If you are the sole proprietor of a small business, rather than filing a separate income tax return, you must report your business’s income on the Sch C of your personal income tax return. The IRS requires individuals to report all business income or losses with Form 1040. The individual is taxed on the profits (income minus expenses) of the business. They are not taxed on how much they withdraw from the business.
Example: Jill is the sole proprietor of a small business and withdrew $50,000 in 2021. The same business had a profit of $300,000 in 2021. Jill is taxed on the full $300,000 in 2021, not just the $50,000 that she withdrew from the business.
S corporations are pass-through entities which means the corporation itself does not pay taxes. Instead, the shareholders of S corporations pay taxes on the business’s profits. Shareholders can receive their profits from an S corporation through distributions or salaries. The S corporation will issue all its shareholders a K-1 at the end of the year to report their portion of the business’s profit. The shareholder must pay taxes on their portion of the S corporation’s profits, even if they choose to leave some or all their profits in the corporation. Similar to sole proprietor businesses, taxes are not determined by how much a shareholder physically takes from the S corporation, taxes are determined by how much profit the S corporation had in a given year.
Like S corporations, partnerships are also pass-through entities. Partnerships do not pay taxes, instead, each partner of a partnership pays taxes on their distributive share. A partner’s distributive share is the portion of the profits they are entitled to each year. Partners are taxed as though they received their full distributive share, regardless of how much they actually withdrew from the business.
C corporations are set up differently from S corporations and partnerships. C corporations are tax-paying entities. Similar to individuals, C corporations pay taxes on their income each year. Shareholders receive their dividends from the C corporation’s after-tax income. Shareholders are then taxed on their individual income tax returns (Form 1040) for the dividends they receive.