In previous installments of this series, we've discussed various aspects of managing your MSP's money, from revenue enhancement to banking to going public to creating and sticking to a budget. An important and sizable part of your budget is an expense that isn't discretionary: paying your company's taxes. That will never be a fun part of doing business, but in these next few installments, we'll take a look at how you might be able to make tax time a little less painful.
I'll be talking here about businesses located in the U.S.; tax issues will vary from country to country and in the U.S., you'll be liable for different types of taxes paid to different governmental entities.
What's your business structure?
The federal income tax returns that you have to file and the rules governing how your business's income is taxed at the federal level depends on what business structure your company operates under. Possible business structures include the following:
- Sole proprietorship: This is a business owned by one person. Many small businesses start out this way and change later as they grow. The income from your business is taxed on your individual 1040 form, with which you have to file a Schedule C or Schedule C-EZ showing the profit and loss from your business. You'll also have to file a Schedule SE for calculating self-employment taxes (both the employer and employee portions of social security plus Medicare), and you'll have to file Form 1040-ES every quarter, calculating and sending in your estimated tax for the income earned that quarter. If you have employees other than yourself, you also have to file Form 940 and pay the employer's annual federal unemployment tax, file form 944 and pay the employer's portion of their social security and the withheld employee's portion of social security and Medicare taxes, and send W-2s to the employees and W-3 to the social security administration, providing information on the taxes you withheld.
- Partnership: This a business owned by two or more people. A partnership has to file an annual income tax return (Form 1065) but each partner is taxed on his/her individual 1040 form, with which he/she files a Schedule E, Supplemental Income and Loss. Like sole proprietors, partners must file Schedule SE and pay estimated quarterly taxes. The business must also file the same forms and make the same payments for employees (941, 940, 944).
- S Corporation: This is a company that operates as an incorporated business that must file a corporate tax return (form 1120S and Schedule K-1), but passes corporate income, losses, and deductions through to the shareholders. S corps often have only one or two shareholders and are limited to a maximum of 100. The shareholders have to be individuals (and some trusts/estates) and can't be non-resident aliens, partnerships or other corporations. Some types of businesses, such as financial institutions and insurance companies, cannot be S corps. S corps pay estimated taxes via form 1120-W and file the same employment forms (940,941) for employees, including the shareholders/owners who are paid a salary. Shareholders file Schedule E with their 1040s and must pay estimated quarterly taxes (1040-ES) on their corporate incomes.
- C Corporation: This is a company that operates as an incorporated business and is recognized as a tax-paying entity separate from its shareholders. It is also recognized as a "person" by law for many purposes, in that it can be held civilly and criminally liable separately from its shareholders, and has certain rights such as the right to enter into contracts and the right to free speech. Corporations file a corporate tax return (form 1120) and pay taxes on corporate income. They must also pay estimated taxes (form 1120-W) and the same employment taxes (940,941). In addition, certain corporations must pay excise taxes, which must be paid on specific products and activities.
Note that Limited Liability Companies (LLC) are another business structure that is created/recognized by state law but not by the federal government. This is a business structure that combines some of the benefits of a corporation (limitations on personal liability) with some of the benefits of a partnership (pass-through taxation). Instead of being shareholders, owners of LLCs are members of the company. An LLC owner files federal tax returns as a sole proprietor, partner or corporation. LLCs file form 8832 to elect how they want to be classified for federal taxation.
Federal income taxes are likely to be one of your company's largest tax expenses, and how the business is taxed depends on its business structure. Next time, we'll look at some basics of planning to minimize the federal income tax burden.