Business Taxes (Legal Angle)

Tax planning is its own profession; this guide covers the tax law a business operator should understand: how entity choice affects taxation, the S-Corp election, payroll tax and trust fund liability, sales tax economic nexus, 1099 reporting, and how IRS audits work. Specific tax planning requires a CPA or tax attorney. The mechanics here help you recognize when one is needed.

Entity tax classification

The IRS taxes business entities based on classification, not state-law form. Default classifications:

• Sole proprietorship. Schedule C on owner's Form 1040; self-employment tax on net earnings.
• Single-member LLC. Disregarded entity by default; treated as sole proprietorship for tax purposes. Can elect corporate taxation via Form 8832.
• Multi-member LLC. Partnership by default; Form 1065 (information return) plus K-1s to each member who reports their share on individual returns. Can elect corporate taxation via Form 8832.
• State-law corporation. C-Corp by default; Form 1120; entity-level tax. Can elect S-Corp status via Form 2553.
• State-law partnership (general/limited). Partnership; Form 1065 plus K-1s.

Important consequence: an LLC isn't a tax category. An LLC can be a disregarded entity, partnership, S-Corp, or C-Corp depending on how many members and what elections have been filed. The state-law entity choice and the federal tax classification are independent decisions.

Federal entity tax rates

Current federal rates:

• C-Corp. 21% flat federal corporate income tax rate (post-TCJA).
• S-Corp. No entity-level federal tax; income passes through to shareholders at individual rates.
• Partnership / multi-member LLC. No entity-level federal tax; income passes through to partners/members at individual rates.
• Sole prop / disregarded LLC. Owner's individual marginal rate plus self-employment tax (15.3% on first portion of net earnings, 2.9% Medicare on remainder).

The double-taxation issue with C-Corps: the entity pays 21% on earnings, then shareholders pay tax again on dividends (qualified dividends at 0%, 15%, or 20% depending on income; ordinary income rates for ordinary dividends). Effective combined rate can exceed 35% for distributed earnings.

Section 199A Qualified Business Income deduction provides up to 20% deduction for pass-through business income (S-Corp, partnership, sole prop), subject to thresholds, wage limits, and "specified service trade or business" restrictions for higher-income taxpayers.

S-Corp election

An LLC or corporation can elect to be taxed as an S-Corp by filing Form 2553. Effect: income passes through to shareholders (Schedule E on Form 1040), avoiding the C-Corp double-taxation problem. Plus a specific payroll-tax benefit: working owners receive both salary (subject to payroll tax) and distributions (not subject to self-employment tax), which can save FICA compared to a pass-through partnership or sole prop where all net earnings are subject to SE tax.

S-Corp restrictions:

• No more than 100 shareholders
• Only one class of stock (differences in voting rights are permitted)
• Shareholders limited to US individuals (citizens and resident aliens), certain trusts, and certain estates; not entities (with limited exceptions), not non-resident aliens
• Must be a domestic entity

These restrictions make S-Corp incompatible with venture capital financing (VC funds aren't permitted shareholders), with foreign investment, or with stratified equity structures.

The S-Corp salary requirement: working owners must take "reasonable compensation" before taking distributions. The IRS challenges arrangements where owners take little or no salary and large distributions to avoid payroll tax. What's "reasonable" is fact-specific; aiming for industry-standard compensation for the work performed is the conservative approach.

Section 2553 election timing: file within 75 days of formation, or by March 15 of the year the election is to take effect. Late election relief is available (Rev. Proc. 2013-30) but adds complexity.

State income tax

States with no individual income tax: Alaska, Florida, Nevada, New Hampshire (interest/dividends only, being phased out), South Dakota, Tennessee, Texas, Washington (capital gains tax on high earners only), Wyoming. Pass-through business income to owners in these states is not state-taxed.

States with corporate income tax: 44 states plus DC, with rates varying significantly. Some states tax pass-through entities at the entity level despite federal pass-through treatment.

