Understanding Business Taxes

Share on facebook
Share on twitter
Share on linkedin
Share on email

The Orange County business tax attorneys here at Evolution Tax & Legal frequently receives questions on how to plan for and appropriately file taxes for your business, whether it operates in the United States or abroad.

To help better understand your obligations, we’ve put together answers to some of the most frequently asked questions to help you understand the tax obligations as the owner and/or manager of a business.

In this article, we’ll address the following types of business entities:

· C Corporations (IRS Form 1120)
· S Corporations (IRS Form 1120-S)
· Partnership (IRS Form 1065)
· Sole Proprietorships (IRS Form 1040, Schedule C)
· Tax-Exempt and Charitable Organizations (IRS Form 990)
· Foreign Corporations (IRS Form 5471)
· Foreign Partnerships (IRS Form 8865)
· Foreign Proprietorships and Disregarded Entities (IRS Form 8858)

 

Does Your Business Have to File a Tax Return?

So, how do you know that your business is subject to US tax filing requirements? Well, if your business entity makes more than the applicable thresholds listed below, then you are subject to filing taxes in the US.

C Corporation (Domestic)

Form 1120

$0. A domestic corporation is required to file even if it has $0 of income.

C Corporation (Foreign)

Form 1120-F

Filing required if the foreign corporation was engaged in a US trade or business or had US source income if not engaged in a US trade or business.

S Corporation (Domestic)

Form 1120S

$0. A domestic corporation (whether and C or an S corporation is required to file even if it has $0 of income.

Partnership (Domestic)

Form 1065

$0, unless the partnership neither receives income nor incurs any expenditures treated as deductions or tax credits.

Partnership (Foreign)

Form 1065

Filing required if the foreign partnership has income from a US trade or business or US source income, subject to certain exceptions.

Tax Exempt Organization (Domestic and Foreign)

Form 990

A tax-exempt organization must file Form 990 if it has either (1) gross receipts greater than or equal to $200,000 or (2) total assets greater than or equal to $500,000 at the end of the tax year, subject to certain exceptions depending on the organization type.

Disregarded Entity (Domestic)

N/A

Domestic disregarded entities do not have separate filing from that of their owner and report their activity on their owner’s return if their owners are required to file a return.

Disregarded Entity (Foreign)

Form 8865

To determine if you are required to file Form 8858 on your foreign disregarded entity, please see Series 107: Ownership and Reporting of Foreign Businesses for Individuals. To note, Form 8865 is an informational return that is required to be filed along with the owner’s own tax filing.

Tax Filing Deadline for Businesses

Whether you operate solely in the US, across multiple borders, or exclusively outside the US, so long as you have US tax filing requirements, the deadlines to turn in the required filing, and make the related tax payments, stay the same.

An entity organized as a corporation, S corporation, partnership, tax-exempt organization, or a disregarded entity must file, and pay their taxes, to the federal government by the following dates:

C Corporation (Form 1120)

April 15th

S Corporation (Form 1120S)

March 15th

Partnership (Form 1065)

March 15th

Tax-Exempt Organization (Form 990)

May 15th

Disregarded Entity (Activity Reported on Return of Owner and Form 8858 if Foreign)

Due Date of Owner’s Filing

How Are Different Business Entities Taxed

There are various types of entities through which businesses operate. These generally consist of corporations, general and limited partnerships, and LLCs. Each type of entity has its own specific operating structure as imposed by state law and provides varying degrees of protection to their owners. This state law treatment does not necessarily follow how the entities are treated for tax purposes.

There are four general entity types recognized for tax purposes. These consist of a C Corporation, a Partnership, an S Corporation, and a Disregarded Entity. Each of these tax entities is subject to its own set of rules and regulations as to how taxable income is ultimately calculated. Some entities are more advantageous than others depending on the business operating structure and ultimate goals.

Each business entity is discussed in turn below.

C Corporation

To put it simply, a C corporation is treated as a separate and distinct entity from its owners. It must calculate its own income and loss and is obligated to pay tax on its own income. No income earned by the C corporation is reportable by its owners unless it makes a distribution to them in the form of a dividend.

The taxable income of a C corporation is subject to a flat 21% rate. Taxable income of a C corporation is calculated similarly to that of an individual (gross income minus allowable deductions), but is subject to its own set of restrictions and exceptions.

While the 21% federal rate is lower than the top marginal rate of an individual (currently at 37%), this is somewhat of a misnomer. Once the income of a C corporation is subject to tax at 21%, and thereafter distributed to its owners in the form of a dividend, its owners must pay tax on said income again. Thus, the income of a C corporation is subject to two layers of tax when ultimately returned to its owners. This dual-layer of taxation is an inefficient method of taxation on income earned by a partnership or an S corporation which is taxed as “flow-through” manner (see discussion below).

