BB.2 How are business owners paid and taxed?

A business may take a variety of legal forms, and the legal form of the business affect how owners are paid and how they are taxed. 

A sole proprietorship is a business owned by one person only, if that person has not taken any steps to create a separate legal entity. Owners of a sole proprietorship may put money into the business and take money out of the business as they wish. An owner of a sole proprietorship may not be on the payroll of the business. The owner of a sole proprietorship files a regular individual tax return and reports the income and expenses of the business on a Schedule F for a farm or ranch business, or a Schedule C for any other type of business. No where on the tax forms does a sole proprietor report how much of their money they put into or took out of the business, because the owner is taxed on the net income of the business regardless of how much money they contributed or withdrew. 

A partnership is a business owned by more than one person if those people all intend to work together in some way to share risk and reward and they have not taken any steps to create a separate legal entity. A partnership is governed by a written partnership agreement, or else by state law. Generally partners may contribute money to the business and withdraw money from the business as they see fit, subject to limitations they may have put in the partnership agreement. Partners may not be on the payroll of the partnership. A partnership files its own federal and state tax returns, but does not pay taxes. The partnership tax returns generate a Form K-1 for each partner, showing that partner’s share of taxable income and expense from the partnership. The partners then each report the items on the K-1 on their individual income tax returns. Although the amounts partners put into or take out of the partnership are not part of calculating their taxable income, there are complex rules governing what happens if the total amount each partner has invested in the partnership does not equal the ownership percentages reported on the partnership tax returns. 

A limited liability company or a corporation is a legal entity created by one or more business owners to provide protection under state law, to limit the financial responsibility of the owners for debts and other liabilities of the business. A limited liability company may be considered a “disregarded entity” for tax purposes. This means it is ignored. If there is one owner, it is, for tax purposes as if it were a sole proprietorship. If there is more than one owner, it is, for tax purposes, as if it were a partnership. 

An S-corporation is a special type of limited liability company that allows the business owner to be on the payroll of the company. Owners of a sole proprietorship or a partnership may not be on the payroll of the business. An S-corporation files its own tax return and gives each owner both a W-2 for payroll wages paid, and a K-1 for other income and expense items.