The most common and simplest form of business is a sole proprietorship. Many small businesses and farming operations in the United States are sole proprietorships. An individual proprietor owns and manages the business and is responsible for all business transactions. The owner is also personally responsible for all debts and liabilities incurred by the business. A sole proprietor can own the business for any duration of time and sell it when he or she sees fit. As owner, a sole proprietor can even pass a business down to his or her heirs. This is also true of today’s family farm.
In this type of business, there are no specific business taxes paid by the company. The owner pays taxes on income from the business as part of his or her personal income tax payments.
Sole proprietors need to comply with licensing requirements in the states in which they’re doing business, as well as local regulations and zoning ordinances. The paperwork and formalities, however, are substantially less than those of corporations, allowing sole proprietors to open a business quickly and with relative ease — from a bureaucratic standpoint. It can also be less costly to start a business as a sole proprietor, which is attractive to many new business owners who often find it difficult to attract investors.
For U.S. federal income tax purposes, an LLC is treated by default as a pass-through entity. If there is only one member in the company, the LLC is treated as a “disregarded entity” for tax purposes, and an individual owner would report the LLC’s income or loss on Schedule C of his or her individual tax return. The default tax status for LLCs with multiple members is as a partnership, which is required to report income and loss on IRS Form 1065. Under partnership tax treatment, each member of the LLC, as is the case for all partners of a partnership, annually receives a Form K-1 reporting the member’s distributive share of the LLC’s income or loss that is then reported on the member’s individual income tax return.
An LLC with either single or multiple members may elect to be taxed as a corporation through the filing of IRS Form 8832. After electing corporate tax status, an LLC may further elect to be treated as a regular C corporation (taxation of the entity’s income prior to any dividends or distributions to the members and then taxation of the dividends or distributions once received as income by the members) or as an S corporation (entity level income and loss passes through to the members). Some commentators have recommended an LLC taxed as an S-corporation as the best possible small business structure. It combines the simplicity and flexibility of an LLC with the tax benefits of an S-corporation (self-employment tax savings).
A C-Corporation is the most common form of business organization, and one which is chartered by a state and given many legal rights as an entity separate from its owners. This form of business is characterized by the limited liability of its owners, the issuance of shares of easily transferable stock, and existence as a going concern. The process of becoming a corporation, call incorporation, gives the company separate legal standing from its owners and protects those owners from being personally liable in the event that the company is sued (a condition known as limited liability). Incorporation also provides companies with a more flexible way to manage their ownership structure. In addition, there are different tax implications for corporations, although these can be both advantageous and disadvantageous. In these respects, corporations differ from sole proprietorships and limited partnerships.
An S-Corporation is not subject to corporate tax rates. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income, according to the Internal Revenue Service. Instead, an S-Corporation passes-through profit (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder’s Form 1040. The pass-through (sometimes called flow-through) nature of the income means that the corporation’s profits are only taxed once – at the shareholder level. The IRS explains it this way: “On their tax returns, the S corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss.”
S-Corporations therefore avoid the so-called “double taxation” of dividends
S-Corporations, like regular C Corporations, can decide to retain their net profits as operating capital. However, all profits are considered as if they were distributed to shareholders. Thus an S-Corporation shareholder might be taxed on income they never received. (Whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out.)
A partnership is a business owned by several individuals who have signed a partnership agreement and have invested in the business. There are various types of partnerships, but all pay income tax in the same way. A partnership itself does not pay income taxes directly to the Internal Revenue Service. Instead, the partners are taxed on their shares of the income/loss of the partnership on their personal tax returns. The partnership files an information return showing the total amount of income and expenses and other deductions, the net income of the partnership, and the share of that income for each partner. Along with the partnership information return the tax preparer also prepares a Schedule K-1 for each partner, which breaks down the partnership income and share of that income for that partner, along with other information. The Schedule K-1 is filed with the partner’s personal income tax return, and the amount of loss or income is included along with the partner’s other income. Thus, partners pay income tax on their business activities and other income at the applicable personal tax rate for the year.
A trust is a type of tax entity. A trust is created by an individual person to protect or to preserve the person’s assets, and to distribute income to beneficiaries. A trust may take effect during the person’s life, or might take effect upon the person’s death. A trust is managed by a trustee. The trustee is responsible for all aspects of the trust. The trust is a separate entity for tax purposes from the person who created the trust. The trust reports its own income and tax on a specific and separate IRS Form. The trust also reports income distributed to beneficiaries using Form K-1.
Estates are entities that report income after an individual person has died. If the person, for example, earns interest, dividends, or capital gains after his or her death, then that income is consider income for his or her estate, and the income must be reported on a separate and specific U.S. Income Tax form for Estates and Trusts. Estates may also have to pay tax on the total value of it’s assets. A tax on the value of the estate is reported on Form 706, U.S. Estate Tax Return. The estate tax is a tax on assets, whereas the estate income tax is a tax on income.
Non-profit organizations are generally tax-exempt and don’t need to file revenue forms, but the Internal Revenue Service still requires lots of information — all to be painfully extracted and meticulously organized on IRS Form 990.
Not every tax form requires a payment of tax. Sometimes information is what the IRS is after. For example, Forms 990, 990-EZ, and 990-PF (the three are forms of Form 990) are considered information returns or reporting forms. The public uses the information on these returns to evaluate nonprofits and how they operate. On these forms, you can see what a nonprofit’s income and expenses are, how much it pays its key people, and other useful information that can help you assess what a nonprofit does.
Form 990 is a fairly critical form for the public disclosure of information because the law doesn’t require typical annual reports from nonprofit organizations. Even financial audits by independent accountants aren’t required by law (except in special circumstances).
The organizations that must file the Form 990s don’t have to pay federal income tax on income that’s related to their exempt purposes and programs. However, many private foundations do have to pay an excise tax that’s based on their investment income.
After an organization files its completed Form 990 or Form 990-EZ, it’s available for the world to see. This public access is required under Section 6104 of the Internal Revenue Code. Form 990-PF (for private foundations) must also be made available for public inspection by the private foundation, but that usually requires an appointment and a trip down to the foundation’s main office.