This is a very high-level overview of the tax consequences of operating a C corporation. There are many more considerations than those mentioned above, and a tax advisor should be consulted before ultimately choosing the entity to conduct your business through. At the least, the tax consequences of a C corporation should be contrasted of that of a flow-through entity, such as those discussed below.

Partnerships

Partnerships—better known as the quintessential “pass-through” entity. The general tax treatment of a partnership is exactly as it sounds—the income, gain, deductions, and losses pass through the partnership entity and are reported on the income tax returns of its partners. Thus, the partnership is generally not seen as a separate and distinct entity from its owners, but rather an extension of them.

Due to the flow-through treatment of a partnership, the tax filing of a partnership (i.e. Form 1065) is generally seen as an informational filing to report to the IRS what the total operations of the partnership was and what each partner’s share of such income or loss will be in a given year. The partnership itself is generally not subject to tax, but rather its individuals’ partners are responsible for paying such tax. This is very unlike a C corporation which is responsible for reporting and paying the tax due on the income the C corporation generates in a given tax year.

The flow-through nature of the partnership prevents the incidence of double taxation as you normally see in a C corporation. This is because the income flows through the partnership and is ultimately reportable on its partner’s income tax filing. Thus, only the partner is responsible for reporting their share of the partnership’s income and paying tax on such income.

Just as a warning for the wary, these general tax consequences are just that—partnerships are the most complex entity to account for in the tax code and subject to very complex nuances.

With that being said, partnerships offer the most amount of flexibility to its owners and prevent the imposition of two layers of tax. Not to mention, the most recent tax reform, formally known as the Tax Cuts and Jobs Act (“TCJA”), passed a very favorable provision for owners of qualifying pass-through, that provide a 20% deduction to the income that is passed through to them. This provision is contained in IRC 199A and is informally known as the Qualified Business Income Deduction. In combination with this deduction, income earned and passed through to the partnership’s ultimate owners is subject to an effective tax rate of 29% on their income from partnerships.

S Corporation

An S Corporation brings together the worlds of corporations and partnerships. The quintessential line about S corporations is that it provides the benefits of the partnership’s “flow-through” treatment while providing the protection and organization hierarchy that a corporation can provide. One of the major

differences between an S corporation and a C corporation or a partnership is the myriad of restrictions on ownership, which is why S corporation is representative of the term “small corporation”.

The restrictions on an S corporation’s ownership are as follows:

· Shareholders can only consist of individual, certain trusts, estates, and certain tax-exempt organizations;

· All shareholders must be US citizens or residents;

· There is a maximum of 100 shareholders

· Only one class of stock is allowed;

· Profits and loss must be allocated proportionately amongst all shareholders;

· All shareholders must consent to the election to be treated as an S corporation; and

· The business cannot be an “ineligible corporation” such as an insurance company or a domestic international sales corporation.

In addition to the differences in ownership requirements above, the ownership requirement varies from that of a partnership as an S corporation does not require two or more people to operate. An S corporation can be owned and operated by a single person. Generally, you will see an S corporation used by a sole proprietor to avoid or lessen the impact of self-employment taxes as outlined below.

So, once you decide that you want to operate in the S corporation format, how do you form it? Well, it’s through the form of an election filed with the IRS on IRS Form 2553. For all new entities formed, an S corporation election must be filed within two months and fifteen days of the date of the entity’s formation to take effect for the first tax year. For existing businesses, the election must be made within a similar timeline in order to take effect for a given tax year. If the election is filed late, there is a late election filing procedure put out by the IRS that will allow the late filing of such an election without the incurrence of a penalty.

In addition to the flow-through benefits provided by the S corporation structure, it also provides taxpayers relief on payroll and self-employment taxes. Generally, income earned by a self-employed person is subject to a total of 15.3% of Social Security, Medicate, and self-employment taxes on all profits earned. However, with the use of an S-corporation, the amount that is not paid to the S corporation’s owner(s) in the form of a salary is not subject to such taxes.

Disregarded Entities

The final structure that we will discuss here is that of the disregarded entity. Just as the name infers, the entity is disregarded for tax purposes and is treated as if it does not exist. All of the income, gains, expenses, and losses are reported directly on the return of the disregarded entity’s owner. The entity itself is not responsible to make any tax filings and to pay any taxes due.

Generally, a disregarded entity structure will be found when there is a single individual owner of a state limited liability entity such as an LLC who does not wish to operate a sole proprietorship in either the C corporation or S corporation format but needs the protection against potential lawsuits or other liabilities borne by the entity.

However, disregarded entities are widely used by corporations or partnership to provide themselves state limited liability protection when operating in certain states. For example, you will see this in the context of real estate when a company purchases and operates rental real estate in a specific state. The business will form a limited liability company (LLC) to hold ownership of the property to protect themselves from any potential suit, but choose to have the entity treated as disregarded from its parent entity so the activity is directly reported on its return.