If you are thinking about starting a business, you need to know your federal tax responsibilities in addition to the nuts and bolts of running the business itself. The following discussion provides some basic federal tax information for people who are about to start a business, including information on:
Checklist for Starting a Business
Most businesses start out small. The checklist below provides the basic steps you should follow from a federal tax standpoint to start a business. The list is general, not all-inclusive for all businesses and all situations. Other steps may be appropriate for your specific type of business. You also may want to check the Small Business Administration’s Web site for the SBA’s checklist for starting a business.
As you begin your business, you will have to:
- consider and select an appropriate business structure;
- apply for an employer identification number if applicable;
- choose a tax year;
- choose an accounting method;
- pay your business taxes; and
- set up and maintain a record-keeping system suitable for your business.
Each of these points is considered below. And one more point: If you have employees, have them fill out Form I-9 and Form W-4. If your employees qualify for and want to receive advance earned income credit payments, they must give you a completed Form W-5.
Choosing Your Business’s Tax Structure
When beginning a business, you must decide what form of business entity to establish. Your form of business determines which income tax return form you have to file. The most common forms of business for tax purposes are the sole proprietorship, partnership, corporation, and S corporation. A limited liability company is another business structure allowed by state statute. For tax purposes, an LLC may be a proprietorship, partnership, or a corporation, depending on your situation. Legal considerations also enter into selecting a business structure.
Sole Proprietorships. A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company, you are not a sole proprietor if you elect to treat the LLC as a corporation.
Partnerships. A partnership is a relationship between two or more persons who 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.
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead it passes through any profits or losses to its partners. Each partner includes his share of the partnership’s income or loss on his tax return.
Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 must be filed, including extensions.
Usually, neither the partners nor the partnership recognize a gain or loss when property is contributed to the partnership in exchange for a partnership interest. That’s so whether a partnership is being formed or is already operating. The partnership’s holding period for the property includes the partner’s holding period.
A partner also can acquire an interest in partnership capital or profits as compensation for services performed or to be performed.
A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership. The fair market value of such an interest generally must be included in the partner’s gross income in the first tax year in which the partner can transfer the interest or the interest is not subject to a substantial risk of forfeiture.
A profits interest is a partnership interest other than a capital interest. If a person receives a profits interest for providing services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the receipt of the interest is not taxable for the partner or the partnership.
Corporations. In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes, and distributes profits to shareholders.
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. Shareholders cannot deduct any loss of the corporation.
In most cases, a corporation may be formed without a current tax. The transfer of money or property to a corporation is tax free if two conditions are met. First, the transfer must be made solely in exchange for stock of the corporation. Second, the transferors as a group must be
in control of the corporation after the transfer — that is, they must hold 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of each class of nonvoting stock. The tax-free transfer of money or property to a corporation may take place at any time, not just when the corporation is organized. The basis of the property transferred to the corporation has the same basis for the corporation as it had in the hands of the shareholders before the transfer. Similarly, basis of stock received by the shareholders is the same as the basis of the property they transferred.
In some cases, individuals may contribute their services to the corporation in exchange for stock. The performance of services for stock is outside the tax-free transfer of money or property. What’s more, if individuals performing services in exchange for stock receive more than 20 percent of the corporation’s stock, the entire incorporation becomes taxable because the 80 percent control requirement will not have been met by the other shareholders. In that
case, individuals transferring appreciated property to the corporation will be taxed on the appreciation. The basis of the property to the corporation, as well as the shareholders’ basis for the stock received, will be adjusted to reflect the taxable nature of the transaction by increasing basis for the amount of gain recognized.
S Corporations. S corporations are corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on specified built-in gains and passive income.
To qualify for S corporation status, the corporation must:
- be a domestic corporation;
- have only allowable shareholders, which include individuals and some trusts and estates (an allowable shareholder does not include a partnership, corporation, or nonresident alien);
- have no more than 100 shareholders;
- have only one class of stock; and
- not be an ineligible corporation — such as an insurance company, a domestic international sales corporation, or the kind of financial institution described in the Internal Revenue Code’s eligibility requirements for S corporation.
To become an S corporation, the corporation must also submit a Form 2553, “Election by a Small Business Corporation,” that has been signed by all of the corporation’s shareholders.
Limited Liability Company. A limited liability company is a business structure allowed by state statute. An LLC is a popular form of business because, like a corporation, the owners have limited personal liability for the debts and actions of the LLC. Other features of the LLC are more like a partnership, providing management flexibility and the benefit of passthrough taxation.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members. Most states also permit single-member LLCs — that is, those with only one owner.
A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. For more information on the kinds of tax returns to file, how to handle employment taxes, and possible pitfalls, check out IRS Publication 3402, “Tax Issues for Limited Liability Companies.”
An employer identification number (EIN) is also known as a federal tax identification number and is used to identify a business entity. Generally, businesses need an EIN. You may apply for an EIN in many ways, including through the IRS’s Web site. Be sure to check with your state to see if you need a state tax number or charter. Do You Need an EIN?
