The Short Answer
“When does my business start paying taxes?” is a question I hear a lot. But the short answer is that your business probably won’t start paying federal income tax anytime soon.
Wait, what!?!
Well, there’s a reason for this, and it’s because most businesses are considered pass-through, or flow-through, entities.
Think of it like a river. Basically, your business profits are created upstream. When it’s time for taxes, those profits (net income) will then flow downstream to you as the business owner.
This is the case for sole proprietors, single- and multi-member LLCs, partnerships and S corporations so in the majority of cases your business will never pay tax on behalf of itself.
If you’re unsure of your business structure, you can find a Business Structure Breakdown below.
Download the Business Structure Breakdown here.
Why does my business file a separate tax return then?
Well, that’s because the separate business tax return required of multi-member LLCs, partnerships and S corporations is considered informational in nature. These returns show greater aspects of the business, its profits, losses, expenses, ownership, etc. that the government needs to be able to review if necessary.
Once this separate business tax return is filed, each of the owners, shareholders or partners depending on your business structure will receive a document to then include on their personal tax returns. This document, which is usually a Schedule K-1, will detail all of their dealings with the business and make it possible for the taxes on the business profits to be paid at the personal level.
Here are a few quick examples.
Sole Proprietor
Alex’s business made $50,000 in net income during 2019. All of that $50,000 will be placed on Schedule C and included on his personal tax return.
Single-Member LLC
A single-member LLC is taxed the same as a sole proprietor.
Your business is still an LLC for liability purposes, but the IRS sees the business as a sole proprietorship that files a Schedule C on their personal tax returns.
Multi-Member LLC
Alex and Erin both own 50% of an LLC that made $50,000 in net income for the year.
Since there’s two or more members, the LLC will file a separate business tax return on Form 1065, and the $50,000 will be split evenly between Alex and Erin since they are 50/50 owners.
Both Alex and Erin will see $25,000 pass through to them on their personal tax returns (via a Schedule K-1).
Partnerships
Partnerships are taxed the same as multi-member LLCs; however, partnerships tend to have more complex ownership structures.
S Corporations
Alex and Erin are both 50% shareholders in an S corporation that made $50,000 in net income.
The S corporation will file a separate business tax return on Form 1120S, and the business profits will be split evenly between Alex and Erin based on their ownership.
Alex and Erin will each see $25,000 pass through to their individual tax returns (via a Schedule K-1).
In addition to that, though, Alex and Erin are also employees of the S corporation. Because of this, they won’t just have $25,000 in profits flow through to their personal returns. They will also have employee wages from the S corporation via a W-2 that must be included on their personal tax returns as well.
S corporations are a special case where the shareholders are also employees. This allows them to have a tax advantage in regards to self-employment taxes.
To learn more about S corporations, check out our ‘Should I form an S Corp?’ blog post here.
Wrapping it up
All of these examples are very much the same. Regardless of your business structure, most businesses will not pay tax at the business level.
The business profits are going to flow through to the business owners on their personal tax returns, and the business owners will be taxed at the personal level according to their ownership percentage.
The only situation that would be different is that of a corporation or some specific situations with an S corporation, but those are much more complex and not as frequent.
Special Note:
One thing to keep in mind though is that regardless of if you see the business profits, you will still owe taxes on them.
For example, if you’re share is $25,000, but you only received $5,000, you will still pay tax on $25,000. This is because the profits pass through regardless of what happens to the cash.
Note: This blog post is meant for educational and informational purposes only. Please contact a tax or accounting professional if you have specific questions about what this means for your business before taking any further action. Also note that this list may not be exhaustive depending on your business situation.
