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How Small Business Taxes Work


Common Business Structures: Sole Proprietorships and Partnerships

The most common types of businesses are sole proprietorships, partnerships, LLCs, corporations (or "C corporations") and S corporations [source: SBA]. These are legal designations that, for tax purposes, vary primarily in three ways: how income is taxed, how Medicare and Social Security taxes are levied and who is liable for any debts the business incurs.

The simplest structures are sole proprietorships and partnerships, and many small businesses start out in these categories because they're so easy to set up and run. They don't need to formally organize with any state agency. If you work for yourself/selves and haven't selected a business structure, you're basically considered a sole proprietorship or partnership as far as taxation goes [source: FindLaw].

Liability

Sole proprietorships and partnerships are not legal entities, which means they don't exist apart from their owners. Businesses finances and personal finances are one and the same, so owners are personally responsible for any debts incurred (or legal actions brought against) their companies [source: SBA].

Income Tax

Sole proprietorships and partnerships do not pay income tax at the business level. Business profits "pass through" the company to its owner(s). Income is taxed at the individual level and is reported at the end of the tax year on the owners' individual returns [source: IRS]. (Partnerships also have to file an "information return" at the end of the year reporting their profits and losses [source: IRS]).

Employment/Self-employment Tax

Owners of sole proprietorships and partnerships pay self-employment taxes. The entire amount of the business's taxable income is subject to self-employment tax [source: IRS].

The big upside to sole proprietorships and partnerships is simplicity. There's not much involved in forming the business, and dealing with business taxes is almost as straightforward (relatively speaking) as filing personal taxes.

On the downside, owners are personally responsible for all business liabilities. They're also taking a big hit on self-employment taxes, paying the entirety of the tax on the entirety of their profits.

To address these one or both of these downsides, business owners need to complicate things – but perhaps only slightly.


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