Small Business Taxation

Like large corporations and individuals, small businesses are subject to taxation by the government. Depending on the jurisdiction, small businesses may also be subject to state and local taxes in addition to federal taxes. To help small business thrive, the U.S. government has put a number of provisions into place that encourage entrepreneurs and other small business owners. How a small business is taxed depends on its structure. The most common structures for small businesses include sole proprietorships, partnerships, corporations, subchapter S corporations, and limited liability companies.

Keywords: Accounting; Asset; Corporation; Entrepreneur; Limited Liability Company; Partnership; Small Business; Sole Proprietorship; Taxes

Overview

Although the United States may have a reputation for being the home of big business, industrial giants, and large corporations, it also has a long history of supporting and nurturing small businesses. There is a widespread understanding that the success of small business is good for the economy. The general attitude toward small business in this country is that it helps create jobs, provides healthy competition for existing businesses by improving the quality of goods and services offered and reducing prices, contributes to innovation and technological advances, and, in general, improves the country's standing in the global marketplace (Holtz-Eakin, 1995). Whether or not this is actually true is a matter of debate in the literature. However, based on this widespread assumption, the U.S. government has put a number of provisions into place that encourage entrepreneurs and other small business owners.

What is a Small Business?

The definition of small business can change from context to context. According to the U.S. Small Business Administration (SBA), a small business concern is:

• Organized for profit;
• Has a place of business in the United States;
• Makes a significant contribution to the U.S. economy through payment of taxes or use of American products, materials or labor;
• Is independently owned and operated;
• Is not dominant in its field, on a national basis; and
• Is no larger than SBA's small business size standard for its industry (http://web.sba.gov/faqs/faqindex.cfm?areaID=15).

However, size standards for small businesses often vary from industry to industry. Sometimes "small" is defined in terms of number of employees while at other times it is defined in terms of sales, revenue, or other output measures. In other situations, "small" is defined in terms of assets.

Not all small businesses are entrepreneurial in nature. Although at its most basic, entrepreneur describes a person who starts a new business, the word typically carries with it the connotation of taking risks to turn innovative ideas into profit-making ventures. Although a new convenience store may be classified as a small business, it is unlikely to be entrepreneurial in nature.

There are a number of ways that small businesses may structure themselves. Each of these structures brings with it different tax responsibilities. Because of the long-term implications on structure for a small business, the SBA recommends consulting with an attorney or accountant before making the decision as to how to structure a new business. Optimal choice of a business structure is dependent on many factors including the degree of control the owner desires to have over the operations of the business, how vulnerable to lawsuits the business (or its owners) is willing to be, the need for the owner to access funds from the business to pay him/herself, and the tax implications of the structure.

In addition to federal taxes, in most localities businesses are also required to pay state and sometimes local taxes. On a state level, these tend to be income taxes on a structure parallel to that imposed by the federal government. However, Ertmer and Sash (2006) note that increasingly, states are imposing a type of gross receipts tax on businesses. In this approach to alternative taxation, taxes are imposed on the gross sales receipts of the business and are payable by the seller. Such taxes can be imposed in different ways, including as a tax for permission to operate in the state or may be imposed only on certain types of businesses. As opposed to income taxes imposed on net income, this type of tax tends to be simpler to calculate and does not require complicated accounting procedures. From the perspective of the state, this type of tax often produces more income that traditional income taxes. However, such tax structures tend to be less fair to start-up businesses, loss companies, and organizations that operate at high volume, low profits. As a result, businesses tend to prefer traditional income tax structures to gross receipt tax structures because they tend to be fairer, even though they require more complicated accounting procedures.

Applications

Types of Small Business

According to the SBA, there are five basic ways in which a small business can be structured:

• Sole proprietorship,
• Partnership,
• Corporation,
• Subchapter S corporation, and
• Limited liability company

Each of these approaches has different implications from a tax point of view, including how the business is taxed, the degree to which the owners are liable for the debts of the business, what records need to be kept, what accounting procedures need to be followed, and what forms need to be filed.

Sole Proprietorship

The sole proprietorship is the most common structure for small businesses. In a sole proprietorship, a single individual is the sole owner of the business. In this business structure, there is no legal distinction between the assets and liabilities of the owner and of the business. Therefore, a sole proprietor takes on all the benefits — as well as all the risks — of the business. If the business is profitable, all the profits belong to the individual owner. If the business has debts, on the other hand, the individual owner is fully liable for them. In this situation, both the individual's business and personal assets are at risk.

