Businesses of all sizes and industries have been put through the proverbial ringer in 2020. No one could have foreseen the toll the coronavirus would take on entrepreneurs from independent contractors to C corporations and everyone in between. One positive thing, however, is the tax deadline has been pushed to July 15, 2020. That means there’s still time to learn about the tax issues based on your business entity and take advantage of some tax savings on your 2021 return, no matter what your legal structure.
In a sole proprietorship, there is no legal separation between the business owner and the business. Property and liabilities are held in the owner’s name. Usually, the owner is an individual, but it could also be a married couple. Business taxes are filed as personal income using Schedule C (Profit or Loss from a Business), which is submitted with IRS Form 1040.
Although it is the most simple and inexpensive type of entity to establish and maintain, one drawback is the owner is personally legally and financially liable for the business. For example, if the business is hit with a lawsuit or the business can’t pay its debts, the owner’s personal assets (bank accounts, home, car, retirement savings, etc.) are at risk.
In most locations, starting a sole proprietorship may be as straightforward as filing a fictitious name, also called a DBA (Doing Business As). But even that might not be required if the owner uses his or her first and last name in the business name. Some licensing or permits might be required depending on the type and location of the business. Otherwise, startup and ongoing compliance formalities are minimal.
A sole proprietorship is usually adequate for:
- Home-based businesses
- Businesses with only one owner
- Businesses with no employees
- Businesses that provide products and services with minimal legal risks
Business income is subject to self-employment taxes and therefore business owners of sole proprietorships were eligible for CARES Act funding from both the Paycheck Protection Program (PPP), the Economic Injury Disaster Loan (EIDL) and the EIDL Advance. Under the forgiveness rules of the PPP and the EIDL Advance, as long as 75 percent of the proceeds is used for income replacement and the other 25 percent is used for qualifying business expenses, the business owner would not have to pay the PPP or advance back. However, because the PPP application asked for 2.5 months’ worth of income documentation, some independent contractors may not have enough expenses to count as forgivable. That means, the remaining balance will need to be repaid at 1.00% fixed interest rate. Balance from the PPP loan is due in two years and payments are deferred for six months. The good news is business loan interest is deductible as long as the money is used for business purposes.
Although the self-employed are normally not eligible for unemployment compensation, under the CARES Act, they are eligible for the special Pandemic Unemployment Assistance (PUA) program, if they qualify. How much PUA pays varies by state, just as regular state unemployment insurance (UI) programs but are federally funded. There is an option to have taxes withheld from PUA payments if so desired. (S Corps and LLCs are also eligible to receive PUA benefits.)
Another option for taxpayers claiming business losses on their individual returns: due to the coronavirus crisis previous limitations on individual business loss deductions ($500,000 for couples and $250,000 for other filers) has been suspended for 2018-2020.
In its simplest form, the partnership structure mirrors a sole proprietorship. It is used when there will be more than one owner of the business. In a general partnership, owners share legal, financial, and management responsibilities for the business. In fact, the actions of one partner could impose liability on the personal assets of another partner.
Partners, with the help of their attorney, should have a detailed partnership agreement to spell out the division of ownership and duties. As with a sole proprietorship, there is no separation between the business and its owners. Business tax obligations pass through to the individual owners.
Other types of partnerships exist, as well, including:
- Limited Liability Partnerships: A partnership in which some or all partners have limited liabilities.
- Professional Partnerships: The entity is formed by two or more professionals such as accountants, doctors, or lawyers, who provide professional services to the public.
- Limited Partnerships: A partnership with a general partner (manages the business and has unlimited personal liability for the debts and obligations of the business) and a limited partner (limited liability and does not participate in management).
A partnership is usually adequate for:
- Business partners who do not intend to reinvest money back into the business
- Multi-owner businesses with no employees
- Multi-owner businesses providing products and services with minimal legal risks
Unless there is a special arrangement between partners, the IRS considers all partners as equal when assessing tax obligations. In a partnership, whether you are a partner who contributed financial assets or contributed nothing, you are equally taxed.
Unlike sole proprietorships and partnerships, a C Corp. is a legal entity separate from its owners—all actions of the corporation belong to the corporation only. Owners are employees and therefore the C Corp provides a significant degree of personal liability protection for its owners (shareholders). The ability to sell stock in the business offers an opportunity to raise capital to fund initiatives and fuel growth. Status as a C Corporation often makes a business more attractive to outside investors, as well.
A corporation must file its own income tax return (IRS Form 1120) and can claim deductions for business expenses, which reduces its tax liability when it earns revenue. Dividends paid to stockholders are considered income for stockholders and must be claimed on the individual tax form. The term “double taxation” is often used to describe how the profit of a corporation is taxed, and then profits distributed as dividends (which are not deductible as expenses to the business) are taxed to shareholders.
Incorporating a business involves filing Articles of Incorporation with the state, and it comes with higher startup costs and more administrative complexity than running a business as a sole proprietorship, partnership, or LLC. A corporation must have bylaws, a board of directors, hold meetings on a regular basis, and abide by other regulations to maintain its status.
The advantages of a C Corp are:
- The business is a separate legal identity
- There is limited liability for the owners
- The business has perpetual existence
- There are no restrictions on who can hold shares
- Readily transferable shares
- Preferable to venture capitalists and other investors
- Ability to offer stock options
The Tax Cuts and Jobs Act of 2017 reduced the corporate tax rate from 35 percent to a flat 21 percent, however, the Act also eliminated deductions for business entertainment expenses and transportation benefits provided to employees, such as mass transit passes, commuter vehicles and parking pass.
