How to Reduce Your Business Taxes

    March 6, 2003

It’s tax time (again), and since you are an Internet professional, it’s time for a crash course in Small Business Taxation.

I use the term “Small Business” to include home-based as well as online businesses, either full-time or part-time. Whether you are making a living from the Internet or just getting started to “see what you can do” in your spare time — you will soon find out that in the eyes of the IRS, you own a small business and must report that business on your tax return.

If you always thought that some people pay less tax than you (even though they make the same amount of income), you are absolutely correct. It is legal for one self-employed person to pay less tax than another, even though both have the same income

Any why does this happen? Well, many Small Business Owners are paying too much tax simply because they own the “wrong” type of business.

Now what do I mean by the “wrong type” of business?

I’m talking about whether your business is a Sole Proprietorship, a Partnership, a “C” Corporation, an “S” Corporation, or a Limited Liability Company (LLC).

From a legal entity standpoint these are the five main types of business ownership. You have got to put some thought into this, or you can pay thousands of dollars more in taxes than necessary. There are significant differences in the amount of taxes that each of these business types typically pay.

Here’s a quick overview of the main business entity types, and a brief explanation of how to change your company from one entity to another:

If your business is not a partnership, corporation, or LLC, then by default you are a Sole Proprietorship. From both a legal and a tax standpoint, there is no distinction between you and the business, so you have unlimited liability. You report the business on your personal income tax return (Form 1040) via a special form called Schedule C. Numerous other forms may also be required on your personal return, depending on the complexity of your business and the nature of its operations.

A Partnership is an agreement between two or more persons to carry on a business. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business. A Partnership must file an annual income tax return to the IRS (Form 1065) to report the income, deductions, gains, losses, etc., from its operations, but the Partnership does not pay income tax. Instead, it “passes through” any profits or losses to its partners via a form called Schedule K-1. Each partner includes his or her share of the Partnership’s income and expenses (as reported on the K-1) on his or her personal tax return.

CORPORATIONFor tax purposes, there are two main types of corporations: the “C” Corporation and the “S” Corporation. When you form a Corporation according to the laws of your particular state, the IRS automatically assumes you are a “C” Corporation for tax purposes. To become an “S” Corporation, you have to apply for “S” Corporation status via a special application (Form 2553), which the IRS will accept if you meet the criteria to become an “S” Corporation. From a tax standpoint, there are significant differences between a “C” Corp and an “S” Corp.

C Corporation. The profit of a “C” Corporation is taxed TWICE — once to the Corporation and a second time to the shareholders when distributed as dividends. (This is the dreaded “double taxation of corporate profits”). However, shareholders cannot deduct any losses of the Corporation. The “C” Corporation files Form 1120 to report its income and expenses to the IRS.

S Corporation. If your business qualifies, it can avoid double taxation by becoming an “S” Corporation. An S corporation generally is exempt from federal income tax, but still must file an income tax return called Form 1120S. The income or loss of the S corporation is transferred from the Corporation to the individual shareholder’s personal income tax returns via Schedule K-1, which the Corporation must give to each shareholder.

This is the newest kind of legal entity. It is a cross between a Corporation and a Partnership. From a legal standpoint, the LLC is much like a Corporation, offering limited liability to the owners (which are called “members”). From a tax standpoint, the LLC is taxed like a Partnership (if there is more than one member) or a Sole Proprietorship (if there is only one member). Like a Partnership, the LLC files Form 1065 and gives a K-1 to each member, so that the LLC’s profit or loss is transferred to the personal income tax return of the members.

How does a business owner change his business type? Now that’s a nice juicy can of worms. Items 1 & 2 below are by far the most common scenarios. The other possibilities (3,4,5,6,7) are not a good question to address in article format, however. Best to consult a tax professional if you are considering a change.

Sorry to be so blunt, but that’s taxes!

1. From Sole Prop to Corporation, Partnership or LLC: file the appropriate paperwork with the state.
2. From “C” Corp to “S” Corp — file Form 2553
3. From Corp to any of the other 3 — “dissolving a corporation” = opening Pandora’s box. Don’t go there!
4. From Partnership to Sole Prop — same as 3
5. From LLC to Sole Prop — same as 3
6. From Partnership to Corp — same as 3
7. From LLC to Corp — same as 3

Now let’s address three critical tax issues related to the question of entity type.

