If you’ve decided to start a business, one of the most important decisions you’ll need to make is choosing a legal entity. It’s a decision that impacts many things–from the amount of taxes you pay to how much paperwork you have to deal with and what type of personal liability you could face. Even if you’ve been in business for a number of years, it’s a good idea to periodically reevaluate your business structure because, as we all know, tax laws can change and that business entity you chose when you first started out may not be the best option ten years later. For example, if you operate your business as a sole proprietor, you must pay a self-employment tax rate of 15% in addition to your individual tax rate; however, if you were to revise your business structure to become a corporation and elect S-Corporation status you could take advantage of a lower tax rate thanks to tax reform.

Forms of Business

The most common forms of business are Sole Proprietorships, Partnerships, Limited Liability Companies (LLC), and Corporations. Federal tax law also recognizes another business form called the S-Corporation. While state law controls the formation of your business, federal tax law controls how your business is taxed.

What to Consider

Businesses fall under one of two federal tax systems and the first major consideration in choosing the form of doing business is whether to choose an entity that has two levels of tax on income or a pass-through entity that has only one level directly on the owners:

1. Taxation of both the entity itself on the income it earns and the owners on dividends or other profit participation the owners receive from the business. C-Corporations fall under this system of federal taxation.

2. “Pass through” taxation. The entity (called a “flow-through” entity) is not taxed, but its owners are each taxed (more or less) on their proportionate shares of the entity’s income. Pass-through entities include:

• Sole Proprietorships
• Partnerships, of various types
• Limited liability companies (LLCs)
• “S-Corporations” (S-Corps), as distinguished from C-corporations (C-Corps)

The second consideration, which has more to do with business considerations rather than tax considerations, is the limitation of liability (protecting your assets from claims of business creditors).

Let’s take a general look at each of the options more closely:

Types of Business Entities

Sole Proprietorships

The easiest (and most common) form of business organization is the sole proprietorship, which is defined as any unincorporated business owned entirely by one individual. A sole proprietor can operate any kind of business (full or part-time) as long as it is not a hobby or an investment. In general, the owner is also personally liable for all financial obligations and debts of the business.

If you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

Types of businesses that operate as sole proprietorships include retail shops, farmers, large companies with employees, home-based businesses and one-person consulting firms.

As a sole proprietor, your net business income or loss is combined with your other income and deductions and taxed at individual rates on your personal tax return. Because sole proprietors do not have taxes withheld from their business income, you may need to make quarterly estimated tax payments if you expect to make a profit. As a sole proprietor, you must also pay self-employment tax on the net income reported.

Partnerships

A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

There are two types of partnerships: Ordinary partnerships, called “general partnerships,” and limited partnerships that limit liability for some partners but not others. Both general and limited partnerships are treated as pass-through entities under federal tax law, but there are some relatively minor differences in tax treatment between general and limited partners.

For example, general partners must pay self-employment tax on their net earnings from self-employment assigned to them from the partnership. Net earnings from self-employment include an individual’s share, distributed or not, of income or loss from any trade or business carried on by a partnership. Limited partners are subject to self-employment tax only on guaranteed payments, such as professional fees for services rendered.

Partners are not employees of the partnership and do not pay any income tax at the partnership level. Partnerships report income and expenses from its operation and pass the information to the individual partners (hence the pass-through designation).

Because taxes are not withheld from any distributions partners generally need to make quarterly estimated tax payments if they expect to make a profit. Partners must report their share of partnership income even if a distribution is not made. Each partner reports his share of the partnership net profit or loss on his or her personal tax return.

Limited Liability Companies (LLC)

A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state is different, so it’s important to check the regulations in the state you plan to do business in. Owners of an LLC are called members, which may include individuals, corporations, other LLCs and foreign entities. Most states also permit “single member” LLCs, those having only one owner.

Depending on elections made by the LLC and the number of members, the IRS treats an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return. A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it elects to be treated as a corporation.

An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it elects to be treated as a corporation.