You will need an EIN if any of the following apply:
- you have employees;
- you operate your business as a corporation or a partnership;
- you file employment, excise, or ATF (alcohol, tobacco, or firearms) tax returns;
- you withhold taxes on income, other than wages, paid to a nonresident alien;
- you have a Keogh plan (self-employed retirement plan); or
- your business involves trusts (except some grantor-owned revocable trusts), IRAs, exempt organization business income, estates, real estate mortgage investment conduits, nonprofit organizations, farmers’ cooperatives, or plan administrators.
You must figure your taxable income and file an income tax return on the basis of a tax year. A tax year is an annual accounting period for keeping records and reporting income and expenses. An annual accounting period does not include a short tax year.
The tax years you can use for your business are the calendar year or the fiscal year. A calendar tax year is 12 consecutive months beginning January 1 and ending December 31. A fiscal tax year is 12 consecutive months ending on the last day of any month except December. A 52-53-week tax year is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month.
Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. A required tax year is a tax year that you must use under the Internal Revenue Code and IRS regulations because of the nature of your business. You have not adopted a tax year if you merely filed an application for an extension of time to file an income tax return or for an employer identification number, or you paid estimated taxes for that tax year.
If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, you must continue to use the calendar year unless you get IRS approval to change it or are otherwise allowed to change it without IRS approval.
Generally, anyone can adopt the calendar year. However, if any of the following apply, you must adopt the calendar year:
- you keep no books or records;
- you have no annual accounting period;
- your present tax year does not qualify as a fiscal year; or
- you are required to use a calendar year.
Short Tax Year. A short tax year is a tax year of less than 12 months. A short-period tax return may be required when a taxable entity is not in existence for an entire tax year or changes its accounting period. Tax on a short-period tax return is figured differently for each situation.
For more information, see IRS Publication 538, “Accounting Periods and Methods.”
Changing Your Tax Year. Once you have adopted your tax year, you may have to get IRS approval to change it. To get approval, you must file Form 1128, “Application to Adopt, Change, or Retain a Tax Year.” If you qualify for an automatic approval request, a user fee is not required. If you do not qualify for automatic approval, a ruling must be requested and a user fee is required. See the instructions for Form 1128 for more information.
In addition to figuring taxable income on the basis of an annual accounting period or tax year, every business also must use a consistent accounting method to determine when to report income and expenses. The most commonly used accounting methods are the cash method and an accrual method. Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the tax year you pay them. Under an accrual method, you generally report income in the tax year you earn it, regardless of when payment is received, and deduct expenses in the tax year you incur them, regardless of when payment is made. For much more information on accounting periods and methods, see IRS Publication 538, “Accounting Periods and Methods.”
Your Business’s Taxes. The form of business you operate, as discussed above, determines what taxes you must pay and how you pay them. The four general types of business taxes you may pay to the federal government are the income tax, the self-employment tax, various employment taxes, and excise taxes.
Income Tax. All businesses except partnerships must file an annual income tax return. Partnerships file an information return. The federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. Because there likely will be no withholding on your business income, you might have to pay estimated tax.
Self-Employment Tax. Self-employment tax is a Social Security and Medicare tax primarily for individuals who work for themselves. Your payments of welfare-employment tax contribute to your coverage under the Social Security system. Social Security coverage provides you with retirement benefits, disability benefits, survivor benefits, and hospital insurance (Medicare) benefits.
Generally, you must pay the self-employment tax and file Schedule SE of Form 1040 if either your net earnings from self-employment are $400 or more or you work for a church or a qualified church-controlled organization (other than as a minister or member of a religious order) that elected an exemption from Social Security and Medicare taxes and you receive $108.28 or more in wages from the church or organization.
Employment Taxes. When you have employees, you as the employer have employment tax responsibilities that you must meet and forms you must file. Employment taxes include Social Security and Medicare taxes, federal income tax withholding, and federal unemployment (FUTA) tax.
Excise Taxes. Depending on the products you manufacture or sell; the kind of business you operate; the equipment, facilities, or products that you use in your course of business; and the services for which you receive payment, you may have to pay excise taxes.
Form 720. The federal excise taxes reported on Form 720, “Quarterly Federal Excise Tax Return,” consist of several broad categories of taxes, including the following:
- environmental taxes;
- communications and air transportation taxes;
- fuel taxes;
- tax on the first retail sale of heavy trucks, trailers, and tractors; and
- manufacturer’s taxes on the sale or use of a variety of different articles.
Form 2290. There is a federal excise tax on some trucks, and buses that are used on public highways. The tax applies to vehicles having a taxable gross weight of 55,000 pounds or more.
Form 730. If you are in the business of accepting wagers or conducting a wagering pool or lottery, you may be liable for the federal excise tax on wagering.
Good records will help you monitor the progress of your business, prepare your financial statements, identify the source of receipts, keep track of deductible expenses, prepare your tax returns, and support items reported on tax returns.
