Introduction
Starting and operating a successful business in the United States have tax implications. There are responsibilities at both the state and federal levels by the business.
This article explores the basic summary of what you need to know about successfully operating your business as well as provide you with some of the resources for additional information.
This is part of the IRS lessons that explain the purpose of the employer identification number, describe basic recordkeeping requirements for tax purposes, define basic bookkeeping and accounting methods, explain the forms of business organizations, and finally, suggest how to select the paid tax preparer.
You need to also understand your state and local tax reporting requirements in addition to the federal requirements we will be describing here.
Employer Identification Number (EIN)
Let’s start first with the Federal Employer Identification Number or EIN. An EIN identifies tax returns filed with the IRS and, as a business owner, you may be required to get an EIN.
You will need an EIN if you pay wages, have a self-employed retirement plan, operate your business as a partnership or corporation, or if you’re required to file any of these tax-returns: employment, excise, fiduciary, or alcohol, tobacco, and firearms.
Your type of business may not be required to obtain an EIN, but you may need an EIN for dealing with other businesses, including banks, that require an EIN to set up business accounts. The IRS will give you an EIN even if you don’t need it for IRS purposes. The fastest and easiest way to get an EIN is online.
Just go to www.irs.gov and type in the keyword EIN.
From there you’ll find out more information including the application. The EIN assigned is the permanent Federal Employer Identification Number for your business. This EIN may be canceled if the name or social security number of the principal officer does not match the social security administration records or if your business already has an EIN.
Recordkeeping
As a business owner you must keep receipts, sales slips, invoices, records for cash receipts, and expenditures, bank deposit slips, canceled checks, and other documents to substantiate items of income, deductions, and credits.
Although it may sound like a lot of work, unless you have records showing the source of your receipts, you may not be able to prove that some are non-business or non-taxable.
Recording these items will help you pay only the tax you owe. Your records must support the claimed amount, the time and the place, the business purpose, and your business relationship to any other person involved.
If your records are incomplete, they may not support your deductions. You must keep your records if their contents may be material in the administration of any Internal Revenue Service law. Usually the statute of limitations for an income tax return expires 3 years after the return is due or filed or 2 years from the date the tax is paid, whichever is later.
To support items of income or deduction on your tax return, you must keep records until the statute of limitations for that return expires. There are special recordkeeping rules if the records are connected to a property.
Generally, keep these records until the period of limitation expires for the year in which you dispose of the property. You must keep these records to figure any depreciation, amortization, or depletion deduction and to figure the gain or loss when you sell or otherwise dispose of the property.
If you received property in a nontaxable exchange, your basis in that property is the same as the basis of the property you gave up, increased by any money you paid.
You must keep the records on the old property, as well as on the new property, until the period of limitation expires for the year in which you dispose of the new property.
If you have employees, then you must keep employment tax records, too. You must keep all employment tax records for at least four years after the date on which the tax return becomes due or the taxes paid, whichever is later.
There are some circumstances where records may have to be kept longer. If you change your method of accounting, records supporting the necessary adjustments may be material for an indefinite time. And as discussed earlier, records that established the basis for original or replacement property must also be kept longer. If you lost your records due to circumstances beyond your control such as a flood or an earthquake, you may substantiate a deduction by reasonable reconstruction.
For more information about recordkeeping, see IRS Publication 583, Starting a Business and Keeping Records. For information about employment tax records, see IRS Publication 15, Employer’s Tax Guide.
You can find these publications at www.irs.gov. You can also go to www.irs.gov and search using the key word “recordkeeping.”
Bookkeeping Systems
Many people who operate their own one-person business never bother to set up a business bookkeeping system. Their personal checking account serves as both a personal and a business account. The IRS, however, recommends that you open a separate business bank account.
There are two types of bookkeeping systems: single entry and double entry.
The single entry system is the simplest to keep: with the single entry system, you record a daily and a monthly summary of business income, and a monthly summary of business expenses. This system focuses on the business’s profit and loss statement, and not on its balance sheet. While a single entry is not a complete accounting system, it shows income and expenses in enough detail for tax purposes.
The double entry system is more complex: it has built-in checks and balances, it is self-balancing, and is more accurate than the single-entry system. Because all businesses consist of an exchange of one thing for another, double entry bookkeeping is used to show this two-fold effect.
Accounting Methods
Once you’ve selected a bookkeeping system, you also need to select an accounting method. Your accounting method is a set of rules that you use to decide when and how you report your income and expenses.
The two most commonly used accounting methods are the cash method and the accrual method. On your tax return, you must use the same accounting method you use to keep your records.
Under the cash method, you report all income in the year you receive it. You usually deduct expenses only in the tax year in which you pay them.
Under the accrual method, you report income in the year you earn it, regardless of when you receive payment. You deduct expenses in the year you incur them whether or not you pay them that year.
Businesses that have inventory for sale to customers must generally use an accrual method for sales and purchases. However, many small businesses with gross receipts averaging less than 10 million dollars a year may use a cash method for sales and purchases.
For more information on the differences between the cash and the accrual methods of accounting, see IRS Publication 538, Accounting Periods and Methods.
