Mwenye Pesa is a relatively well-to do Kenyan-American who has been moderately successful in selling tourist packages to his home country. Before immigrating to the United States in 2000, he operated an equally successful hospitality outfit from the basement of Hotel Hilton in downtown Nairobi. To help with starting capital, Pesa had “sold” 20 percent of the business to Mwenye Akili in 2003. Annual sales from his Esabari Travels and Tours, LLC average around $450,000.
From the outset, Pesa must be warned that the subject of business taxes is complex and expansive. Understandably, many business owners loathe dealing with it. However, taxes can be a costly nightmare if not handled well and in a timely manner.
Therefore, this article can only point out the more salient features that may form part of a conversation with a competent tax professional, usually a tax attorney or CPA.
Choice of Entity
Tax treatment of a business is dependent to a large measure, on how the business was set up. The most common forms of business organization in the United States are Sole Proprietorship, Partnership, Corporation, S-Corporation and Limited Liability Company (LLC).
Sole Proprietorship: this is the simplest form of business organization with minimal registration requirements. Contrary to what many believe, sole proprietors who hire employees bear the same tax obligations for their employees, as would a corporation, partnership or LLC.Because they are unincorporated, sole proprietors file Form 1040 and report business activity on Schedule C or C-EZ.
Partnership: this is a relationship between two or more people for the purpose of carrying on a trade or business. In other words, they must intend to make a profit, not merely engage in a hobby or sport. Setting up a partnership – be it a general or limited one – is relatively simple. Partnerships are not taxable entities. Instead, items of income, deductions, gain or loss are passed through to the partners to report on their Form 1040.
Corporation & S-Corporation: a corporation is a separate legal entity owned by shareholders. Corporations’ profits are taxed to the entity when earned, and again taxed to the shareholders when distributed as dividends, resulting in double taxation. C-Corporations file Form 1120. S-Corporations are special corporations that have sought and obtained approval by the IRS to be treated as partnership for tax purposes. S-corporations file Form 1120S only as an informational return, but no tax is payable.
Limited Liability Company (LLC)
LLCs are a recent invention. They combine the limited liability of the corporation with the favorable tax treatment of the partnership. Owners of an LLC (called members) enjoy limited personal liability for the debts and obligations of the entity. Many states (including Minnesota) allow single-member LLCs. Like S-Corporations, LLCs have no tax at the entity level but are not subject to the restrictions of the former. Two-member LLCs can elect to be taxed either as corporations or partnerships. Generally, income and deductions are reported on Form 1065, an informational return. If it were a single-member LLC, Esabari Tours would be disregarded as an entity and Mwenye Pesa can file Form 1040 and report his income and expenses on Schedule C. However, since Mr. Akili owns 20%, the company will file a Form 1065 and each member gets a Schedule K reporting his income from the entity.
Many small business owners are shocked to learn that in addition to individual taxes, they are subject to a slew of business taxes. The most common are:
Income Tax: All businesses except partnerships are subject to this tax. The required filing depends on the form of business organization.
Estimated Tax: All sole proprietors, partners, S-Corporation shareholders and members of LLCs are required to make estimated payments if their income taxes exceed a set threshold for a particular tax year. For computation, seek the help of a professional.
Employment Taxes: Small businesses are also subject to the following:
Social Security and Medicare taxes under the Federal Insurance Contributions Act (FICA), Federal Unemployment tax (FUTA), Federal Income tax withholding and Self-Employment tax. Other lesser known taxes confronting small businesses include excise tax, state sales and use (where applicable), gas tax.
Deductible Business Expenses
According to the Tax Code, a business owner may deduct any ordinary and necessary expenses related to the operation of his business. While the law attempts to list such expenses, the IRS may find reason why an expense may no be deductible. This conclusion has far-reaching implications on the business under consideration.
Due to the prevalence of audits attributable to business deductions, we will address this in a future column.
It cannot be overemphasized that business taxation is a very complicated subject. Small business owners should be wary of facing the IRS or state taxing authorities without professional help.
The author is a tax and business lawyer and consultant at ABC GROUP, LLC of Minneapolis and H.M. ONGERI & ASSOCIATES, an international law firm with offices in the United States and Africa. He is the immediate past president of the Pan African Business Alliance (PABA). For a more detailed tax treatment of the various forms of business organizations, visit the ABC GROUP website here. He can be reached at firstname.lastname@example.org, or email@example.com or 952-544- 1039.
Disclaimer: The information contained in this article is for informational purposes only. It does not, nor is it intended to, constitute legal or tax advice. Readers who need help with any specific matter are strongly advised to consult a competent professional.