Pass-Through Entity Tax (PTET) elections: 35+ states now allow pass-through entities to elect entity-level tax, which is deductible at the federal level (avoiding the $10,000 SALT cap on individual deduction). The election can produce significant federal tax savings for owners in high-tax states.

State franchise taxes are separate from income tax: California's $800 minimum, Texas margin tax, Delaware franchise tax, etc. apply regardless of profitability.

Payroll tax

Employer-side payroll obligations:

• Federal income tax withholding. From employee paychecks based on W-4 elections.
• Social Security tax. 6.2% withheld from employee (up to wage base) plus 6.2% employer match.
• Medicare tax. 1.45% withheld from employee plus 1.45% employer match. Additional 0.9% Medicare withheld from employee on wages above thresholds.
• Federal unemployment tax (FUTA). 6% on first $7,000 per employee per year, reduced to 0.6% with state UI credit.
• State income tax withholding. In states with income tax.
• State unemployment insurance. Rate varies by state and employer experience rating.
• State disability insurance. California, Hawaii, New Jersey, New York, Rhode Island, Puerto Rico.
• Local payroll taxes. Some cities (e.g., New York, San Francisco, Newark) have local payroll taxes.

Filing and deposit requirements:

• Form 941 quarterly. Employer's Quarterly Federal Tax Return.
• Form 940 annually. FUTA return.
• Form W-2 and W-3 annually. Wage reporting to employees and SSA.
• Federal tax deposits. Generally monthly or semi-weekly depending on tax liability, electronically through EFTPS.
• State equivalents.

Payroll services (commercial providers or PEOs) handle the mechanics. Many small businesses use payroll services from day one of having employees because the penalty structure for getting it wrong is severe.

Trust fund recovery penalty

Withheld income tax, Social Security, and Medicare withheld from employees are "trust fund" taxes — held in trust for the government rather than belonging to the employer. The Trust Fund Recovery Penalty (TFRP) imposes personal liability on "responsible persons" who "willfully" fail to pay over trust fund taxes.

"Responsible person" is broad: anyone with significant authority over the company's financial affairs — CEO, CFO, bookkeeper, controller, sometimes outside accountants or directors. Multiple people can be jointly and severally liable.

"Willful" doesn't require malice; knowledge of unpaid taxes plus preferring other creditors satisfies the standard.

TFRP equals 100% of the unpaid trust fund tax. The penalty is personal — piercing the entity's liability shield. It's one of the most aggressive collection tools the IRS has and one of the few areas where a corporation's owners can be personally liable for tax debts of the entity.

Practical implication: trust fund taxes must be paid even when the business is struggling. Borrowing from withheld taxes to fund operations is a common path to personal liability and sometimes criminal prosecution.

Sales tax and Wayfair nexus

Before South Dakota v. Wayfair (2018), states could only require sales tax collection by sellers with physical presence in the state. Wayfair overruled Quill and held that "economic nexus" — sales activity exceeding state-specific thresholds — was sufficient to require collection.

Typical economic nexus thresholds:

• $100,000 in sales into the state in the prior or current year, or
• 200 transactions into the state in the prior or current year

(Thresholds vary by state — some have one or the other, some have both, some have higher dollar amounts.)

Once nexus is established:

• Register for sales tax permit in the state
• Collect sales tax on taxable sales to in-state customers
• File sales tax returns (monthly, quarterly, or annually depending on volume)
• Remit collected tax to state DOR
• Maintain records of sales and tax collected

Marketplace facilitator laws (now in nearly all sales-tax states) shift collection responsibility to the marketplace platform for sales made through it. Sales made directly through the seller's own website remain the seller's responsibility.

Multi-state sales tax compliance for an online seller can quickly become unmanageable manually. Sales tax automation services calculate, file, and remit across multiple states; the cost is typically much less than the penalty exposure for missed jurisdictions.