It can be difficult to raise money for a sole proprietorship, and the owner frequently uses his/her personal assets or consumer loans. In addition, not all expenses frequently thought of as business deductions can be directly or fully deducted for tax purposes. Although in many ways structuring as a sole proprietorship carries with it a number of risks for the owner, it also has a number of advantages. First, sole proprietorship is the easiest and least expensive form of business to organize. Second, from a tax standpoint, all the profit and loss from the business are addressed within the individual's personal tax returns rather than through a more complicated corporate tax paperwork. Third, just as it is easy to establish a sole proprietorship, it is similarly easy to dissolve one since only one person is involved. Sole proprietorships require the least record keeping, are subject to minimal regulatory controls, and allow one to avoid double taxation.

Some of the federal tax forms that may apply to sole proprietorships include:

• Form 1040: Individual income tax return
• Schedule C (or Schedule C-EZ): Profit or loss from business
• Schedule SE: Self-employment tax
• Form 1040-ES: Estimated tax for individuals
• Form 4562: Depreciation and amortization
• From 8829: Expenses for business use of one's home
• Employment tax forms for any employees

(It is important to note that the lists of tax forms mentioned in this article are representative and are not intended to present a complete list of forms needed or reporting requirements nor are all forms necessary for all small businesses.)

Partnerships

Partnerships are similar to sole proprietorships in terms of risks and benefits to the owners. In a partnership there are two or more owners of the business rather than a single sole proprietor. Partnerships are more complicated than sole proprietorships because the needs of all the partners need to be taken into account. To ease both operations and potential dissolution of the partnership, therefore, it is advisable that the partners draw up a legal document at the time of start up that articulates how decisions will be made and disputes between the partners resolved, how the profits will be distributed, and the steps taken to dissolve the partnership. Before starting a partnership, the partners also need to decide how much capital or other assets each partner will bring to the business.

Partnerships have a number of advantages. As with sole proprietorships, partnerships are easy to establish (except for the time involved in working out an agreement between the partners). From a tax standpoint, all the profits and loss from the business are addressed within the partner's personal tax returns rather than through a more complicated corporate tax structure. Partnerships have additional advantages over sole proprietorships in that partners may be able to bring complementary skill sets to the business which may help it be more successful and make it easier to raise money. On the other hand, partnerships are not without their disadvantages. As with sole proprietorships, all the partners are legally and fiscally responsible for the business. As such, partners are also responsible for the actions of each other. Another disadvantage of the partnership is that the profits must be shared among the partners. Since decision making is shared, individual partners lose some control and conflict among partners may arise.

There are several different types of partnerships that are applicable to small businesses. A general partnership is the simplest type of partnership. In this structure, the partners share both liability and profits according to their written agreement. If there is no written agreement, it is assumed that all partners share equally in the business. A second class of partnership is the limited partnership and the partnership with limited liability. This approach to partnerships limits the liability of the individual partners in proportion to their investments in the business. Typically, their inputs into the running of the business are similarly limited. A third type of partnership structure that can be useful to small businesses is the joint venture. This structure is similar to a general partnership, but is limited in scope to a particular project or for a given period of time. If the partners in a joint venture continue to work together indefinitely, they are considered an ongoing partnership and are required to file as such for tax purposes.

Some of the federal tax forms that may apply to partnerships include:

• Form 1065: Partnership return of income
• Form 1065 K-1: Partner's share of income, credit, and deductions
• Form 4562: Depreciation
• Form 1040: Individual income tax return
• Schedule E: Supplemental income and loss
• Schedule SE: Self-employment tax
• Form 1040-ES: Estimated tax for individuals
• Employment tax forms for any employees

Corporations

Perhaps the best known structure for a business is the corporation, or C corporation. A corporation is a unique entity separate from the individuals who found it. As such, it can buy, sell, own, enter into a contract, sue and be sued, and is taxed. All these things can happen separately to the corporation from its owners. The owners of the corporation have limited liability for what is done by the corporation. Unless the owners have guaranteed debt, for example, with their personal assets, they are only liable up to the limit of the assets of the corporation. The shareholders (i.e., the owners) of the corporation elect a board of directors who oversee the operation of the organization at a high level. The shareholders share the profits and losses incurred by the corporation. As opposed to a sole proprietorship and many partnerships, corporations can continue even after the loss of the original owners.

