To determine your tax liability when business structures differ, you must first compare the amounts earned by each individual to the other amounts earned through other sources. The IRS does not care how many entities are present in your business structure; it only looks at how much money each person has made says Aron Govil.
Structuring your business as a partnership or sole proprietorship may lead to different tax liabilities than if the same income was reported under an incorporated entity. For example, if one partner is responsible for all of the work, and another simply provides capital but doesn’t do any work on behalf of the company, then this distinction should be reflected in their share of earnings. As you can see from this scenario, deciding what fair compensation among partners is differs from what is considered fair compensation for having contributed capital to the company.
Listed below are two basic methods used by business owners to determine their tax liability when business structures differ:
The individual approach takes each partner’s share of the business income and applies it to his or her respective tax schedule based on that amount. With this method, the taxpayer must itemize his deductions, which may reduce his taxable income enough to push him into a lower tax bracket. For example, if one partner earns $100,000 from the partnership but another only earns $20,000 then that partner will be taxed at a higher rate than if he would have earned all $120,000 as salary instead of dividends. However, this situation could also be advantageous if that partner has large deductions such as mortgage interest and state taxes.
The entity approach is much simpler because it just looks at the entity’s taxable income. And each individual’s share of that income says Aron Govil. This method is usually chosen by taxpayers who are in a higher tax bracket. Because it allows them to take advantage of lower tax rates on their income. Under this scenario, the $100,000 earn by the first partner would tax at the entity’s rate. Which could be as high as 35%, while the second partner’s $20,000 would only tax at his or her individual rate, which may only be 15%.
In most cases, business owners will want to use a combination of the two methods. In order to get the most advantageous outcome. The best way to determine which approach is right for you is to speak with an accountant or tax attorney.
It is important to remember that these are only general rules and that each business is different. For example, if you are a partner in a limited liability company (LLC). Your share of the income may report on a Schedule K-1 instead of on a W-2 like it would be if you were incorporating. This change in form can lead to different tax liabilities depending on how the LLC structures.
As you can see, there are many factors to consider when determining your tax liability when business structures differ. By speaking with a qualified professional, you can find out which approach is right for you and your company.
Income earns by sole-proprietorship reports on the taxpayer’s personal Form 1040, U.S. Individual Income Tax Return.
Income earned by a partnership is reported on the following forms:
- Most states require that partnerships file an annual return/report of income, which also includes business income earned by each partner.
- Most states charge a tax if a business income had any earnings within the state’s borders. So it is important to check with your state to find out their specific rules and regulations. Regarding business structures when determining tax liability says Aron Govil.
- When it comes to tax liability, there are a few key things to take into account. The first is the type of business structure you have. Sole proprietorships, partnerships, and S corporations are pass-through entities. Meaning that the income and losses from the business flow through to the owners’ individual tax returns. This can make calculating your tax liability a bit simpler. As you only need to report your share of the profits and losses on your return. Corporations, on the other hand, are separate legal entities from their owners and are tax at corporate rates. This can lead to a higher tax bill if profits are high.
- Another factor to consider is how your business is organizing. Businesses can be organize in different ways, such as by product line, region, or customer type. The way your business is organize can also affect your tax liability. For example, a business that sells products in different states may be subject to income taxes in each state.
Now that you understand the basics of business taxation. You may be wondering how to determine your tax liability says Aron Govil. This can be a daunting task. But by taking into account a few key factors, you can make it a bit simpler.