Owning your own business means that you make all the major de-cisions, including the ones that can have a real impact on your taxes.One of the earliest and most impor-tant decisions you’ll make is to choose the legal form your business should adopt. The most common forms are a sole proprietorship, a partnership, or a corporation. Each has different tax consequences and making the right choice can have a verry positive effect on your tax picture.
A sole proprietor is an unincorporat-ed business that has only one owner. It is a simple legal entity in which you are your own master.A sole proprietorship has three major tax advantages:You can deduct any losses you incur from your business start up costs on your personal income tax return. These start up costs can be used to reduce your taxable income from other sources.You avoid double taxation. Income generated from a regular corporation is taxed twice. First, your busi-ness pays a corporate income tax on its profits. And then, as a share-holder, you pay personal income taxes on any dividends you receive from the corporation. On the other hand, income from a sole propri-etorship is taxed only once - as in-come on your personal income tax return.Your overall tax burden may be less depending upon the tax bracket you are in.
A partnership is similar to a sole pro-prietorship with the exception that it has more than one owner. Each partner’s share of income, loss, and deductions is set forth in the partner-ship agreement. As in a sole propri-etorship, these items are reflected on each partner’s personal income tax return.partnerships have additional tax ad-vantages:Income is taxed at each individual partner’s personal income tax rate.You avoid double taxation because a partnership does not pay taxes.As a partner, you can deduct busi-ness losses to the extent that you are liable for obligations of the partnership. You can allocate loss-es differently than profits. If you provide most of the start up costs, you can take a larger share of the losses, even if the profits are shared equally by the partners. And the way you allocate profit and loss to each partner can be changed from year to year to accommodate changes in your personal circum-stances.
An “S” corporation is a business that is formed under the rules of Sub-chapter S of the Tax Code.Operating your business as an “S” cor-poration has several tax advantages:You may pay less taxes, depending upon the tax bracket you are in.You avoid double taxation. Your business profits are taxed only once, directly to you as a shareholder, on your personal income tax return.
You avoid tax penalties on excess accumulated earnings. Since “S” corporation profits are taxed to stockholders even if they don’t receive them, you can’t be penalized for accumulated excess earnings in the business as can a regular corporation.You don’t pay double taxes when your “S” corporation is liquidated. If a regular corporation is liquidated, the corporation is taxed on the gain and you and other shareholders are taxed on the portion of the gain which you receive. Since there are no corporate income taxes for an “S” corporation, you avoid double taxation when an “S” corporation is liquidated.
Regular “C” Corporations
Regular “C” corporations are a unique form of business. They are subject to a special tax structure and their earn-ings can be taxed twice, first at the corporate level and again when they are distributed to stockholders as dividends.The double tax can be avoided by retaining earnings in the corporation rather than distributing them as dividends. This must be carefully planned, however, since the IRS can penalize a corporation for excessive accumulation of earnings. The penalty can be avoided only if a corporation can demonstrate that it has good business reasons for accumulating earnings.Even if you own a small business, you can gain certain tax advantages from incorporating. For example, corporate tax rates on the first $75,000 of income are often lower than personal income tax rates.