There are computer software packages that are very useful, relatively easy to use, and require very little knowledge of bookkeeping and accounting. For proper bookkeeping and accounting, you may hire a bookkeeper or an accountant/accounting firm to help.
Be careful, if you use software, you must be able to produce records from the system to support what is on your tax return. And always keep a backup copy in a safe place.
Types of Business Structures
Early in the life of your small business, you’ll need to decide on the structure of ownership.
There are five common types of business organizations.
Sole Proprietorship, Partnership, Corporation, S Corporation, and Limited Liability Company.
Sole Proprietorship
A sole proprietorship is the simplest type of business organization. It is an unincorporated business that one person owns. The business does not exist apart from its owner and it is the owner who assumes the risks of the business to the extent of all of his or her assets, even if the owner does not use his or her personal assets in the business. Additionally the ability to finance the business, known as capital, is limited to whatever the owner can come up with including loans from financial institutions of which the owner is personally responsible.
A sole proprietor files his or her taxes using a Schedule C, Net Profit from Business. The Schedule C is included with the 1040 to report the profit or loss from operating the business. The sole proprietor also files Schedule SE, Self-Employment Tax to Report the Social Security and Medicare Taxes on net profits of the current year’s threshold. If you or your spouse jointly own and operate an unincorporated business in a non-community property state and share in the profits and losses, you are partners in a partnership and not a sole proprietorship. So you should not use a Schedule C but there are exceptions to this. For example, if you and your spouse wholly own and operate an unincorporated business as community property under the community property laws of a state, you can treat the business either as a sole proprietorship or a partnership. There’s another exception for qualified joint ventures for spouses. If you and your spouse each materially participate as the only members of a jointly owned and operated business and you file a joint income tax return for the tax year, you can make a joint election to be treated as a qualified joint venture instead of a partnership. This allows you to avoid the complexity of partnership Form 1065, US Return of Partnership Income, but still gives each spouse credit for Social Security earnings on which retirement benefits are based.
Partnership
The second type of business organization is a general partnership. A partnership is a relationship between two or more persons who come together to carry on a trade or business. Each person contributes money, property, labor, or skills, and each expects to share both in the profits or the losses of the business. Any number of persons may join in a partnership. The advantages of a partnership are that it is easy to organize, it has a definite legal status and it may have a greater financial strength than a sole proprietorship. The first disadvantage is that decision authority is divided. The other disadvantage to a partnership is that the liability of the partners is usually unlimited, unless otherwise stated in the partnership agreement. That is, each partner may be held liable for all the debts of the business. For example, if one partner does not exercise good judgment, that partner could cause not only the loss of the partnership’s assets, but also the loss of the other partner’s personal assets.
Partnerships report profit or losses on Form 1065, US Return of Partnership Income. Form 1065 summarizes the business activity of the partnership. A partnership does not pay tax on income from daily operations and all the income, losses, deductions, and credits generated by a partnership pass through to the partners. Each partner gets a Form 1065, Schedule K-1, Partner’s Share of Income, Deductions, Credit, etc., and the partners report these items on their personal income tax returns. Partnerships must still file employment tax returns and pay employment taxes on employees’ compensation. If you would like more information about partnerships see IRS publication 541, Partnerships, as well as the instructions to Form 1065 and 1040.
Corporation
Corporations are treated by the law as legal entities.
That is, the corporation has a life separate from its owners and has rights and duties of its own. The owners of a corporation are known as stockholders, or shareholders. And it may be worth noting, one person can be the sole shareholder of a corporation. Managers of a corporation, may or may not be shareholders. Forming a corporation involves the transfer of money or property or both by the prospective shareholders in exchange for capital stock in the corporation. For purposes of federal income tax, corporations include associations, joint stock companies, and trusts, as well as partnerships that operate as associations or corporations. Let’s cover advantages and disadvantages of a corporation. The advantages of a corporation are that the stockholders have limited liability for corporate debts or actions, transfer of ownership is easy, stock can be sold, and raising capital in expanding the business may be easier. The disadvantages are that the corporation is subject to tax on its income at the corporate level. And when the income is distributed as dividends, that income is taxed again, at the shareholder level. Owners of a corporation who work in the business are typically considered employees, are paid a salary, and both the corporation and the employee pay employment taxes on that salary. It is wise to consult an accountant and an attorney specializing in corporate law, as corporations may be more difficult and expensive to organize than other business structures. Additionally, the corporate charter filed with the secretary of your state restricts the type of business activities and is subject to many state and federal controls.
S Corporation
An S Corporation is a small business corporation, whose shareholders elect to report corporate profits or losses in the same manner as that of a partnership. Like partnerships, S corporations do not pay tax.
Unlike S corporations, C corporations are taxed at the corporate level; then, when the income is distributed as dividends, it is taxed again at the shareholder level. Organizing shareholders of a corporation who wish to avoid double taxation can file Form 2553, Election by a Small Business Corporation.
This election must be submitted by the 15th day of the third month of the first S corporation year.
If your first S corporation tax year begins on January 1st, you must submit Form 2553 by March 15th. Otherwise, the election is effective for the next tax year.
