Small Business Taxation
Like large corporations and individuals, small businesses are subject to taxation by the government. Depending on the jurisdiction, small businesses may also be subject to state and local taxes in addition to federal taxes. To help small business thrive, the U.S. government has put a number of provisions into place that encourage entrepreneurs and other small business owners. How a small business is taxed depends on its structure. The most common structures for small businesses include sole proprietorships, partnerships, corporations, subchapter S corporations, and limited liability companies.
Keywords: Accounting; Asset; Corporation; Entrepreneur; Limited Liability Company; Partnership; Small Business; Sole Proprietorship; Taxes
Although the United States may have a reputation for being the home of big business, industrial giants, and large corporations, it also has a long history of supporting and nurturing small businesses. There is a widespread understanding that the success of small business is good for the economy. The general attitude toward small business in this country is that it helps create jobs, provides healthy competition for existing businesses by improving the quality of goods and services offered and reducing prices, contributes to innovation and technological advances, and, in general, improves the country's standing in the global marketplace (Holtz-Eakin, 1995). Whether or not this is actually true is a matter of debate in the literature. However, based on this widespread assumption, the U.S. government has put a number of provisions into place that encourage entrepreneurs and other small business owners.
What is a Small Business?
The definition of small business can change from context to context. According to the U.S. Small Business Administration (SBA), a small business concern is:
- Organized for profit;
- Has a place of business in the United States;
- Makes a significant contribution to the U.S. economy through payment of taxes or use of American products, materials or labor;
- Is independently owned and operated;
- Is not dominant in its field, on a national basis; and
- Is no larger than SBA's small business size standard for its industry (http://web.sba.gov/faqs/faqindex.cfm?areaID=15).
However, size standards for small businesses often vary from industry to industry. Sometimes "small" is defined in terms of number of employees while at other times it is defined in terms of sales, revenue, or other output measures. In other situations, "small" is defined in terms of assets.
Not all small businesses are entrepreneurial in nature. Although at its most basic, entrepreneur describes a person who starts a new business, the word typically carries with it the connotation of taking risks to turn innovative ideas into profit-making ventures. Although a new convenience store may be classified as a small business, it is unlikely to be entrepreneurial in nature.
There are a number of ways that small businesses may structure themselves. Each of these structures brings with it different tax responsibilities. Because of the long-term implications on structure for a small business, the SBA recommends consulting with an attorney or accountant before making the decision as to how to structure a new business. Optimal choice of a business structure is dependent on many factors including the degree of control the owner desires to have over the operations of the business, how vulnerable to lawsuits the business (or its owners) is willing to be, the need for the owner to access funds from the business to pay him/herself, and the tax implications of the structure.
In addition to federal taxes, in most localities businesses are also required to pay state and sometimes local taxes. On a state level, these tend to be income taxes on a structure parallel to that imposed by the federal government. However, Ertmer and Sash (2006) note that increasingly, states are imposing a type of gross receipts tax on businesses. In this approach to alternative taxation, taxes are imposed on the gross sales receipts of the business and are payable by the seller. Such taxes can be imposed in different ways, including as a tax for permission to operate in the state or may be imposed only on certain types of businesses. As opposed to income taxes imposed on net income, this type of tax tends to be simpler to calculate and does not require complicated accounting procedures. From the perspective of the state, this type of tax often produces more income that traditional income taxes. However, such tax structures tend to be less fair to start-up businesses, loss companies, and organizations that operate at high volume, low profits. As a result, businesses tend to prefer traditional income tax structures to gross receipt tax structures because they tend to be fairer, even though they require more complicated accounting procedures.
Types of Small Business
According to the SBA, there are five basic ways in which a small business can be structured:
- Sole proprietorship,
- Subchapter S corporation, and
- Limited liability company
Each of these approaches has different implications from a tax point of view, including how the business is taxed, the degree to which the owners are liable for the debts of the business, what records need to be kept, what accounting procedures need to be followed, and what forms need to be filed.
The sole proprietorship is the most common structure for small businesses. In a sole proprietorship, a single individual is the sole owner of the business. In this business structure, there is no legal distinction between the assets and liabilities of the owner and of the business. Therefore, a sole proprietor takes on all the benefits — as well as all the risks — of the business. If the business is profitable, all the profits belong to the individual owner. If the business has debts, on the other hand, the individual owner is fully liable for them. In this situation, both the individual's business and personal assets are at risk.
It can be difficult to raise money for a sole proprietorship, and the owner frequently uses his/her personal assets or consumer loans. In addition, not all expenses frequently thought of as business deductions can be directly or fully deducted for tax purposes. Although in many ways structuring as a sole proprietorship carries with it a number of risks for the owner, it also has a number of advantages. First, sole proprietorship is the easiest and least expensive form of business to organize. Second, from a tax standpoint, all the profit and loss from the business are addressed within the individual's personal tax returns rather than through a more complicated corporate tax paperwork. Third, just as it is easy to establish a sole proprietorship, it is similarly easy to dissolve one since only one person is involved. Sole proprietorships require the least record keeping, are subject to minimal regulatory controls, and allow one to avoid double taxation.
Some of the federal tax forms that may apply to sole proprietorships include:
- Form 1040: Individual income tax return
- Schedule C (or Schedule C-EZ): Profit or loss from business
- Schedule SE: Self-employment tax
- Form 1040-ES: Estimated tax for individuals
- Form 4562: Depreciation and amortization
- From 8829: Expenses for business use of one's home
- Employment tax forms for any employees
(It is important to note that the lists of tax forms mentioned in this article are representative and are not intended to present a complete list of forms needed or reporting requirements nor are all forms necessary for all small businesses.)
Partnerships are similar to sole proprietorships in terms of risks and benefits to the owners. In a partnership there are two or more owners of the business rather than a single sole proprietor. Partnerships are more complicated than sole proprietorships because the...
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