There are many advantages to incorporation. One of the most obvious is the limits on liability for the owners of the business (although officers of the corporation are still legally liable for their actions). As opposed to sole proprietorships and partnerships, corporations may deduct the cost of benefits provided to its officers and employees. On the other hand, incorporation involves a much more complicated process than does the establishment of a sole proprietorship or partnership. Record keeping and reporting requirements for corporations are also more onerous. Corporations are monitored by government agencies and often are required to document compliance with various government regulations. Taxes on corporations tend to be higher than those on sole proprietorships and partnerships. Corporations are also not allowed to deduct the dividends paid to shareholders, so these monies are essentially taxed twice.

Some of the federal tax forms that may apply to a C Corporation include:

• Form 1120 or 1120-A: Corporation income tax return
• Form 1120-W: Estimated tax for corporations
• Form 8109-B: Deposit coupon
• Form 4625: Depreciation
• Employment tax forms for any employees
• Appropriate tax forms for capital gains, sale of assets, alternative minimum tax, etc.

Subchapter S Corporation

A particular type of corporation that is often used by small business is the subchapter S corporation. This type of corporate structure affects the business's tax liability by enabling earnings and profits to directly pass through to the personal income tax returns of the shareholders. Under this type of structure, shareholders who work for the business must pay themselves reasonable wages, which then are counted as income on their personal taxes rather than as profits against the business.

Some of the federal tax forms that may apply to subchapter S corporations include:

• Form 1120S: Income tax return for subchapter S corporation
• Form 1120S K-1: Shareholder's share of income, credit, deductions
• Form 4625: Depreciation
• Employment tax forms for any employees
• Form 1040: Individual income tax return
• Schedule E: Supplemental income and loss
• Schedule SE: Self-employment tax
• Form 1040-ES: Estimated tax for individuals
• Appropriate tax forms for capital gains, sale of assets, alternative minimum tax, etc.

Limited Liability Company

Finally, small businesses may also be structured as a limited liability company (LLC) in most states. This structure incorporates many of the advantages of a partnership (tax efficiency, operational flexibility) and of a corporation (limited liability). Formation of an LLC is more complicated than for a partnership, however. Although a time limit must be placed on an LLC, this can typically be extended. Although LLCs have some of the characteristics of corporations, they are limited to having only two (i.e., limited liability, continuity of life, centralization of management, free transferability of ownership interests).

Some of the federal tax forms that may apply to LLCs include:

• Form 1040: Individual income tax return
• Schedule C: Profit of loss from business
• Schedule E: Supplemental income and loss
• Schedule SE: Self-employment tax
• W-2: wage and tax statement
• W-3: Transmittal of wage and tax statements
• Form 940: Employer's annual federal unemployment tax return
• Form 944: Employer's annual federal tax return
• Form 1065: Return of partnership income
• Form 1096: Annual summary and transmittal of U.S information returns
• Form 1120: Corporation income tax return
• Form 1120-S: income tax return for an S corporation
• Form 8832: Entity classification election

Conclusion

It has long been observed that the only things of which one can be certain in life are death and taxes. Taxes are used by governments to finance their expenditures and may also be used to encourage desirable outcomes or discourage undesirable outcomes in the national economy. Like individuals, therefore, businesses are required to pay taxes — not only to the federal government, but to state and often local governments as well. How a business is taxed depends on how it is structured. New businesses need to carefully examine their short -and long-term goals before determining which type of structure is best for them.

Terms & Concepts

Accounting: The systematic practice of recording, verifying, and communicating the financial information of the organization. Accounting practices include recording transactions, keeping financial records, performing internal audits, and communicating this information to the appropriate stakeholders.

Asset: A valuable resource that has monetary value, is owned by an individual or business entity, and returns a benefit to the owner in the process of generating income. Assets may include tangible property (e.g., cash, machinery, real estate, inventory) and intangible property (e.g., patents, trademarks, goodwill).

Business: An economic system in which goods and services are exchanged between parties. The metric for the exchange of goods and services is based on their relative perceived worth, and may be done for money or for other goods and services. To be viable, a business requires an investment, customers, and the ability to consistently sell goods and services at a profit.