Sales tax audits are common in states with aggressive enforcement. The look-back period is often 3 years; for unregistered sellers who later register, voluntary disclosure programs can limit look-back and waive penalties.

1099 reporting

Form 1099 information returns report payments to non-employees:

• 1099-NEC (Non-Employee Compensation). Payments of $600+ to independent contractors for services. Due January 31.
• 1099-MISC. Payments of $600+ for rent, prizes, awards, attorney fees (in some cases), royalties, and other categories. Due January 31 (paper) or March 31 (electronic) depending on box.
• 1099-K. Third-party network payments (PayPal, Stripe, Etsy, etc.) reported by the payment settlement entity. The reporting threshold has been subject to recent statutory changes — check current IRS guidance.
• 1099-INT, 1099-DIV, 1099-B. Interest, dividends, broker transactions.
• Other 1099 series: 1099-S real estate, 1099-R retirement distributions, 1099-G government payments.

To issue 1099s, the payer needs the payee's Form W-9 (Request for Taxpayer Identification Number). Best practice: collect W-9 before issuing first payment, not at year-end.

Penalties for late or missing 1099 filings: per-form penalties on increasing scale based on how late. Penalties for intentional disregard are significantly higher.

1099 reporting also matters for Section 530 relief on contractor classification — the business must have filed all required 1099s to qualify for relief from employment-tax assessments. See contractor classification.

Estimated taxes

US tax is pay-as-you-go. Employees satisfy this through withholding; self-employed individuals and corporations make quarterly estimated tax payments.

• Individuals (including pass-through owners). Form 1040-ES quarterly payments (April 15, June 15, September 15, January 15 of following year) covering income tax and SE tax. Safe harbor: pay the lesser of 90% of current-year tax or 100% of prior-year tax (110% for higher-income taxpayers) to avoid underpayment penalty.
• C-Corps. Form 1120-W quarterly estimated payments.

Failure to pay estimated taxes results in underpayment penalty interest. The penalty is modest at current interest rates but adds up for large underpayments.

IRS audits

IRS audits take three forms:

• Correspondence audit. Letter requesting specific documentation for specific items on the return. Most common type. Handled by mail or fax.
• Office audit. Taxpayer visits the IRS office to review documentation for several issues. Used for more complex individual and small-business returns.
• Field audit. IRS agent visits the taxpayer's business or representative's office. Used for businesses, more complex returns, or where larger issues are identified.

Audit triggers can include: high income, large losses, large or unusual deductions, mismatches between returns and 1099s/W-2s, certain industries the IRS focuses on, random selection. Schedule C losses, business meals, vehicle expenses, and home office deductions are recurring areas of scrutiny.

Audit response process:

1. IRS notice describing items examined and documentation requested.
2. Taxpayer provides documentation, either directly or through representation (CPA, EA, or attorney with power of attorney via Form 2848).
3. Agent issues examination findings (Form 4549 or similar) — agreement with taxpayer's return, proposed adjustments, or no-change.
4. Taxpayer agrees, requests informal conference with supervisor, or appeals to IRS Independent Office of Appeals.
5. If unresolved at appeals, statutory notice of deficiency issued; taxpayer can petition Tax Court (before paying) or pay and sue for refund in district court / Court of Federal Claims.

Statute of limitations

IRS assessment deadlines:

• 3 years from filing for most situations.
• 6 years if more than 25% of gross income is omitted from the return.
• No limit for fraudulent returns or returns not filed.

Collection statute is generally 10 years from assessment, with extensions for specific events (offer-in-compromise, bankruptcy, etc.).

State tax limitations vary; many follow the federal 3-year pattern but some are longer.

