Tax Ramifications of Starting Your Own Small Business

Tax Ramifications of Starting Your Own Small Business

Tax Ramifications of Starting Your Own Small Business ImageMany entrepreneurs have a great idea, product or service that they believe is marketable to the public, but they are clueless about the tax implications of running their own business.  Knowing how your business will be taxed can save you a great deal of time and money and help to simplify your life.  There are four main types of business entities, each of which is taxed in a different manner:

Sole Proprietorship

This is by far the simplest type of business entity. The owner, or proprietor, simply reports all income and expenses from the business directly onto the Schedule C, which is then carried to the 1040.

Partnership

There are two types of partnerships: limited and general. In a limited partnership, each partner’s liability is limited to their share of the partnership. In a general partnership, each partner is liable for the actions of all other partners. Partnerships are also classified as “pass-through” entities, which means that the expenses and income that they generate are passed through to the personal tax returns of each partner in due proportion. Partnership income and expenses are carried to the 1040 from Form 1065.

Subchapter S Corporation

This entity also passes through all of its income and expenses to its employees and officers, but it can issue shares of stock and does not have the liability issues that beset many partnerships. S Corporation income and expenses are carried to the 1040 from Form 1120S.

C Corporation

This type of corporation is a separate taxable entity, and its income and expenses are reported on a completely separate return and filed separately from the owner’s personal tax return. C Corporations have their own set of tax rates and tables, and all income that the owner draws from the corporation is taxed again as personal income. Although this form of business entity completely shields the owner from personal liability, it is also subject to double taxation; once at the corporate level and again at the individual level.

There is also another, newer type of business entity known as a Limited Liability Corporation (LLC) that can be structured as a partnership, S or C corporation. This flexible entity can be used for a multitude of purposes and its taxation is dependent upon its structure. But the right type of business entity for you will depend on several factors, such as the number and type of employees you will hire, the amount of income you expect (or least hope) to generate and the amount and type of liabilities that you may incur.

Self-employment and payroll tax are other major issues to consider when you go into business for yourself. When you receive W-2 wages from your employer, you will have 7.65% of your pay deducted to cover Social Security and Medicare tax. Your employer also pays that same amount out of its pocket to the IRS on your behalf, although it doesn’t show up on your pay stub or W-2. When you work for yourself, you will have to pony up that additional amount yourself-and also pay it for all of your employees just as your employer did for you. This additional amount of tax should always be factored into your cash flow computations when you make business projections.

For more information on going into business for yourself, contact a business consultant or your financial advisor.

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