Critical Tax Issue #1: How to avoid the dreaded double taxation of corporate profits.

Yes, I did say that the “C” Corporation pays income tax on its profit not once, but twice. Did you understand what that means? This is an incredibly important part of our beloved Tax Code. If you want to enjoy the legal benefits of incorporation (and there are many), then you must come to grips with this issue — how are you going to legally avoid the possibility of paying both corporate income tax and personal income tax on your business profit?

There is a perfectly legal strategy available to the Small Business Owner to avoid the dreaded double taxation of corporate profits: form an “S” Corporation. If you are giving serious thought to forming a Corporation, you should also give serious consideration to applying for “S” Corporation status with the IRS.

Becoming an “S” Corporation is a two-step process. First, you file the appropriate paperwork with your state to incorporate. Then you file Form 2553 with the IRS to be recognized for tax purposes as an “S” Corporation.

To qualify for “S” Corporation status, your business must meet several criteria. Be sure to consult with a tax professional to determine your eligibility. The main requirements include:

1. All shareholders must consent to becoming an “S” Corporation by signing Form 2553.
2. The corporation can have no more than 75 shareholders
3. The corporation can have only one class of stock
4. The corporation must be a domestic corporation
5. All shareholders must be citizens or residents of the U.S.
6. Only individuals, estates, certain trusts and certain charities can be shareholders
7. The corporation must use a calendar year or a fiscal year that has an established business purpose.

Critical Tax Issue #2: How to legally reduce self-employment taxes.

If you start a business and do not take action to form a Partnership, a Corporation or a LLC, then by default you are a Sole Proprietorship. And Sole Proprietors face another “double tax-whammy”: the dreaded Self-Employment tax. This is the Sole Proprietor’s equivalent of Social Security tax and Medicare tax that is shared equally by employees and employers.

As a Sole Proprietor you end up paying twice as much Self-Employment Tax as an employee pays in Social Security/Medicare tax. Does that sound fair? Sorry, but the Tax Code isn’t necessarily about fairness.

And it turns out that LLC members and Partnership partners are also hit with the Self-Employment tax, because for tax purposes, members and partners are treated just like Sole Proprietors.

The solution? Again, for many the “S” Corporation offers relief. You only pay the Social Security/Medicare tax on your wages as an employee of the business, and your wages can be less than the business profit. The remaining “S” Corporation profits (a.k.a. dividends) legally avoid Social Security/Medicare taxes.

Critical Tax Issue #3: When it comes to filing business tax returns, strive to understand the basics.

You’re running an online business, not a tax preparation firm. But there are some basic concepts you need to master, depending on which entity you own. Here’s a recap of the primary tax forms applicable to each entity.


Sole Proprietorship
Form 1040, Schedule C
Form 1065
“C” Corporation
Form 1120
“S” Corporation
Form 1120S
Form 1065

If you’re a Sole Proprietor, note that all the required business income tax forms are filed as part of your personal income tax return (Form 1040).

If you’re an “S” Corporation, a Partnership, or an LLC, note that you must file a separate business income tax return, but technically the business doesn’t pay any income tax. I know that sounds strange, but it’s true.

The “S” Corporation files Form 1120S. The Partnership and LLC file Form 1065. If you look on these forms, the heading says “income tax return.” But the “S” Corporation, Partnership and LLC do not actually pay any income tax!

In effect, this so-called “income tax return” (Form 1120S or Form 1065) is really just an information return, giving the IRS the information about the business’s income and expenses.

These three entities then give the business’s owners a Schedule K-1, which reports each owners’ share of the business’s profit or loss. The owner then reports this K-1 information on his/her personal income tax return (Form 1040), where the income is taxed or the loss is deducted.

Still with me? Great. Welcome to the wild and wacky world of business taxes.

To get copies of the tax forms mentioned in this article, visit the IRS website:,,id=97817,00.html

Wayne M. Davies is author of 3 tax-slashing
eBooks for small business owners and the self-employed. For a
free copy of Wayne’s 25-page report, “How To Instantly Double
Your Deductions” visit