C-Corporations

In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.

A corporate structure is more complex than other business structures. When you form a corporation, you create a separate tax-paying entity. The profit of a corporation is taxed to the corporation when earned and then is taxed to the shareholders when distributed as dividends. This creates a double tax.

The corporation does not get a tax deduction when it distributes dividends to shareholders. Earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal tax returns. Shareholders cannot deduct any loss of the corporation.

If you organize your business as a corporation, generally are not personally liable for the debts of the corporation, although there may be exceptions under state law.

S-Corporations

An S-corporation has the same corporate structure as a standard corporation; however, its owners have elected to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations generally have limited liability.

Generally, an S-Corporation is exempt from federal income tax other than tax on certain capital gains and passive income. It is treated in the same way as a partnership, in that generally, taxes are not paid at the corporate level. S-Corporations may be taxed under state tax law as regular corporations, or in some other way.

Shareholders must pay tax on their share of corporate income, regardless of whether it is actually distributed. Flow-through of income and losses is reported on their personal tax returns and are assessed tax at their individual income tax rates, allowing S-Corporations to avoid double taxation on the corporate income.

S-corporation owners can choose to receive both a salary and dividend payments from the corporation (i.e., distributions from earnings and profits that pass through the corporation to you as an owner, not as an employee in compensation for your services). Dividends are taxed at a lower rate than self-employment income, which lowers taxable income. S-corp owners also save on Social Security and Medicare taxes because their salary is less than it would be if they were operating a sole proprietorship, for instance.

Furthermore, as a corporation, profits and losses are allocated between the owners based on the percentage of ownership or number of shares held. If the S-corporation loses money, these losses are deductible on the shareholder’s individual tax return. Here’s an example: If you and another person are the owners and the corporation’s losses amount to $20,000, each shareholder is able to take $10,000 as a deduction on their tax return.

To qualify for S-Corporation status, the corporation must meet a number of requirements. Please call if you would like more information about which requirements must be met to form an S-Corporation.

Professional Guidance

When making a decision about which type of business entity to choose each business owner must decide which one best meets his or her needs. One form of business entity is not necessarily better than any other and obtaining the advice of a tax professional is critical.

If you’ve ever used–or provided services for– Uber, Lyft, Airbnb, Etsy, Rover, or TaskRabbit. then you’re a member of the sharing economy and it could affect your taxes. The good news is that if you’ve only used these services (and not provided them), then there’s no need to worry about the tax implications.

However, if you’ve rented out a spare room in your house through a company like Airbnb then you need to be aware of the tax consequences. You may not realize that the extra income you’re making could impact your taxable income–especially if you have a full-time job with an employer. That extra income is taxable even when the activity is cash only or is a part-time “side gig” and it could turn into a tax liability if you’re not careful.

To avoid surprises at tax time, it’s more important than ever to be proactive in understanding the tax implications of your new sharing economy gig and seek the advice of a competent tax professional.

If you have a job with an employer make sure your withholding reflects any extra income derived from your side gig (e.g. boarding pets at your home through Rover or driving for a ride-share company like Uber on weekends). Use Form W-4, Employee’s Withholding Allowance Certificate, to make any adjustments and submit it to your employer who will use it to figure the amount of federal income tax to be withheld from pay.

New Business Owner

While you may not necessarily think of yourself as a newly self-employed business owner, the IRS does. So, even though you work through a company like Airbnb or Rover, you are considered a business owner and are responsible for your own taxes (including paying estimated taxes if you need to). It’s up to you to keep track of income and expenses–and of course, to keep good records that substantiate your income and expenses (more on this below).

If you receive income from a sharing economy activity, it’s generally taxable even if you don’t receive a Form 1099-MISC, Miscellaneous Income, Form 1099-K, Payment Card and Third Party Network Transactions, Form W-2, Wage and Tax Statement, or some other income statement.

