Startups, freelancers, and small businesses all have one thing in common: they don’t like dealing with taxes. We can understand why. They are complicated and there’s always a fear you’ll screw them up.
To help, here’s a primer on how the IRS taxes entrepreneurs and businesses.
The 30,000 Foot View
Here’s the most basic way of looking at how the IRS taxes businesses:
- Pass-Through Taxation: Most new businesses are taxed as “pass-through” entities. This means the profits and losses of the company are passed through to the owners’ individual tax returns. Accordingly, the company will not have any income tax liability. Unless you elect otherwise, the following entities are taxed as pass-through business structures: (1) Sole Proprietors; (2) Partnerships; and (3) LLCs.
- Double Taxation: A small number of new businesses pay two levels of income taxes (mostly corporations). The first income tax is paid by the business itself when it receives income. The second income tax is paid by the business owners when they receive profit distributions. Corporations are taxed like this by default. And while uncommon, LLCs can also elect this tax status.
(What about S-Corps? An S-Corp is just a tax election. When you make an S-Corp tax election, you are electing for your business to be taxed under special tax rules. Learn more in this guide: What Entrepreneurs Should Know About S-Corps.)
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How to Save, Report, & Pay Your Taxes
There are a number of factors that will dictate how you (and sometimes your company) will actually pay your taxes. Below is an outline of the four most common tax structures and processes.
Sole Proprietors (most freelancers)
Entrepreneurs that pay taxes as a sole proprietor have the easiest process. All income and losses “pass- through” to your personal tax return and the “business” doesn’t have to file an income tax document. There are three parts to paying income taxes in this situation: (1) you should save about 15-30% of your profit throughout the year to make sure you have money to pay your taxes (I recommend you open a dedicated savings account where you save this money); (2) you should pay estimated taxes quarterly to cover your anticipated tax liability (an accountant can help you determine your estimated payments); and (3) you must complete and attach a Schedule C to your personal income tax return where you’ll report your annual profits or losses (you may owe additional taxes or you may get a refund if you overpaid).
When entrepreneurs are taxed as a partnership, all of their profits or losses will “pass-through” to the individual tax returns of each partner based on their ownership percentage. There are five parts to paying income taxes in this situation: (1) each partner should save about 15-30% of their profit throughout the year to make sure you have money to pay your taxes (I recommend you open a dedicated savings account where you save this money); (2) each partner should pay estimated taxes quarterly to cover their anticipated tax liability from their share of the company’s profits; (3) the company must give each partner a K-1 annually to let her know how much profit or loss was allocated to her; (4) the company must file an informational return with the IRS; and (5) each partner must attach her K-1 to her personal income tax return where she will report her annual share of the company’s profits or losses (she may owe additional taxes or she may get a refund if she overpaid).
LLCs are unique and there is not a tax class for LLCs. Rather, the LLC must elect one of the other tax structures. Unless you elect otherwise, single-owner LLCs will be taxed like a sole proprietor and multi-owner LLCs will be taxed as a partnership.
If you are taxed as a corporation, then both you and your company will report and pay income taxes. Because this is less common for small businesses we won’t get into the details here. But in short, the corporation will file a corporate tax return and will pay income taxes on its profits. If it distributes profit to its shareholders, then the shareholders will report that income on their personal tax returns and they must pay income taxes on those profits.