A lot of people fail to realize that when you're self-employed, the legal form under which you operate your business directly affects the way the IRS views your tax status and, therefore, will have some bearing on how you pay yourself.
The easiest way to get into business is as a sole proprietor. A sole proprietor doesn't have any partners to worry about, nor a corporate identity to hide behind. As a sole proprietor, the buck stops at your desk and nobody else's. If you get tagged with a lawsuit, you face the liability. It's as simple as that.
On the other side of the coin, if your company does well, you reap the profits. Under a sole proprietorship, profits from the business and your personal income are treated the same by the IRS. There is no distinction.
After deducting all your overhead expenses on Schedule C of Form 1040, the resulting profit is your income and you are taxed on that portion, including a tax for social security under the Federal Insurance Contributions Act.
A partnership is a totally different vehicle from the sole proprietorship in terms of operations, but from the point of view of the IRS they are practically the same. Any profit generated through a partnership is treated as personal income. Instead of completing Schedule C of Form 1040, however, partnerships must file Form 1065, U.S. Partnership Return of Income. This lists all expenses that can be directed against income to arrive at the taxable income generated from your business. Schedule K-1 should be sent to each partner to help them report their share of the income on Form 1040. You do not need to file Schedule K-1.
If your business is organized as a corporation, you will get paid a salary like other employees. Any profit the business makes will accrue to the corporation, not to you personally. At the end of the year, you must file a corporate income tax return.
Corporate tax return may be prepared on a calendar- or fiscal- year basis. If the tax liability of the business is calculated on a calendar year, the tax return must be filed with the IRS no later than March 15 each year.
Reporting income on a fiscal-year cycle is more convenient for most businesses because they can end their tax year in any month they choose. Pursuant to the 1986 Tax Reform Act, a corporation whose income is primarily derived from the personal services of its shareholders must be a calendar year end for tax purposes. In addition, most Subchapter S corporations are required to use calendar year ends.
The salary you receive from the corporation is, of course, reported as your own personal income on Form 1040. As the CEO of a corporation, you'll be able to plan your salary with an eye toward tax rates. You may be able to set up a staggered fiscal year, differing from the calendar year by which individuals are typically taxed. You may accrue or defer income between the corporation and yourself so you can stay in the lower tax bracket consistently. You can zero out the income of the company. In other words, make sure the corporation doesn't have any income outstanding at the end of the year.
How can you achieve this? Pay salaries that will absorb whatever profits there are in the company. There is a limit to how much of this you can do, and in most states you have to document the process with appropriate resolutions and directors' meetings. But for most small companies not making a tremendous amount of money, it makes sense to pay income out of the corporation in the form of salary.
There is a danger to this strategy, especially when it comes to awarding big bonuses to yourself. If you're the owner of a small, privately owned C-corporation, the IRS will look closely at returns to determine if there is "excessive compensation" to lower the tax liability of the company. If the IRS determined the bonus, in addition to your regular salary, is too large, they'll disallow the deduction of the bonus as an expense to the corporation. In addition to the loss of the deduction, increasing the amount of tax to be paid, the IRS will also charge you interest and, more than likely, penalty fees. There is also a possibility that the IRS may establish the excessive bonus as a dividend payment, which will cause that payment to be "double-taxed" to both the corporation and your personal taxes.
No matter which legal form you choose, it's vital that you discuss this decision with your tax accountant or attorney to make sure you're operating legally and getting the best deal on your taxes.
This article was excerpted from The Small Business Encyclopedia.