International tax basics

Cross-border activity triggers additional rules:

• US source vs foreign source income. Determines whether foreign tax credit is available.
• Subpart F / GILTI. US shareholders of controlled foreign corporations face current taxation on certain foreign income.
• FDII. Reduced US tax rate on foreign-derived intangible income.
• Withholding on payments to foreign persons. Generally 30% on US-source FDAP income, subject to treaty reduction. Form W-8 series documents foreign payee status.
• FATCA reporting. Foreign financial assets and accounts.
• FBAR (FinCEN Form 114). Foreign bank accounts with aggregate value over $10,000.
• Transfer pricing. Inter-company transactions across borders must follow arm's-length pricing principles.

International tax is specialist territory. Any business with foreign operations, foreign income, foreign owners, or significant inbound foreign transactions should engage international-tax counsel early.

Recordkeeping

IRS recordkeeping general rule: keep records supporting items on the return for as long as the IRS could examine them. Practical guidelines:

• Tax returns and supporting documents: 7 years
• Records of asset purchases (basis): Keep until 7 years after disposition
• Payroll records: 4+ years per IRS, longer per DOL (typically 3 years for wage records; 2 years for time/wage computation records)
• Property records: 7 years after disposition
• Permanent records: Articles of incorporation, bylaws, board minutes, equity records

Digital records are acceptable if accurate and accessible. Cloud storage with regular backups is the modern standard.

Common mistakes

• Missing the S-Corp election deadline. Form 2553 within 75 days of formation, or by March 15 for current-year effect. Late election relief is available but adds complexity.
• S-Corp owner taking no salary. The "no salary, all distributions" approach attracts IRS challenge and reclassification.
• Trust fund tax non-payment. Borrowing from withheld taxes to fund operations is the path to personal liability and sometimes criminal prosecution.
• Ignoring sales tax economic nexus. Post-Wayfair, online sellers can owe collection in dozens of states. Discovery often happens in due diligence for a sale or financing.
• 1099 reporting gaps. Failure to issue 1099s forfeits Section 530 relief and produces per-form penalties.
• Worker misclassification. See contractor classification.
• Estimated tax shortfalls. Owners switching from employment (with withholding) to self-employment often underpay estimated taxes for the first year and face penalty.
• Missing the 83(b) election. Founder stock subject to vesting requires 83(b) within 30 days of issuance to lock in tax treatment. Non-extendable deadline.
• Not using a PEO or payroll service. Doing payroll in-house at small scale is risk-heavy for marginal cost savings.
• Mixing personal and business finances. Veil-piercing risk on liability side, audit risk and disallowed-expense risk on tax side.
• Filing late. Late-filing penalties are higher than late-payment penalties; file even if you can't pay in full.

FAQ

When should I elect S-Corp status? When net earnings are sufficient to make the payroll-tax savings exceed the added compliance cost — roughly $40,000–$60,000 of net earnings is a common breakeven, but it varies. Run the numbers with a CPA.

Do I need to register for sales tax in every state I sell to? Once you cross economic nexus thresholds in a state, yes. For online sellers below thresholds, no. The thresholds vary by state.

Can I deduct business meals? Generally 50% deductible. The 100% deduction for restaurant meals (TCJA temporary provision) has sunset; current law allows 50%.

Can I deduct home office expenses? Yes if the space is used regularly and exclusively for business and is the principal place of business. Simplified method (square footage) or actual expense method.

How do I respond to an IRS notice? Read it carefully — many are automated and address narrow issues. If you understand the issue and can respond with documentation, do so by the deadline. If it's complex or large, engage a CPA, enrolled agent, or tax attorney.

What's a tax attorney vs CPA vs enrolled agent? CPA is licensed by state for accounting and tax (broad scope); EA is federally licensed to represent taxpayers before the IRS; tax attorney is a lawyer with tax specialization (can also advise on legal aspects with privilege). For litigation or criminal issues, tax attorney is essential.

Are LLC distributions taxed? The income is taxed (allocated to members regardless of distribution) but the distribution itself generally isn't a separate taxable event unless it exceeds the member's basis.