How the IRS Taxes Entrepreneurs and Small Businesses

Startups, freelancers, and small businesses all have one thing in common: they don’t like dealing with taxes. It’s understandable. Taxes are complicated, and there’s always a fear of making a costly mistake.

To help, here’s a primer on how the IRS taxes different types of businesses and what you need to know to stay compliant and minimize your tax burden.

The 30,000-Foot View of Business Taxes

Business taxation can be broken down into two main categories:

• Pass-Through Taxation
• Double Taxation

Pass-Through Taxation

Most new businesses are taxed as pass-through entities, meaning the profits and losses of the company are passed through to the owners’ individual tax returns. This means the business itself doesn’t pay income tax. 

By default, the following entities fall under pass-through taxation:

• Sole proprietorships
• Partnerships
• LLCs (unless they elect corporate taxation)

Double Taxation

Some businesses, primarily corporations, face double taxation—meaning the business pays income taxes on its profits, and the owners pay personal income taxes on dividends or profit distributions. 

This structure applies to:

• Traditional corporations (C-Corps)
• LLCs that elect to be taxed as corporations

What About S-Corps?

An S-Corp isn’t a separate business entity; it’s a tax election that LLCs and corporations can make. This election allows business owners to reduce self-employment taxes under certain circumstances. Learn more in my guide: What Entrepreneurs Should Know About S-Corps.

How to Save, Report, and Pay Business Taxes

Your tax responsibilities depend on your business structure. Below is a breakdown of the most common tax structures and what you need to do.

Sole Proprietors (Most Freelancers)

Sole proprietors have the simplest tax process. All income and expenses flow through the owner’s personal tax return. 

Here’s how to manage your tax obligations:

1. Set aside 15-30% of your profit throughout the year to cover tax payments.
2. Pay estimated taxes quarterly to avoid a large tax bill at year-end.
3. File a Schedule C with your personal tax return to report business income and expenses.

Pro Tip: Open a dedicated business savings account for tax savings to avoid spending money meant for taxes.

Partnerships

Partnerships operate similarly to sole proprietorships but involve multiple owners. The IRS treats partnership income as pass-through, meaning profits and losses are divided among partners and reported on their personal tax returns. Tax responsibilities include:

1. Each partner must save 15-30% of their earnings for taxes.
2. Partners must pay estimated quarterly taxes on their share of the profits.
3. The company must issue a K-1 to each partner detailing their allocated profit or loss.
4. The partnership must file an informational tax return (Form 1065).
5. Each partner must attach their K-1 to their personal tax return.

Partnership taxation can be complex, so consulting an accountant is highly recommended.

LLCs

LLCs do not have a specific tax classification and must elect a tax structure. By default:

• Single-member LLCs are taxed like sole proprietorships.
• Multi-member LLCs are taxed like partnerships.
• LLCs can elect to be taxed as S-Corps or C-Corps for potential tax benefits.

Your LLC Operating Agreement should specify which tax structure your LLC will use along with the appropriate tax provisions for the chosen structure.

Corporations

If your business is taxed as a corporation, both the company and its owners will have tax obligations:

• The corporation files a corporate tax return and pays taxes on its profits.
• If the corporation distributes profits to shareholders, those shareholders must pay income taxes on dividends.

This structure is less common for small businesses but can be beneficial for high-growth startups looking to raise investment.

Key Takeaways for Managing Business Taxes

• Choose the right tax structure: Your entity type affects how much you pay in taxes.
• Pay estimated taxes: Most small business owners must make quarterly payments to avoid penalties.
• Keep business and personal finances separate: Use a dedicated business account for income and expenses.
• Work with an accountant: Tax planning can help you reduce your tax liability and avoid costly mistakes.

Understanding and managing your business taxes is crucial for long-term success. By staying proactive and working with professionals when needed, you can reduce stress and keep your finances on track.

*This article is general in nature and is not legal advice.