When you start a business in Utah, you are going to make money. When you make money, you will have to pay taxes. The type of business you create will determine how you account to the IRS for the money you make. The four business entities that an entrepreneur will typically encounter are partnerships (including limited liability companies), C corporations, S corporations, and disregarded entities.
The focus of this article is to help provide guidance as to the tax implications of each business entity and best practices for your new business. Tax only. Other considerations are discussed elsewhere. You should not pick your business entity based solely on tax implications because a business entity decision should take into consideration many other factors not discussed here– things like personal liability protection, expansion and taking on partners, management structure, and obtaining investors or loans.
Typically partnerships are “pass through” entities. This means that the partnership does not pay taxes or file a tax return but instead files a Form 1065 U.S. Return of Partnership Income. The Form 1065 identifies, according to percentage of ownership, the partnership income/loss, deductions, credits, etc., and distributes to the partners a Schedule K-1 with this information. Each partner then files their own tax return which incorporates the numbers from the Schedule K-1.
Unless you are certain about your accounting and tax abilities, you should get a tax accountant to prepare your Form 1065. There are issues that you may want to consider which are beyond the scope of this article such as whether you would benefit from electing to file as a C corporation or an S corporation or have partnership income/loss, etc. allocated in percentages other than according to ownership. All are possible but may or may not be right for you.
A disregarded entity is simply one that has only one member (i.e., a single member limited liability company). A disregarded entity is not required to file a Form 1065 but simply includes all income, losses, deductions, credits, etc. under the single partner’s individual tax return.
An S corporation is a small business corporation and is, like a partnership, considered a “pass-through” entity. The difference between a partnership and S corp is that the income/loss, deductions, credits, etc. are determined at the corporate level and then paid at the shareholder level through a Schedule K-1. The tax implication may be a distinction without a difference depending on your circumstances. The tax implication will not likely sway your decision as between an S corp and a partnership.
A C corporation and its shareholders are subject to double taxation: the entity (C corp) files a corporate tax return and potentially pays taxes on its net income and when shareholders receive dividends, the dividend income is taxable income to the shareholder on the shareholder’s tax return. There are reasons to use a C corp but the tax implication makes it untenable for many small businesses. Unless you have a really good reason (not discussed here– I told you this is focused on tax), you should likely avoid the C corp business entity.
The Employer Identification Number
Whatever entity you choose (except for disregarded entities) will need to obtain an EIN from the federal government at the IRS website here. Disregarded entities do not need an EIN.
Unless you want the IRS visiting you, you must keep accurate, substantiated, and timely books and records of your income and expenses. This means keeping accounting records, bank statements, receipts, invoices, etc. The IRS accepts electronic copies so, do yourself a favor and scan everything. Depending on the evidentiary purpose of the record, you may need to keep it indefinitely. Your business will affect the type of records you need to keep for the IRS. For example, if you maintain long-term deductions or expenses, you will need the supporting documentation. Also, expenses identified in basis calculations for assets must also be maintained as long as that basis calculation is relevant to your tax calculations. You also need to keep records connected to property so that you can calculate any depreciation, amortization, or depletion deduction, and to factor the gain or loss when you sell or dispose of the property. How long you need to keep it depends on many factors. When in doubt, keep it.
There are issues and nuances that cannot all be addressed here– this is tax stuff! If you have questions, you should get specific legal advice. If you would like more information about business entities or tax, call me, Utah attorney Ken Reich, directly. I have represented both companies and individuals in business formation and related matters of all kinds. I will definitely engage the services of my partners, however, if you have any thorny tax questions! Using my many years of experience and backed by a firm of legal specialists in nearly every legal field, I can help you or your company evaluate your situation and help you make smart decisions about your business and your life that will best fit your circumstances.