The Income Tax Impact – Your Payment Strategy Impacts Your Personal Taxes
Like most of the other tax issues surrounding your business, the impact on your personal tax return depends on the entity you’ve chosen for your company. No matter which business structure you’ve used, though, if your company has earned proﬁts (and even sometimes when it hasn’t), you will pay some kind of tax on business-related income. One of the main differences among the entities, when it comes to your personal taxes, is where the business income shows up. Other twists are based on how you’ve chosen to take money out of the company. Those decisions affect how much tax you’ll pay on that income.
One thing most business owners have in common (the exception being C corporation shareholders) is the obligation to make quarterly personal estimated tax payments throughout the year. Since your business income isn’t subject to withholding taxes, you have to make periodic payments to the IRS, which really are prepayments against your ﬁnal tax bill. To do this, you have to estimate your share of business income for the whole year, ﬁgure out the tax that would be due on that estimate, divide it by four, and ﬁle Form 1040-ES along with a check for the estimated taxes. This is another area where your accountant can be very helpful.
For Sole Proprietors
All of the proﬁts (or losses) for your sole proprietorship are reported on Schedule C, as part of your overall Form 1040. Proﬁts are added to your total income for income tax purposes; losses are deducted directly from your other income (and directly reduce your total taxable income). That proﬁt or loss information is reported in detail on Schedule C and as one lump-sum line item on your 1040. In addition to income taxes, sole proprietorship proﬁts are subject to self-employment taxes. Self-employment taxes cover Social Security and
Medicare in one chunk, which includes the amount you would have had withheld as an employee plus the additional expense you would have had to pay as an employer. These taxes are calculated on Schedule SE, based on the lion’s share of the bottom-line proﬁts you’ve reported on Schedule C. One-half of the total self-employment tax you have to pay is deductible from your income (right on the front of your 1040) for income tax purposes, similar to the deduction you’d get as an employer paying the tax on behalf of an employee.
As a sole proprietor, you also get to deduct all health insurance premiums you’ve paid for yourself (and your family) as well as any contributions you have made into a retirement plan on your own behalf. These deductions show up on the first page of your 1040 and go toward reducing your taxable income.
In partnerships, every penny of proﬁt (or loss) ﬂows through to the partners, whether they take cash distributions for the year or not. The K-1s dictate how those proﬁts are shown on the personal tax returns. For example, interest income on the K-1 turns up as interest income on the partner’s personal return. Even if you’ve been doing your own personal income tax returns for years with no problem, the year you get your ﬁrst Schedule K-1 could be the time to pay a professional. These forms are intricate and a little tricky, and it will help to at least have someone walk you through it the ﬁrst time.
Like sole proprietors, partners have to pay self-employment tax on their share of the company’s proﬁts. This goes for both your share of the year’s proﬁts and any guaranteed payments you’ve received. Your self-employment taxes are calculated on Schedule SE and added to the total tax bill on your 1040. Half of these taxes can be deducted from your total taxable income; there’s a special line for that deduction on the front page of your 1040. There you will also ﬁnd the lines you can use to deduct health insurance premiums and retirement plan contributions made on your behalf.
For Small-Corporation Owners
When you own and work for a corporation, at least part of the money you get out of the company will be in the form of salary. That shows up on your tax return just as it would from any job. You just copy the information from the W-2 you got from the corporation onto your Form 1040. That’s the same whether you have an S or a C corporation. After salary, though, the two corporation types head in different directions on your tax return.
The question of whether your S corporation losses are fully deductible on your personal tax return is pretty tricky. It depends on how much basis (a special measurement of equity) you hold in the company. To avoid any reporting snafus, have a professional help you with your personal tax preparation along with that of the business.
Each shareholder in an S corporation gets a Form K-1 reporting her share of the company’s income. The speciﬁc kinds of income pass through the corporation directly onto your tax return. For example, if the S corporation had some capital gains, you have some capital gains. Your share of the regular business proﬁts also show up on your personal tax return, but they aren’t subject to self-employment taxes; you can also (sometimes) get a dollar-for-dollar taxable income reduction for losses suffered by your S corporation. You’ll pay tax on your full share of the proﬁts whether or not you take a single dollar in dividends. Beneﬁts paid on your behalf by the company also are added to your income, but the biggest one is also 100 percent person- ally deductible: health insurance premiums. Other common (but not wholly deductible) add-backs include life and disability insurance and many traditional fringe beneﬁts, such as parking and transportation.
Dividend income from your C corporation is reported on Schedule B of your personal tax return, along with any other interest and dividend income you’ve earned throughout the year. It gets treated no differently from dividends you received from your investments. Any money you take out of the corporation that isn’t speciﬁcally considered salary (or loans or leases, as you’ll learn in the next section of this chapter), is considered a taxable dividend by the IRS.
If you use your corporate checkbook to pay your personal cable bill, you’ve just paid yourself a personal dividend—even if you pay the money right back. Use caution here, or you could end up with a very high amount of dividend income, which is subject to double taxation.