Generally, you may choose any record-keeping system suited to your business that clearly shows your income and expenses. Except in a few cases, the law does not require any special kind of records. However, the business you are in affects the type of records you must keep for federal tax purposes.
Record Retention. The length of time you should keep a document depends on the action, expense, or event the document records. You must keep your records as long as they may be needed to prove the income or deductions on a tax return. You must keep all of your employment tax records as long as they may be needed; however, keep all records of employment taxes for at least four years.
The responsibility to prove entries, deductions, and statements made on your tax returns is known as the burden of proof. Keep in mind that you must be able to prove (substantiate) specific elements of expenses before you can deduct them.
Need for Records. Everyone in business must keep records. Good records help you do many of the things necessary for a successful business.
Prepare Your Tax Return. You need good records to prepare your tax returns. The records must support the income, expenses, and credits you report. Generally, these are the same records you will use to monitor your business and prepare your financial statement.
Support Items Reported on Tax Returns. You must keep your business records available at all times for inspection by the IRS. If the IRS examines any of your tax returns, you may be asked to explain the items reported. A complete set of records will speed up the examination.
Keep Track of Deductible Expenses. You may forget expenses when you prepare your tax return, unless you record them when they occur.
Monitor the Progress of Your Business. You need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make. Good records can increase the likelihood of business success.
Prepare Your Financial Statements. You need good records to prepare accurate financial statements, including income (profit and loss) statements and balance sheets. These financial statements can help you in dealing with your bank or creditors and help you manage your business.
Identify Source of Receipts. You will receive money or property from different sources. Your records can identify the source of your receipts. You need this information to separate business from nonbusiness receipts and taxable from nontaxable income.
Types of Records. You may choose any record-keeping system suited to your business that clearly shows your income and expenses. Except in a few cases, you are not required to keep any special kind of records. However, the business you are in affects the type of records you need to keep for federal tax purposes. Your record-keeping system should also include a summary of your business transactions. This summary is ordinarily made in your business books (for example, accounting journals and ledgers). Your books must show your gross income, as well as your deductions and credits. For most small businesses, the business checkbook is the main source for entries in the business books.
Purchases, sales, payroll, and other transactions you have in your business will generate supporting documents such as invoices and receipts. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents contain the information you need to record in your books. It is important to keep these documents because they support the entries in your books and on your tax return. You should keep them in an orderly fashion and in a safe place. For instance, organize them by year and type of income or expense.
Gross Receipts. Gross receipts are the income you receive from your business. You should keep supporting documents that show the amounts and sources of your gross receipts. Documents for gross receipts include:
- cash register tapes;
- bank deposit slips;
- receipt books;
- credit card charge slips; and
- Forms 1099-MISC.
Purchase Documents. Purchases are the items you buy and resell to customers. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. Your supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include:
- canceled checks;
- cash register tape receipts;
- credit card sales slips; and
Expenses. Expenses are the costs you incur (other than purchases) to carry on your business. Your supporting documents should show the amount paid and that the amount was for a business purpose. Documents for expenses include:
- canceled checks;
- cash register tapes;
- account statements;
- credit card sales slips;
- invoices; and
- petty cash slips for small cash payments.
Travel, Transportation, Entertainment, and Gifts. If you deduct travel, entertainment, gift or transportation expenses, you must be able to prove (substantiate) specific elements of expenses. For information on how to do it, see IRS Publication 463, “Travel, Entertainment, Gift, and Car Expenses.”
Business Assets. Assets are the property, such as machinery and furniture that you own and use in your business. You must keep records to verify information about your business assets. You need records to compute the annual depreciation and the gain or loss when you sell the assets. Documents such as purchase and sales invoices, real estate closing statements, and canceled checks may support your records for business assets. Your records should show:
- when and how you acquired the assets;
- purchase price;
- cost of any improvements;
- section 179 deduction taken;
- deductions taken for depreciation;
- deductions taken for casualty losses, such as losses resulting from fires or storms;
- how you used the asset;
- when and how you disposed of the asset;
- selling price; and
- expenses of sale.
Employment Taxes. There are specific employment tax records you must keep. Keep all records of employment for at least four years. The records should be available for IRS review and should include:
- your employer identification number;
- amounts and dates of all wage, annuity, and pension payments;
- amounts of tips reported;
- the fair market value of in-kind wages paid;
- names, addresses, Social Security numbers, and occupations of employees and recipients;
- any employee copies of Form W-2 that were returned to you as undeliverable;
- dates of employment;
- periods for which employees and recipients were paid while absent because of sickness or injury and the amount and weekly rate of payments you or third-party payers made to them;
- copies of employees’ and recipients’ income tax withholding allowance certificates (forms W-4, W-4P, W-4S, and W-4V);
- dates and amounts of tax deposits you made;
- copies of returns filed;
- records of allocated tips; and
- records of fringe benefits provided, including substantiation.
For more information, see IRS Publication 15, “Circular E, Employer’s Tax Guide.”