If you are planning to start a new business this year, you must be aware of your responsibilities regarding federal taxes. Here are the seven things that the IRS considers vital for you to know if you plan on opening a new business this year.
1. Business Structure
First, you must decide what type of business entity you are going to establish. The type you decide upon will determine a great deal about your taxes, such as which tax forms you have to file. The most common types of business are the sole proprietorship, partnership, corporation and S corporation.
Sole proprietor. A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
Partnerships . A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.
Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.
C Corporations . Here, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.
The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.
S Corporations . S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income. To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders including individuals, certain trust, and estates and may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
- Submit Form 2553 Election by a Small Business Corporation (PDF) signed by all the shareholders.
Limited Liability Companies (LLC). This is a relatively new business structure similar to a corporation in that the owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation. Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
There are a few types of businesses that generally cannot be LLCs, including banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are also special rules for foreign LLCs. For additional information on the kinds of tax returns to file, how to handle employment taxes and possible pitfalls, refer to Publication 3402, Tax Issues for Limited Liability Companies (PDF).
2. Types of Taxes
The type of business you operate determines what kind of taxes you must pay and how you pay them. There are four general types of business tax you will have to face. They are income tax, self-employment tax, employment tax and excise tax.
The big question that many people have is this: What is taxable and what is not? Generally, an amount included in your income is taxable unless it is specifically exempted by law. Income that is taxable must be reported on your return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but is not taxable. A list is available in Publication 525, Taxable and Nontaxable Income.
Constructively-received income. You are generally taxed on income that is available to you, regardless of whether it is actually in your possession. For example, if the postal service tries to deliver a check to you on the last day of the tax year but you are not at home to receive it, you must include the amount in your income for that tax year. If the check was mailed so that it could not possibly reach you until after the end of the tax year, and you could not otherwise get the funds before the end of the year, you include the amount in your income for the next year.
Assignment of income. Income received by an agent for you is income you constructively received in the year the agent received it. If you agree by contract that a third party is to receive income for you, you must include the amount in your income when the party receives it.
Prepaid income. Prepaid income, such as compensation for future services, is generally included in your income in the year you receive it. However, if you use an accrual method of accounting, you can defer prepaid income you receive for services to be performed before the end of the next tax year. In this case, you include the payment in your income as you earn it by performing the services.
Employee compensation . In addition to wages, salaries, commissions, fees, and tips, this includes other forms of compensation such as fringe benefits and stock options. Employees should receive a Form W-2, Wage and Tax Statement, from their employer showing the pay they received for their services.
Business and investment income . If you rent out personal property, such as equipment or vehicles, how you report your income and expenses is generally determined by whether or not the rental activity is a business, and whether or not the rental activity is conducted for profit. Generally, if the primary purpose is income or profit and you are involved in the rental activity with continuity and regularity, your rental activity is a business. See Publication 535, Business Expenses, for details on deducting expenses for both business and not-for-profit activities.
Partnership income . While partnerships are generally not considered taxable entities, the income, gains, losses, deductions, and credits of a partnership are passed through to the partners based on each partner's distributive share of these items, which is based upon the partnership agreement. However, your distributive share of the partnership losses is limited to the adjusted basis of your partnership interest at the end of the partnership year in which the losses took place.
Although a partnership generally pays no tax, it must file an information return on Form 1065, U.S. Return of Partnership Income. This shows the result of the partnership's operations for its tax year and the items that must be passed through to the partners. For more information, refer to Publication 541.
S corporation income . In general, an S corporation does not pay tax on its income. Instead, the income, losses, deductions, and credits of the corporation are passed through to the shareholders based on each shareholder's pro rata share, to be reported on their individual tax returns. Generally, the items passed through to you will increase or decrease the basis of your S corporation stock as appropriate.
