The federal tax code is incredibly complex—so complex that it covers almost 7,000 pages. Added to the U.S. tax regulations, which are the U.S. Treasury’s official interpretation of the tax code, you’d be up to 75,000 pages...that is a lot of pages filled with complex legal terminology. To gain a better understanding of the contents of the tax code, we have prepared this overview for those interested in familiarizing themselves with its coverage.
The tax code and subsequent regulations are put in place to guarantee that businesses are accurately categorized and taxed based on their specific activities, industry, and organizational structure.
Incorrectly categorizing your business, such as filing taxes as an LLC instead of a C corporation, even if your business does not qualify as an LLC, can result in several negative consequences. These can include paying more than necessary, facing legal repercussions, or losing out on potential deductions and credits.
U.S. Tax Code's Common Classifications
The tax code is responsible for regulating different categories such as:
1. Business entity: Various forms of business structures, including sole proprietorships, partnerships, corporations, and LLCs, are subject to specific tax laws and guidelines. Selecting the appropriate business entity is the initial crucial step in ensuring that your business is accurately categorized.
2. Industry: Certain tax codes are tailored for specific industries, considering the distinct traits and difficulties of particular sectors. These industries may include agriculture, cannabis, real estate, and those that have a tradition of tipping. If your company falls under one of these specialized fields, it is crucial to have a clear understanding of how these regulations are applicable.
3. Income Type: Different types of income, such as earned income, passive income, and capital gains, are distinguished by tax regulations. Accurately identifying the type of income is crucial to determine the appropriate tax rates and deductions.
Tax Code and Tax Rate Comparision
The tax code encompasses all regulations dictating how American taxpayers fulfill their tax obligations, while the tax rate denotes the portion of one's income that must be paid in taxes. This rate is determined by the individual's tax bracket, which is determined by their level of income.
As we continue, there are two key tax-related terms to consider: deductions and credits. Deductions decrease the amount of your income that is subject to taxes, while credits directly reduce your tax liabilities. The tax codes determine which credits can be applied to certain types of income or activities.
Identifying the appropriate tax regulations for your business
The main factor that will dictate the tax classification of your business is the type of business entity.
Sole Proprietorships
Sole proprietorships are the most basic type of business structure, where a single person is responsible for owning and managing the business. In this scenario, the owner and the business are treated as a single entity for tax purposes. The owner's personal tax return (Form 1040) reflects the profits and losses of the business, and the income is taxed at the individual income tax rates. Additionally, sole proprietors are required to pay self-employment taxes, which cover their contributions to Social Security and Medicare.
Partnerships
A partnership is formed when two or more people come together to share the duties and earnings of a business. Similar to sole proprietorships, partnerships are considered pass-through entities, where the profits and losses are distributed to each partner individually. Each partner must declare their portion of the income on their personal tax return, while the partnership itself is not subject to income taxes. To report their income, deductions, and credits, partnerships must submit an informational return (Form 1065).
Corporations
Corporations are distinct legal entities from their owners and offer limited liability to shareholders. C corporations must pay corporate income tax (Form 1120) and any profits given to shareholders as dividends are also taxed at the individual level. This leads to double taxation, as both the corporation and its shareholders are taxed. Nevertheless, certain corporations, referred to as S corporations, have the option to choose pass-through taxation to be taxed on their personal return (Form 1040), in which income is directly passed on to shareholders, preventing double taxation.
Limited Liability Companies (LLCs)
The structure of LLCs incorporates features from partnerships and corporations, providing a versatile approach to taxation. LLCs are not a recognized entity type by the IRS and typically, an LLC operates as a pass-through entity, with profits reflected on the individual tax returns of its owners. However, there is also the option for an LLC to opt for corporate taxation, allowing for more opportunities for tax strategy. The tax treatment of an LLC is determined by the number of members involved and the selected tax classification.
The best way to identify the regulations that will govern your business, and potentially reduce your tax liability is to consult with a tax professional.
Lucrum Legal Accounting has an in-depth understanding of what tax regulations your business needs to comply with, as well as how to handle your entire tax filing process.