Small Business Taxes For Dummies - Eric Tyson

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      So if the business shows a loss in some years, the owners/shareholders may claim those losses in the current year of the loss on their tax returns against other income earned. This is potentially useful in the early years of a new business, a time when most companies lose money. To be able to claim losses, you must “materially participate” in the business, which generally means that you actively work in the company at least 500 hours per year, although 100 hours will suffice if that’s the most among all other shareholders.

      If, like most businesses, the company becomes profitable, it may actually make sense then to convert back to a regular C corporation to partake of the potential advantages of that status. That includes being able to retain earnings in the company, which you can’t do with an S corporation, and being able to use tax-advantaged fringe benefits. (If you plan to take all the profits out of the company, an S corporation may make sense for you.)

      

One way an S corporation can save its owner/shareholders tax money is by paying them some of their compensation in the form of dividends. The reason this saves tax money is because dividends aren’t subject to payroll or employment taxes. You must be careful, though, to ensure employee salaries are reasonable and not set artificially low and made up for by high dividend payments. Speak with a tax advisor who has experience advising other small business owners in situations similar to yours.

An illustration of page one of IRS Form 1120S, U.S. Income Tax Return for an S Corporation.

      Courtesy of the Internal Revenue Service

      FIGURE 2-2: Page one of IRS Form 1120S, “U.S. Income Tax Return for an S Corporation.”

      S corporation requirements

      All corporations actually begin as so-called C corporations, which are the corporations discussed in the section “Deciding whether to incorporate” earlier in this chapter. To become an S corporation, your business must go through an additional “tax election” step. See IRS Form 2553, “Election by a Small Business Corporation.”

       Be a U.S. company

       Have just one class of stock

       Have no more than 100 shareholders who are all U.S. residents or citizens and aren’t partnerships, other corporations, or, with certain exceptions, trusts

      

Be sure to investigate limited liability companies (LLCs), the subject of a later section, before committing to forming an S corporation. LLCs offer the passing through of income that S corporations do and are generally simpler to initiate and operate. As the operator of an LLC, you can still have the future option of converting to an S corporation.

      Partnerships

      A partnership occurs in the eyes of the tax authorities when two or more people — the general partners (GPs) — operate a business together and divide the profits (or losses). The division need not be done equally.

      The GPs are responsible for the company’s debts and liabilities. A partnership may also have limited partners (LPs) who generally provide financing to the business and who aren’t active in the company itself. Most small-business partnerships don’t have LPs.

      

Though the partnership itself doesn’t pay any federal income tax, it has plenty of federal income tax reporting requirements. In fact, the tax rules and reporting requirements of a partnership are quite extensive and challenging. The partnership must file IRS Form 1065, “U.S. Return of Partnership Income.” And the partnership must complete and annually issue IRS Schedule K-1 of Form 1065 to each partner. You’d be well advised to use the services of a tax advisor if you’re going to have your business function as a partnership (see Chapter 13 for the scoop on getting help).

An illustration of page one of IRS Form 1040 Schedule E, Supplemental Income and Loss.

      Courtesy of the Internal Revenue Service

      FIGURE 2-3: Page one of IRS Form 1040 Schedule E, “Supplemental Income and Loss.”

      Limited liability companies (LLCs)

      In recent decades, a new type of corporation has appeared. Limited liability companies (LLCs) offer business owners benefits similar to those of S corporations and partnerships but are even better in some cases.

      LLCs also pass the business’s profits through to the owner’s personal income tax returns, like a sole proprietorship or partnership. You can pass through losses as well and deduct them against your other income so long as you materially participate in the business.

      LLCs are generally much simpler to set up and administer than a corporation. But, to be realistic going into it, don’t expect an LLC to be as simple as a sole proprietorship. And LLCs don’t give you the ability to tap into some of the tax advantages (for example, specific fringe benefits) that some corporations offer.

      LLCs have fewer restrictions regarding shareholders than S corporations. For example, LLCs have no limits on the number of shareholders, and the shareholders can be foreigners, corporations, or partnerships.

      Compared with S corporations, the only additional restriction LLCs carry is that sole proprietors and professionals can’t always form LLCs (although some states allow this). All states now permit the formation of LLCs, but most state laws require you to have at least two partners for an LLC to be taxed as a partnership and not be a professional firm.

      

Single-owner LLCs (which also include married couples in community property states) are treated as sole

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