Businesses may be subject to a number of different taxes by local, state, and federal governments. Virtually every state, and some municipalities, impose a sales and use tax. Furthermore, each taxing authority has its own rules regarding the property and services that are subject to tax, the method of collection, and the tax rate.
Businesses that own real estate are required to pay local real estate taxes. If they lease their space, they may also be obligated to pay a tax on their leasehold interest. Businesses may also be required to pay a tax to a city or state based upon the amount of their payroll.
Federal and states governments also impose separate taxes on certain so-called "luxury" items. These excise taxes are imposed on the sale of items, such as:
- gasoline and related products
- cigarettes and other tobacco products
- alcoholic beverages
- heavy trucks and trailers
- telecommunication charges
- transportation by air and water
- luxury and gas-guzzling automobiles
- and other items
The most pervasive type of tax is the tax imposed upon the net income of a business. The federal government and most states impose an income or franchise tax on businesses. Because the federal rate is much higher than the rate charged by the states, it is of primary importance in deciding how a business is formed and operated.
A sole proprietorship is the simplest form of doing business. No new legal entity needs to be created. No assets need to be transferred to a separate entity. All profits are taxed to the sole proprietor as ordinary income on Form 1040, Schedule C, or Schedule C-EZ. However, the sole proprietor is not insulated from the risks associated with the business.
Partnerships and Limited Liability Companies
A partnership is an association of two or more persons that carry on a business for profit. A partnership in itself is not subject to federal income tax. Instead, all the income, deductions, and other tax attributes of the business are allocated to the partners in accordance with their partnership agreement. Partnerships are required to file an information return (Form 1065) by April 15th of each year.
There are two types of partnerships: general and limited. In a general partnership, all partners have unlimited personal liability for the debts of the partnership. In a limited partnership, partners that are designated as limited partners only have exposure for liabilities to the extent of their contributions to the partnership.
An increasingly important alternative to partnerships is the limited liability company ("LLC"). Since owners of an LLC are not responsible for its debts, but the LLC is treated as a partnership for federal income tax purposes.
A corporation has a separate legal entity from its shareholders. The shareholders are not personally liable for corporate obligations. A corporation's net income is subject to federal income taxation. However, under some circumstances, a corporation can elect for federal income tax purposes to be taxed as an "S" corporation.
The income of an "S" corporation is generally taxed to the shareholders as ordinary income and not to the corporation itself. An "S" corporation is required to file an information return (Form 1120S) by March 15th of the following year. The income of an "S" corporation is not taxed a second time when it is distributed to shareholders as it is with "C" corporation.
A corporation not electing "S" status is referred to as a "C" corporation. Unlike an "S" corporation, a "C" Corporation's taxable income is subject to tax at graduated rates.
- the first $50,000 of income is taxed at 15 percent
- the next $25,000 at 25 percent
- all additional income is taxed at 34 percent
The benefit of the lower tax brackets is recaptured by the imposition of an additional 5 percent surtax for income in excess of $100,000 but less than $335,000.
- Taxable income over $10,000,000 is taxed at 35 percent.
- A 3 percent surtax is imposed to recapture the lower tax brackets.
- Certain personal service corporations are instead taxed at a flat rate of 35 percent.
When the earnings of a "C" corporation are distributed as a dividend to the shareholders, those shareholders are also taxed on the receipt of the corporate profits which are treated as ordinary income.
Question For Your Attorney
- Given my circumstances and the taxes I could incur, which type of business would best suit me?
- What state, local, and federal taxes would affect my business?