There is nothing more exciting than starting your own business. Self-employment gives you the opportunity to live out your passions, but it also comes with the risks of owning your own business.
One risk comes with managing your own taxes and making sure you have the right legal structure in place that will protect you as your business grows and hire employees or retain independent contractors.
Small Business Legal Structures
This article covers the basic business structures and the ways each of them is taxed. Also discussed are the legal risks and consequences a small business faces when they begin to hire employees but fall behind in collecting and paying employment taxes.
We begin by covering different types of small business structures and how such businesses are taxed for the profit they generate.
Small Business Taxes
Being taxed as a small business
Suppose you are a solo proprietor and have your own business or are in partnership with other owners in a small business. In that case, you need to have a firm grasp of the tax consequences of different types of business structures and your legal obligations to collect and pay employment tax on behalf of your employees.
Sole proprietorships (self-employed)
A sole proprietorship is legally considered a small business even though it has just one owner who pays personal income tax on profits earned from the business.
Most of the most successful businesses started out as sole proprietors. Sole proprietorships are the easiest and fastest way to get your business started. It has the least form of state and federal government regulation but carries with it the highest form of financial risk because it exposes the owner to personal liability.
Most sole proprietorships remain that way or they grow into other forms of business structures such as a limited partnership or assume a corporate structure.
Business partnerships
Business partnerships consist of two or more people working together to make a profit. There are two types of business partnerships, general and limited. While there are differences regarding partnership liability and management rights, they are generally treated the same for federal tax purposes.
Business partnerships are “pass-through” entities (sometimes also called “reporting” entities) in that they do not pay taxes themselves. They calculate their income and expenses on a partnership tax return and then “pass” the results through to the partners in proportion to their partnership rights to share profits which is usually the same as the partner’s percentage of ownership in the company. Each partner then reports their share on their income tax return.
Partnership limitation on deducting certain expenses
The partners can take losses, but they are more limited than a sole proprietorship. Certain expenses, such as charitable contributions, cannot be deducted by the partnership but are passed through to the partners.
Why is this important? Because not deducting expenses at the partnership level raises the amount of partnership profit attributed to each partner. This means there is more income tax liability – unless the partner can deduct the expense on their own tax return.
More profits mean the partnership must pay more taxes. However, a partner’s personal tax obligations are not reduced, even if the partner can figure out a way to personally deduct the expense. This is because the deduction has already been expensed into the partnership profit.
C-Corporation tax advantages
The major disadvantage of the C-Corporation is that of double taxation. By the time the shareholders receive their after-tax shares of the profits, there will have been two levels of tax – a tax on the corporation and a tax on the dividends. For this reason, many people choose a different entity – such as an S-Corporation or a partnership.
Another disadvantage of the C-Corporation is that should the corporation liquidate or sell its corporate assets, either event could become a form of double taxation to the individual shareholders if it is determined to be a taxable gain.
C-Corporations are also less flexible than partnerships regarding special allocations of profits or expense items. Losses stay in the corporation and cannot be passed through to the shareholders.
S-Corporation tax advantages
An S-Corporation is a C-Corporation that has filed an election to be taxed as a “pass-through” entity. This means that instead of being taxed on its income, it passes the payment through to the shareholders, who are then taxed on it. An S-Corporation files a different tax return than a C-Corporation.
S-Corporation election timing
The election to become an S-Corporation must be filed no later than 60 days after the beginning of the year in which the election is to be effective. Once the election is made, it is effective until revoked.
Beware of Business Income Deductions
According to the IRS, if you understate the Qualified Business Income Deduction on your tax return resulting in a substantial reduction in your tax liability, you can be subject to a substantial tax liability penalty.
The Understatement Penalty
If your understatement exceeds what you should have reported or the understated amount is greater than a specific amount, the IRS can charge a more substantial understatement penalty.
The tax preparer’s penalty for engaging in unreasonable positions will result in a statutory penalty under Internal Revenue Code Section 6694, based on the tax preparer’s income on preparing the return. However, should the tax preparer be determined to have engaged in willful or reckless conduct, a far more substantial penalty will be assessed against the tax preparer.
Three ways to avoid the substantial understatement penalty:
- Establishing that the positions taken on the return were based on “substantial authority.”
- Adequate disclosure on the tax return of a place with a reasonable basis of success.
- Establishing that you acted with likely cause and in good faith
Employer’s Legal Responsibility To Pay Employment Taxes
As a business employer, be aware that the IRS has a strict policy concerning the employer’s legal responsibility for paying and collecting outstanding employment tax obligations. The employer will not receive any leniency from the IRS in this area as a general practice.
No legal requirement to separate funds into a different account
While there is no legal requirement that the employer put employment tax funds in a separate account, it is highly suggested that an employer do so. Use of such funds designated for employee taxes and remittance for any purpose other than payment of employment taxes is illegal.
An employer’s act of desperation and last resort
When an employer’s business is struggling, perhaps on the brink of going under, the employer may choose between paying a creditor or remitting employee withholding and employer employment taxes to the IRS.
When an employer uses the employee’s withheld tax to cover business or personal expenses rather than lawfully remitting the employee’s withheld taxes to the IRS, the consequences are usually devastating for the small business owner.
Even if the employer tried to justify his unlawful actions as a desperate attempt to save the company and that the money was viewed as a short-term loan, which he intended to pay back to the IRS in full. This argument and excuses like it will always fail.
Why? Because the IRS is not just another creditor. Whatever the circumstances or justification, it is illegal to fail to withhold or remit employment taxes and will subject the employer to personal liability, penalties, and interest.
The IRS takes the nonpayment of employment tax very seriously, and the IRS has plenary powers to collect taxes from the employer for nonpayment of employment tax. The IRS can take everything you own with few exceptions and shut down your business permanently.
Consulting With A Small Business Tax Attorney
Whether you are starting your own business or going into partnership with another, it’s essential that you consult a verified Small Business Attorney.
