If you are a small business owner and receive income from your business for services, you will need to eventually pay employment tax as well as individual income tax on that money. As this is commonly misunderstood at tax time, many small business owners and sole proprietors end up with sizable IRS bills come tax time.
The confusion around the tax implications
Part of the confusion is that many individuals are more familiar with being an employee of a corporation that is considered to be the employer. An employer bears one-half of the employment tax cost and the employee bears the other half. Since the employee’s one-half is withheld from wages, the employee may not appreciate that the tax burden for one-half of employment tax falls upon the employee.
Small business owners often think because they pay themselves through their companies for their services, this income escapes self-employment tax. However, the opposite is true. This applies to all types of business structures for tax purposes, just to varying degrees. These business types are in place to determine the amount of tax liability in which the business is responsible.
Business structure and personal income tax responsibilities
- Sole proprietorship
In this instance, there is often confusion over how this income is taxed. Any money made from the company is not paid on a separate federal business income tax return. The income and deductions for this type of business structure are reported on a Schedule C filed as part of the individual’s Form 1040. A limited liability company having an individual as its sole member reports on Schedule C, unless the business activity is the passive rental of real estate reported which is reported on Schedule E.
This is a broad term that includes general partnerships and limited liability companies taxed as partnerships filing Form 1065 for partnership income. Form 1065 includes Form K-1 for each partner, which sets forth the partner’s share of each item. Every item of income or deduction that is subject to a limitation at the partner level is reported separately so the partner may properly prepare his or her own tax return. The partnership structure is particularly tricky for small business owners.
While a partnership does not pay business income taxes on the earnings of the partnership, it does need to report all gross earnings and expenses from partnership activity. The partners of the partnership or members of the company use Form k-1 to report their share of the various totals. Many small business owners know that the partnership is an employer of those non-owners who perform services for the partnership. What is not evident is that a partner is not an employee of the partnership but is considered self-employed and must pay self-employment income on the share of income received for services. The IRS position on this is clear. Omitted from this commentary are limited partnerships and limited liability partnerships which have nuances on issues other than self-employment taxes, and coverage of guaranteed payments.
- Limited liability companies
LLCs may be taxed as partnerships, S corporations or regular C corporations. When taxed as a C corporation or S corporation, the corporation is the employer, the small business owner is an employee and the discussion in the first paragraph applies. LLCs taxed as partnerships are treated as described in the preceding paragraph. LLCs must elect to be taxed as a C corporation or S corporation.
- C corporation or S corporation
These corporations pay one-half of the self-employment tax, unlike the LLC taxed as a partnership. Some persons prefer S corporations to an LLC because the corporation pays one-half of the self-employment tax. The preference for C or S status has less to do with employment taxes than it has to do with two levels of taxation, the ability to raise capital from the public and the limitations imposed on benefit and compensation plans. Ownership of S corporation is restricted and inflexible when compared to that of a C corporation or LLC
These are just some of the ways in which small business owners are taxed. However, if you have any questions or would like to discuss the matter further, please contact me, James McDonough, at 201-806-3364.