The 2020 CARES Act has initiated a few tax advantages C Corp owners can take advantage of including:
- Net Operating Loss (NOL) Carrybacks. The CARES Act has temporarily lifted the NOL exclusion, which was eliminated under the 2017 Tax Cuts and Jobs Act. Net operating losses that occurred in 2018, 2019 and 2020 will now be allowed to be carried back up to five years. Also, the 80 percent taxable income limit for using NOLs for 2018 through 2020 has been lifted.
- Expanded Interest Deduction. The 2017 Tax Cuts and Jobs Act limited the deduction businesses could claim for interest on business debt to 30 percent of adjusted taxable income (ATI). The CARES Act now caps net interest write-offs at 50 percent for 2019 and 2020.
- Charitable Donation. C Corps are allowed take a charitable donation tax deduction, however only up to 10 percent of its annual taxable income. Under the CARES Act, C Corps can temporarily take up to 25 percent for cash donations in 2020. Also, donations of food inventory have been raised from 15 percent to 25 percent.
The S Corp is a subtype of the corporation structure. It allows a C corporation to elect to be taxed as a partnership, with all business income taxed at the owner (shareholder) level at the tax rate for individuals. This avoids the double taxation that corporations normally face. One potential tax advantage for owners is that instead of all their business income being subject to self-employment tax, only owners’ salaries are. Any profit given to shareholders as distributions are not.
Some other advantages of a C Corp, such as personal liability protection, are retained. On the other hand, a number of restrictions on ownership of stock apply in an S Corp. For example, it may only issue one class of stock, it may only have up to 100 stockholders, and it cannot have shareholders who are nonresident aliens.
Today, the IRS allows multiples types of entities to elect to be taxed as an S Corp. For example, an LLC, just like a corporation, could elect to be taxed as an S Corp if it files for the S Corp election by the required deadline.
The S Corp is preferable when:
- C Corp shareholders or LLC members want to minimize their self-employment tax burden
- The corporation wants to avoid double taxation on dividend income
- A company doesn’t have a need for issuing more than one class of stock or having more than 100 shareholders
Again, the primary advantage of the S Corp election status is that only income paid on the payroll is subject to self-employment taxes. Profits paid as distributions/dividends are not subject to Social Security and Medicare taxes.
Limited Liability Company (LLC)
The Limited Liability Company (LLC) combines the advantages of a corporation and those of a partnership or sole proprietorship. It can be a single-member LLC or a multiple-member LLC. An LLC is considered a separate entity from its members, so it provides some liability protection to its owners. Generally, LLC members’ personal assets are not at risk if the company gets sued or cannot pay its debts.
In an LLC, members may choose how their business will divide the company’s profits and losses among its owners. This allows for members to consider not only money invested, but also time and work invested when distributing profits. The LLC is a pass-through entity, like in a sole proprietorship and partnership, with all income flowing through to members and reported on their personal tax returns, however, the LLC can also elect to be taxed as a C Corp or an S Corp.
The LLC structure also provides management flexibility. It can be member-managed, in which owners handle the day-in-day-out management responsibilities. Or an LLC can designate a person (or persons) as a manager(s), which is called a manager-managed LLC. Most states will by default consider an LLC “member-managed” unless the formation paperwork specifies that it should be “manager-managed” LLC. Learn more about Member-Managed LLC vs Manager-Managed LLC options.
The LLC structure is preferable when:
- Business owners want limited personal liability but do not want the compliance formalities of a corporation
- Business owners want flexibility in who owns and manages their company
- The business does not plan to seek venture capital and equity funding
The business profits of an LLC when passed through to individual members are subject to Social Security and Medicare taxes. This may create an unfavorable financial situation for LLC owners as they must pay self-employment taxes on their distributive share of the LLC’s profits, even if they invest that money back into the business rather than taking a distribution of those profits.
CARES Act Tax Changes for Employers
Payroll Tax Deferment
Businesses with employees are eligible for delayed payroll tax payments under the CARES Act. This means the business can choose to defer the business’s share of Social Security tax on employee wages during the period of March 27 through December 31, 2020. As an employer, you must pay half of the deferred amount by December 31, 2021, and the other half by December 31, 2022. Self-employed individuals can also defer half of the self-employment tax they owe. Employers, however, that received a PPP loan may not defer the deposit and payment of the employer’s share of Social Security tax once the business receives notification of PPP loan forgiveness.
Employee Retention Tax Credit
If a business has had to fully or partially suspend business operations during any quarter of 2020 due to the pandemic, the business is eligible for the Employee Retention Tax Credit. Likewise, the business is eligible if gross receipts have significantly declined. Again, a business cannot take the employee retention tax credit if the business received PPP funding. The credit is equal to 50 percent of employee wages from March 12, 2020 and before January 1, 2021, however, self-employed individuals are not eligible for this tax credit. Per the IRS, eligible employers can then use the funds to pay wages in anticipation of receiving the Employee Retention Credit. A business can either use the saved money for wage purposes or request an advance of the credit from the IRS for the amount of the credit that is not funded by accessing the federal employment tax deposits, by filing Form 7200, Advance Payment of Employer Credits Due to COVID-19.
Families First Coronavirus Relief Act (FFCRA)
Effective April 2, 2020, through December 31, 2020, the FFCRA expands on FMLA benefits and provides businesses with reimbursement for paid sick leave due to the coronavirus. Employers must pay paid sick leave if:
- The employee is ordered to quarantine or self-isolate due to the coronavirus.
- The employee experiences coronavirus symptoms and is waiting on a diagnosis.
- The employee is a caregiver for an individual (does not have to be family members) who is ordered to quarantine or self-isolate.
- The employee is caring for their child because their school or child-care is closed.
- Employers will then receive a refundable tax credit equal to 100 percent of the family leave wages that were paid. The FFCRA also applies to the self-employed.
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This article was originally published on SmallBusinessTrends.com.