Corporation: A business structure that is unique entity separate from the individuals who own it. Corporations can buy, sell, own, enter into a contract, sue and be sued, and be taxed. Owners of a corporation have limited liability for what is done by the corporation, and are only liable up to the limit of the assets of the corporation in most cases. The shareholders of the corporation elect a board of directors who oversee the operation of the organization at a high level. The shareholders share the profits and losses incurred by the corporation. As opposed to a sole proprietorship and many partnerships, corporations can continue even after the loss of the original owners.

Entrepreneur: At its most basic, an entrepreneur is a person who starts a new business. However, the word typically carries with it the connotation of taking risks to turn innovative ideas into profit-making ventures.

Partnership: A business with two or more owners rather than a single proprietor. As in a sole proprietorship, business partners are liable for the debts and liabilities of the business. Partnerships are similar to sole proprietorship in terms of risks and benefits to the owners.

Small Business: According to the U.S. Small Business Administration, "[a] small business concern is organized for profit; has a place of business in the United States; makes a significant contribution to the U.S. economy through payment of taxes or use of American products, materials or labor; is independently owned and operated; is not dominant in its field, on a national basis; and is no larger than SBA's small business size standard for its industry" (http://web.sba.gov/faqs/faqindex.cfm?areaID=15).

Sole Proprietorship: A business structure in which a single individual is the sole owner of the business. In a sole proprietorship, there is no legal distinction between the assets and liabilities of the owner and of the business. Therefore, the owner takes on all the benefits — as well as all the risks and liabilities — of the business. Sole proprietorship is the most common structure for small businesses.

Taxes: A mandatory contribution imposed by the government on individuals, groups, and business entities. Taxes are used by governments to finance their expenditures and may also be used to encourage desirable outcomes or discourage undesirable outcomes in the economy.

Bibliography

Bruce, D., & Deskins, J. (2012). Can state tax policies be used to promote entrepreneurial activity?. Small Business Economics, 38, 375-397Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=73036435&site=ehost-live

Ertmer, B. & Sash, R. (2006). State of the states. Journal of State Taxation, 24 , 15-20. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=33979454&site=ehost-live

Holtz-Eakin, D. (1995). Should small businesses be tax-favored? National Tax Journal, 48 , 387-395. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9511062878&site=ehost-live

Hulse, D. S. & Pope, T. R. (1996). The effect of income taxes on the preference of organizational forms for small businesses in the United States. Journal of Small Business Management, 34 , 24-35. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9603063376&site=ehost-live

Ming Ling, L., & Arifin, M. (2011). Small business enterprises and taxation: A case study of corporate clients of a tax firm. Academy of Accounting & Financial Studies Journal, 11-24. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=65031075&site=ehost-live

U. S. Internal Revenue Service. (2010). Tax information for businesses. Retrieved 23 August 2010 from IRS Website http://www.irs.gov/businesses/index.html

U.S. Small Business Administration. (n.d.). Choose a structure. Retrieved 23 August 2010 from SBA Website http://www.sba.gov/smallbusinessplanner/start/chooseastructure/index.html

Wilkie, P. J. (1996). Discussion of organizational form and taxes: An empirical analysis of small businesses. Journal of the American Taxation Association, 18 , 68-74. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6144904&site=ehost-live

Suggested Reading

Bruce, D. & Mohsin, M. (2006). Tax policy and entrepreneurship: New time series evidence. Small Business Economics, 26 , 409-425. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21806058&site=ehost-live

Hasseldine, J., Hite, P., & Toumi, M. (2007). Persuasive communications: Tax compliance enforcement strategies for sole proprietors. Contemporary Accounting Research, 24 , 171-194. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24470538&site=ehost-live

Holtz-Eakin, D., Phillips, J. W. R., & Rosen, H. S. (2001). Estate taxes, life insurance, and small business. Review of Economics and Statistics, 83 , 52-63. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4101673&site=ehost-live

Joulfaian, D. & Rider, M. (1998). Differential taxation and tax evasion by small business. National Tax Journal, 51 , 675-687. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=1427260&site=ehost-live

Larkins, E. R. & Jacobs, F. A. (1996). Tax incentives for small businesses with export potential: A capital budgeting decision analysis. Accounting Horizons, 10 , 32-50. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9606192925&site=ehost-live

Marples, D. J. (2007). State and local tax policy: Evidence of its effect on entrepreneurship. Proceedings of the Annual Conference on Taxation, 225-230. Retrieved 16 August 2010 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=31322886&site=ehost-live