S corporations must file a return on Form 1120S, U.S. Income Tax Return for an S Corporation. This shows the results of the corporation's operations for its tax year and the items of income, losses, deductions, or credits that affect the shareholders' individual income tax returns. For additional information, see the Instructions for Form 1120S.
Royalties . Royalties from copyrights, patents, and oil, gas and mineral properties are taxable as ordinary income. You generally report royalties in Part I of Schedule E (Form 1040), Supplemental Income and Loss. However, if you hold an operating oil, gas, or mineral interest or are in business as a self-employed writer, inventor, artist, etc., report your income and expenses on Schedule C or Schedule C-EZ. For additional information, refer to Publication 525, Taxable and Nontaxable Income.
Bartering. Bartering is an exchange of property or services and it is taxable. You must include in your income, at the time received, the fair market value of property or services you receive in bartering. For additional information, Refer to Tax Topic 420 - Bartering Income and Barter Exchanges.
3. Employer Identification Number
You will probably need an Employer Identification Number, which is used to identify a business entity for tax purposes. Visit IRS.gov for more information about whether you will need an EIN. You can also apply for an EIN online at IRS.gov.
Good records will help you ensure successful operation of your new business. You may choose any recordkeeping system suited to your business as long as it clearly shows your income and expenses. Except in a few cases, the law does not require any special kind of records. However, the business you are in affects the type of records you need to keep for federal tax purposes.
5. Tax Year
Every business taxpayer must figure taxable income on an annual accounting period called a tax year. The most common tax years used are the calendar tax year, 12 consecutive months beginning January 1 and ending December 31, and the fiscal year, 12 consecutive months ending on the last day of any month except December. There is also a 52-53-week tax year, which is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month.
Adopting a tax year . Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. A required tax year is a tax year required under the Internal Revenue Code and the Income Tax Regulations. You have not adopted a tax year if you merely filed an application for an extension of time to file an income tax return, filed an application for an employer identification number, or paid estimated taxes for that tax year.
If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, you must continue to use the calendar year unless you get IRS approval to change it or are otherwise allowed to change it without IRS approval. Generally, anyone can adopt the calendar year. However, if any of the following apply, you must adopt the calendar year.
- You keep no books or records;
- You have no annual accounting period;
- Your present tax year does not qualify as a fiscal year; or
- You are required to use a calendar year by a provision of the Internal Revenue Code or the Income Tax Regulations.
Short tax year . This is a tax year of less than 12 months and it may be required when you, as a taxable entity, are not in existence for an entire tax year, or change your accounting period. In either case, the tax on a short period tax return is figured differently.
Even if a taxable entity was not in existence for the entire year, a tax return is required for the time it was in existence. Requirements for filing the return and figuring the tax are generally the same as the requirements for a return for a full tax year (12 months) ending on the last day of the short tax year. For more information, see Publication 538, Accounting Periods and Methods (PDF).
Once you have adopted your tax year, you may have to get IRS approval to change it. To get approval, you must file Form 1128, Application To Adopt, Change, or Retain a Tax Year (PDF). See the instructions for Form 1128 for exceptions. If you qualify for an automatic approval request, a user fee is not required. If you do not qualify for automatic approval, a ruling must be requested and a user fee is required. See the instructions for Form 1128 for information about user fees if you are requesting a ruling.
6. Accounting Methods
Each taxpayer must also use a consistent accounting method, which is a set of rules used to determine when to report income and expenses. The most commonly used accounting methods are cash and accrual.
Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the tax year you pay them. Under an accrual method, you generally report income in the tax year you earn it and deduct expenses in the tax year you incur them. The difference is subtle but important. For example, say you invoice a client for work. Under the cash method, that money is reported as income only when the client actually pays you. Under the accrual method, you report it when the invoice goes out, but before the money is in your hand.
7. More Information
Always get as much information as possible before making tax-related decisions. Consult your tax advisor and visit the Business Section of IRS.gov for a wide variety of tax resources designed to assist entrepreneurs with starting and operating a new business.