Small businesses each have an organizational form, such as a sole proprietorship, a partnership or a corporation. The business's organizational form determines what kinds of federal taxes it will have to pay. There are tax considerations that go along with each business form, and any small business must choose and use an accounting method. Finally, a small business owner must pay state taxes.

Organizational Forms

For federal income tax purposes, there are only two basic types of business organizations: the partnership and the corporation. Associations, joint stock companies and insurance companies are corporations. Practically all other types of business organizations, including syndicates, groups, pools, joint ventures, and any organization that is not an association, are partnerships. For most purposes, a sole proprietor is taxed in the same way as a partnership in its dealings with persons outside the partnership.

Each organizational form has federal tax considerations. A sole proprietor should know that:

  • Sole proprietors pay income tax on an individual basis
  • The sale of a sole proprietorship may cost more than the sale of a partnership interest because of the taxes involved

Partnerships have the following tax considerations:

  • Partners pay only a single income tax
  • Partners can deduct a share of the firm's losses
  • A partnership can increase its tax basis for assets to take a larger deduction for depreciation when ownership changes hands
  • Partnerships can allocate income and expenses among partners
  • Family partnerships can split income among family members

Corporations have the following tax considerations:

  • Two taxes on the same income, which increases the effective tax rate
  • A partner pays a single capital gains tax on the partnership's capital gain income, but a corporation pays a capital gains tax at corporate rates, and then the shareholder pays ordinary income tax on dividend distributions
  • Personal holding companies may pay penalties on their income
  • Corporations pay penalties for income that is accumulated for the purpose of avoiding income tax to its shareholders
  • Corporations can pay dividends at favorable times for their shareholders
  • Shareholder of a corporation can be an employee of the corporation and obtain tax benefits
  • Small business corporation can qualify for ''pass-through'' tax treatment by electing Subchapter S status

Accounting

Small businesses engage in two basic forms of accounting, tax accounting and financial accounting. The purpose of tax accounting is to determine taxable income. The primary goal of financial accounting is to provide useful and accurate information to management, shareholders, creditors, and others properly interested in the business. Because of their different goals, the two forms of accounting may conflict as to identifying what constitutes income and expenses, and, more often, when certain items of income or expense are to be taken into account. For example, some types of expenses shown in financial statements may not be fully deductible for tax purposes, such as charitable deductions or the amortization of good will.

Businesses have a great deal of flexibility in choosing their accounting method, as long the business computes taxable income under the method of accounting regularly used in keeping its books. Permissible overall methods include the cash receipts and disbursements method (cash method), an accrual method, the long-term contract methods, and hybrid methods combining various overall methods, such as the accrual and long-term contract methods. There are different methods of accounting for special items, such as inventory accounting and the installment sales method.

State Taxes

In addition to paying federal taxes, small businesses also have to pay state taxes, including:

  • Franchise taxes, which are imposed on corporations for the privilege of doing business in the corporate form in a state
  • Income taxes
  • Sales taxes, which are imposed on retail sales of goods and/or services in the state
  • Use taxes, which are imposed on the storage, use or other consumption within the taxing state of tangible personal property purchased outside the taxing state
  • Gross receipts taxes, which are levied on business activities measured by the gross proceeds of sales, the value of products sold or the gross income of the business
  • Property taxes, which are levied on real and/or personal property
  • Severance taxes, which are imposed on the removal or extraction of natural resources from the state

If you have any questions about what kinds of business taxes your business has to pay, contact a small business lawyer in your area.

Questions for Your Attorney

  • My business partners want to allocate half of the partnership income to me so that they will be in a different tax bracket. Can they do that if I did not actually receive half of the income?
  • My business partner says that we can save a lot of money on federal taxes if we change from the cash method to the accrual method of accounting. Can we change accounting methods?
  • After I purchased all of the shares of a small corporation, I received an overdue bill for franchise taxes for the past five years. Do I have to pay that?