And now, for the good news. As a business owner, you are entitled to certain deductions (subject to special rules and limits) that you cannot take as an employee. Deductions reduce the amount of rental income that is subject to tax. You might also be able to deduct expenses directly related to enhancements made exclusively for the comfort of your guests. For instance, if you rent out a room in your apartment through Airbnb, amounts you spend on window treatments, linens, or even a bed, could be deductible. If you drive for Uber and use your personal vehicle you may be able to take the standard business mileage rate, which in 2019, is 58 cents per mile.

Pitfalls: It’s more complicated than it seems

At first glance renting out a spare room through Airbnb or pet sitting through Rover seems like an easy thing to do, but as with most things, it’s more complicated than it seems and you’ll need to keep an eye out for the following pitfalls:

• Insurance requirements
• Business license registration (state or municipal)
• Room and lodging, or tourist taxes
• Estimated Tax Payments
• Tax Withholding
• Forms 1099-MISC or 1099-K

Special Tax Rules for Renting out your Home

If you rent your home out for 15 days or more during a calendar year and you receive rental income for the use of a house or an apartment, including a vacation home, that rental income must be reported on your return in most cases. You may deduct certain expenses such as mortgage interest, real estate taxes, maintenance, utilities, and insurance and depreciation, which reduce the amount of rental income that is subject to tax.

If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. You won’t be able to deduct your rental expense in excess of the gross rental income limitation.

Generally, if you rent out your home for less than 15 days, then you do not need to report any of the rental income and you don’t deduct any expenses as rental expenses.

Recordkeeping

It’s important to keep good records and to choose a recordkeeping system suited to your business that clearly shows your income and expenses. The type of records you need to keep for federal tax purposes depends on what kind of business you operate; however, at a minimum, your recordkeeping system should include a summary of your business transactions (i.e. income and expenses) using a cash basis of accounting. Your records must also show your gross income, as well as your deductions and credits.

If you discover a mistake on your tax return after you’ve already filed, don’t panic. In most cases, all you have to do is file an amended tax return. Here’s what you need to know.

Taxpayers should use Form 1040X, Amended U.S. Individual Income Tax Return, to file an amended (corrected) tax return. An amended tax return should only be filed to correct errors or make changes to your original tax return. For example, you should amend your return if you need to change your filing status or correct your income, deductions or credits. An amended return cannot be e-filed. You must file the corrected tax return on paper. If you need to file another schedule or form, don’t forget to attach it to the amended return.

Taxpayers filing Form 1040X in response to an IRS notice, should mail it to the address shown on the notice.

You normally do not need to file an amended return to correct math errors because the IRS automatically makes those changes for you. Also, do not file an amended return because you forgot to attach tax forms, such as W-2s or schedules. The IRS normally will mail you a request asking for those.

If you are amending more than one tax return, prepare a separate 1040X for each return and mail them to the IRS in separate envelopes. Note the tax year of the return you are amending at the top of Form 1040X. You will find the appropriate IRS address to mail your return to in the Form 1040X instructions.

If you are filing an amended tax return to claim an additional refund, wait until you have received your original tax refund before filing Form 1040X. Amended returns take up to 16 weeks to process. You may cash your original refund check while waiting for the additional refund.

If you owe additional taxes file Form 1040X and pay the tax as soon as possible to minimize interest and penalties on unpaid taxes. You can use IRS Direct Pay to pay your tax directly from your checking or savings account.

Generally, you must file Form 1040X within three years from the date you filed your original tax return or within two years of the date you paid the tax, whichever is later. For example, the last day for most people to file a 2016 claim for a refund is April 15, 2020. Special rules may apply to certain claims. Please call the office if you would like more information about this topic.

You can track the status of your amended tax return for the current year three weeks after you file. You can also check the status of amended returns for up to three prior years. To use the “Where’s My Amended Return” tool on the IRS website, just enter your taxpayer identification number (usually your Social Security number), date of birth and zip code. If you have filed amended returns for more than one year, you can select each year individually to check the status of each.