and Schedule C “Profit or Loss From Business.” It is pretty straightforward and only two pages. Once the numbers are computed on the Schedule C, the bottom line – which is net profit or net loss – gets transferred to page one of the Form 1040 (in 2020, this was on line 3). Here is the income portion of the Schedule C.
Part I Income
| Tax Item # | Item Description | Tax Item Line # | Response Area for Tax Item |
|---|---|---|---|
| 1 | Gross receipts or sales. See instructions for line 1 and check the box if this income was reported to you on From W-2 and the “Statutory Employee” box on that form was checked . . . . . . ☐ | 1 | – |
| 2 | Returns and allowances . . . . . . | 2 | – |
| 3 | Subtract line 2 from line 1 . . . . . . | 3 | – |
| 4 | Cost of goods sold (from line 42) | 4 | – |
| 5 | Gross profit. Subtract line 4 from line 3 | 5 | – |
| 6 | Other income, including federal and state gasoline or fuel tax credit or refund (see instructions) | 6 | – |
| 7 | Gross income. Add lines 5 and 6 | 7 | – |
And part of the expenses portion:
Part II Expenses. Enter expenses for business use of your home only on line 30.
| Tax Item Line # | Tax Item description | Item # for Response | Response Area |
|---|---|---|---|
| 8 | Advertising . . . . . . | 8 | – |
| 9 | Car and truck expenses (see instructions) | 9 | – |
| 10 | Commissions and fees . . . . | 10 | – |
| 11 | Contract Labor . . . . . | 11 | – |
| 12 | Depletion . . . . . . | 12 | – |
| 13 | Depreciation and section 179 expense deduction (not included in Part III) (see instructions) | 13 | – |
| 14 | Employee benefit programs . . . | 14 | – |
| 15 | Insurance (other than health) . . . | 15 | – |
| 16 | Interest (see instructions) . . . . | 16 | – |
| 16a | mortgage (paid to banks, etc.) . . . | 16a | – |
| 16b | Other . . . . . . | 16b | – |
| 17 | Legal and professional services . . . | 17 | – |
| Tax Item Line # | Tax Item description | Item # for Response | Response Area |
|---|---|---|---|
| 18 | Office expense (see instructions) | 18 | – |
| 19 | Pension and profit-sharing plans | 19 | – |
| 20 | Rent or lease (see instructions) | 20 | – |
| 20a | Vehicles, Machinery, and equipment | 20a | – |
| 20b | Other business property | 20b | – |
| 21 | Repairs and Maintenance | 21 | – |
| 22 | Supplies (not included in Part III) | 22 | – |
| 23 | Taxes and Licenses | 23 | – |
| 24 | Travel and meals | 24 | – |
| 24a | Travel | 24a | – |
| 24b | Deductible meals (see instructions) | 24b | – |
| 25 | Utilities | 25 | – |
| 26 | Wages (less employment credits) | 26 | – |
| 27a | Other expenses (from line 48) | 27a | – |
| 27b | Reserved for future use | 27b | – |
| Tax Item Line # | Tax Item description | Item # for Response | Response Area |
|---|---|---|---|
| 28 | Total expenses before epenses for business use of home. Add lines 8 through 27a . . . | 28 | – |
| 29 | Tentative profit or (loss). Subtract line 28 from line 7 . . . | 29 | – |
You can probably tell what is happening here. The sole proprietor must keep track of all expenses and report them here. Line 29 shows how the income and expenses are netted against one another to come up with a tentative profit or loss. (Negative numbers indicate a loss and are typically reflected by being in parentheses not with a minus in front of them.) There is a little more that goes on here but seeing the equation is most important.
Income – Expenses = Profit or (Loss)
This loss can be used to offset income the sole proprietor has from other endeavors.
💡 Any observations? At what tax rate will the income from the business be applied?
That is the easy scenario. The income or loss belongs to the owner and there is no separation between them and the business.
Pass Through Taxation
Pass through taxation is covered in Subchapters K and S. That means that LLCs, Partnerships and S-Corporations are pass through taxation entities – they do not pay taxes. These entities, unless they check a box stating they’d like to pay taxes like C-Corporations, will not have to file a tax return. Instead, they file what is called an “informational” return. It is exactly what it says it is. It is a document that is not intended to remit taxes but rather tell the IRS who is responsible for paying the taxes, and for how much. This form is called a Form 1065: U.S. Return of Partnership Income. It is 5 pages long and contains a lot of boxes that need to be completed. Let the accountants handle this return. When this return is completed, a document called a Schedule K-1 will be completed for each owner of the business. The K-1 gets sent to both the IRS as well as the owner. A K-1 will show the owner pertinent information that will have to be put on their personal Form 1040.
(For the sake of completeness, a few deductions are allowed on the informational return, and applied to reduce the income before the K-1s divvy up the tax liability but that is beyond the scope of this course.)
Let’s think about this:
The business has income coming in. It also has expenses associated with operations. But Sub K and Sub S say that the business does not pay taxes. What happens is the income and expenses “pass through” to the owners so that they can combine them with other taxable items on their personal returns, and then remit tax appropriately. In other words, each owner is responsible for paying tax on their share of the income net of expenses. How do the partners and LLC members share in profits and losses? If we have a two-person business and they share profits and losses 50-50, then 50% of the income and 50% of the expenses will be on each of the owners’ K-1s and they will be responsible for remitting tax on their share.
Corporate Taxation
Alternatively, C-Corporations are not taxed via a “pass through” method. Instead, they are recognized by the IRS as separate tax paying entities. The business has income coming in. It also has expenses associated with operations. The C-Corp files a tax return and pays the taxes owed. It uses its own losses against its own income. In 2020, the corporate tax rate trended around 21%.
Now, what if the C-Corp wants to distribute money to its shareholders? The appropriate course is to issue a dividend. Dividends are taxable to those who receive them because they are income. The shareholders will be taxed on the dividend distribution and the rate varies. When you hear of “double tax,” that’s it. In instances where there are dividends distributed, both the shareholders and the corporation pay income tax.
Unlike owners in a pass through entity, shareholders do not incur tax liability on money unless they receive it. So, as I just said, a received dividend will cause tax liability to the shareholder.
If the C-Corp does not issue a dividend, then the shareholder incurs no tax liability. Hence, no double tax in that instance.
Of note is that when the shareholders work for the C-Corp, they are considered employees and their compensation will be deductible by the C-Corp. In cases where there are no dividends going to shareholders, there is no double taxation.
💡 Compare Pass Through Taxation to Corporate Taxation. Think about the pros and cons.
