If an individual is earning business income and owns an unincorporated business by themselves, that person is considered a sole proprietor. For a sole proprietorship, their business income is reported directly on their personal federal income tax return, which means their business doesn’t owe taxes separately. Instead, they’ll pay taxes on their business’s earnings at their individual federal income tax rate.
In this arrangement, taxable income from the business flows through to the partners’ individual income tax returns via Schedule K-1, generally depending on the percentage of the partnership owned by each partner. If two individuals own the business 50/50, they’ll generally each pay taxes on 50% of the taxable income. But partners can also create a partnership agreement with an income allocation that differs from what the ownership percentages may otherwise dictate. Because a partnership may be formed without formal documentation where two or more individuals are engaged in a trade or business together to earn a profit, the individuals should consult with a legal and/or tax advisor if they potentially may be involved in a partnership.
This is a partnership structure in which each partner’s legal liability is generally limited to the amount of the partner’s investment in the business. If the partnership fails, creditors generally cannot pursue the partners’ individual assets or income. Like with other partnerships, all of an LLP’s income passes through the LLP to the partners’ individual tax returns via Schedule K-1.
This structure offers a good combination of legal and tax benefits. An individual can set up an LLC to obtain some protection from legal liability. A single-member LLC is automatically treated as a disregarded entity (and a sole proprietorship if owned by an individual directly), and a multimember LLC is automatically treated as a partnership for federal income tax purposes, although an individual can elect for the LLC to be treated as a C or S corporation for federal income tax purposes. Unless the member(s) of an LLC elects for the LLC to be treated as a C corporation, their income is still reported directly on their individual tax return (if a multimember LLC, via Schedule K-1).
The most common type of corporation is a C corporation. In this case, the individual’s business — the corporation — pays taxes on its taxable income, a so-called entity-level tax. The U.S. federal corporate income tax rate is currently 21%. Company employees pay individual income tax on wages, and company shareholders pay individual income tax on dividends (at capital gains tax rates if qualified dividends) and certain other distributions from C corporations.
Another kind of corporation, called an S corporation, could have tax advantages in certain specific situations but are subject to strict ownership restrictions. For S corporations, the business owners owe individual income tax on the income of the corporation allocated to them, but the S corporation generally pays no entity-level income tax (subject to certain exceptions). A shareholder may be able to reduce their individual income taxes through “income splitting,” in which they take a reasonable salary on which they pay income, Social Security and Medicare taxes, and take the rest of their compensation as distributions on which they are not required to pay self-employment tax. Business owners should consult a legal and/or tax advisor to ensure compliance with reasonable salary requirements.
If an individual sets up a nonprofit entity with a qualified purpose, such as a charitable mission, the organization generally won’t owe federal income taxes on certain types of its income. But some nonprofits develop income-generating projects that aren’t part of their exempt purposes, and in those cases, they can owe tax on what’s called unrelated business taxable income.
Once an individual has decided on the right structure for their business, the next step is to begin the business formation process.
Third-party providers specializing in business formation can help streamline the process and get the necessary documentation. You can learn more about exclusive offers to legally form your business from Incfile, a national provider of business formation services that has helped more than 500,000 entrepreneurs get started.
Keep in mind that business structures generally are governed by states and set up through state agencies, but local, state and federal governments may all levy taxes. It will fall to the business owner to keep track of all the various tax-filing deadlines. Business owners should consult with a legal and/or tax advisor to determine the right tax structure for their needs and locale.
