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How Your Business Structure Is Taxed and Its Impact

by Brett Backues on January 26, 2011
Last week, I focused on the potential liability related to the choice of entity chosen to operate a small business. This week I’ll review how each business structure is taxed and how that choice will impact whether to remain a sole proprietorship, or if the long-term interests of the company are better served by the creation of some type of corporation.
First, a quick review. An LLC or corporation can serve as a protective layer against litigation that might be used to attack personal assets of the owner if the company is hauled into court. But it’s important to remember that forming a corporation does not eliminate the need for commercial liability insurance.
This post will speak directly to the owners and CEOs of companies headquartered in the state of Washington. Washington State is not only beautiful because of its lush evergreen forests, it is also one of just nine states that does not levy an income tax. Regardless of its formal structure, every business within the state will be taxed in a similar manner by its local government. Every business will be required to pay:
-A revenue-based business and occupation (B&O) tax (paid to the state and local municipality)
-A sales (or use) tax on consumables purchased (paid to the state), and
-Property taxes (paid to the county).
Some companies will also be required to pay miscellaneous fees levied on specific industries.   So, unless the company is an approved non-profit, the state will eventually get its share of the profits.
The real difference in taxation comes on the national scale in the form of taxes collected by the Internal Revenue Service (IRS). How each business will be taxed depends on the type of structure selected at the state level. The chart below identifies the paperwork the CFO of the company will undoubtedly become intimate with:
 
Business Structure, formed in WA State
 IRS tax reporting (the default case)
Sole proprietorship
Schedule C with your 1040
Limited Liability Company or LLC
Schedule C with your 1040 (with no other partner except spouse) 
LLC (with partner other than spouse)
Form 1065, Partnership tax return
Partnership, LLP, Limited Partnership
Form 1065, Partnership tax return
Corporation
Form 1120, Corporate Tax Return
 
In the eyes of the IRS, an individual is considered “self-employed” unless the business is incorporated.  This is where the real fun begins and why accountants and tax attorneys are indebted to the IRS for job security.
The IRS considers all non-corporate earnings as “Self-employment income,” and are thereby subject to “self-employment taxes.” This contribution is the business equivalent to the Social Security and Medicare taxes paid by standard W-2 employees.  The federal government is allowed to retain a certain percentage of an employee’s paycheck. The current tax code allows 6.2 percent for Social Security up to the first $106,800 of wages and 1.45 percent for Medicare.  What employees do not see is that employers are required to match the federal assessments. That means an amount equivalent to more than 15 percent of an employee’s gross wages goes directly into payroll taxes. 
If the W-2 employee takes a leap of faith to become an entrepreneur, that employee is now self-employed. In IRS terms, a sole proprietor translates into an individual paying both the employee and employer portion of the payroll tax, or as much as 15 percent of the business profits.  The self-employment tax is over and above regular income tax.  This means that the typical new business owner (in the 25 percent tax bracket) could be required to turn over as much as 40 percent of the company profits in the form of an income tax.
But there is help available from the lawmakers in the OTHER Washington.  Partnerships, LLCs and corporations can each qualify to be considered an S Corporation by the federal tax collectors.  
Next week, I will examine why one of these business identities could be a great idea, and explain why not.
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