The IRS will send you a CP261 notice, Notice of Acceptance as an S Corporation, to let you know it received and approved your election. You should receive your approval in 60 days. If you do not, contact the IRS campus where you filed your Form 2553.
For more information, see the instructions on Form 2553.
An S corporation does not pay tax on income from daily operations. All income, losses, deductions, and credits generated by an S corporation pass through to the corporate shareholders. The shareholders then report the items on their personal income tax return.
However, there are situations where an S corporation is subject to an entity or corporate level tax. For example, S corporation officer shareholders who provide services to their corporation, are employees, and their compensation is subject to employment taxes. By law, officers of corporations are employees for employment tax purposes, and their compensation is wages.
An S corporation must pay reasonable compensation or wages to a shareholder employee in return for the services the employee provides the corporation before a non-wage distribution may be made to that shareholder employee. In other words, they must be compensated first; then they get the distribution.
An S corporation has the combined advantages and disadvantages of partnerships and regular corporations. S corporations file Form 1120-S, US Income Tax Return for an S Corporation. The S corporation provides each shareholder a Form 1120-S Schedule K-1, Shareholder’s Share of Income Deductions, Credits, etc.
The shareholder uses the Schedule K-1 to complete Part 2 on Form 1040, Schedule E, Supplemental Income and Loss, as well as any other forms and schedules the shareholder must file with the individual return.
Limited Liability Company (LLC)
The final structure we will discuss is limited liability company, LLC, a legal entity created under state law. The LLC is separate from its owners, who are referred to as members. An LLC can own property, incurs debts, and enter into contracts. LLC’s are popular because owners (members)
are personally protected against the LLC debts, have limited personal liability for the debts and actions of the LLC, and without many of the formalities of corporation. Other features of LLC’s are more like partnerships, providing management flexibility and the benefit of flow through taxation. For federal income tax purposes, an LLC may be treated as a sole proprietorship, a partnership, or a corporation. Also for federal tax purposes, owners or members of an LLC can make an election to be treated either as a disregarded entity, or a partnership.
If you want to tell the IRS how to treat your business for federal income tax purposes, you need to file Form 8832, Entity Classification Election. If you do not file Form 8832 for tax purposes, the IRS will treat your business as a sole proprietorship, if it has a single owner, or as a partnership, if it has two or more members. Note that even though the LLC is treated as a sole proprietorship for tax purposes by the IRS, the single-member owner of the LLC generally maintains limited personal liability protection from the debts and actions of the LLC, unlike an actual sole proprietorship where the owner would be equally liable for the debts and actions of the sole proprietorship. There are instructions with the form that explain the classifications. If you disagree with the default classification, you can file Form 8832 to request a change.
Sharing or Gig Economy
If you earn income as a rideshare driver, rental host, or online seller, your business is part of the gig economy. The gig economy, also called sharing economy, or access economy, is any activity where people earn income providing on-demand work, services, or goods. Often, it’s through a digital platform like an app or website.
Visit the www.irs.gov Gig Economy Tax Center, where you will find general information about tax issues that arise in the gig economy and how to file your taxes.
Choosing a paid preparer
If you do decide to use a paid preparer, remember, you are still legally responsible for the information on your own tax returns. Let’s review some points you need to be aware of. First, avoid preparers who claim they can obtain larger refunds than others. Second, avoid preparers who base their fees on the amount of your refund. Also, avoid paid preparers who won’t sign the tax return or won’t give you a copy for your records. Fourth, never sign a blank tax return and never sign a completed form without reviewing it and making sure you understand the return. Finally, consider whether the preparer will still be available to answer questions about the return for months or even years after the return is filed. You can find more tips on irs.gov. Simply type choosing a preparer in the search box. The IRS now has a registration and certification process for preparers. To ensure that you are working with an honest and reputable preparer, make sure that the preparer has a valid preparer tax identification number, also known as a PTIN. All preparers whatever their professional designation must have a valid PTIN. There are variations, however, in the type of return preparer, the testing they must undergo, their continuing education requirements and their practice rights before the IRS. For purposes of this video lesson, we’ll be focusing on three types of preparers: enrolled agents, CPAs, and attorneys. An enrolled agent is a person who has earned the privilege of representing taxpayers before the IRS. Most enrolled agents have passed a three-part comprehensive IRS test covering individual and business tax returns and client representation rules. They must adhere to ethical standards and complete 72 hours of continuing education courses over three years. Enrolled agents have unlimited practice rights, which means they are unrestricted as to which taxpayer they can represent, what types of tax matters they can handle, and which IRS offices they can represent clients before. To learn more about enrolled agents, see Treasury Department Circular 230 or visit irs.gov. Type enrolled agent in the search box.
Some individuals become enrolled agents through experience as a former IRS employee instead of passing the three-part test. These individuals may be limited in their practice rights to only the matters they have expertise in as a former employee. Both Certified Public Accountants also known as CPAs and attorneys have their own professional requirements for continuing education. Both groups have unlimited practice rights before the IRS.
This article is a translation of IRS Lesson on Federal Taxes and Your New Business.
Edited by: Prime2Prime Ideas research
