How to Create a Business for Tax Purposes

Creating a business for tax purposes involves formalizing an operation so it is recognized by the IRS. A core concept in tax law is the distinction between a personal hobby and a legitimate business, as the IRS has specific criteria to determine an activity’s classification.

Formalizing an activity as a business provides access to tax deductions for ordinary and necessary expenses, which can lower your overall tax liability. This process involves making decisions about your business’s structure, registration, and ongoing compliance.

Determining if You Have a Business or a Hobby

The IRS uses nine factors to determine if an activity is a business or a hobby. No single factor is decisive; instead, the IRS considers the overall picture presented by all the facts and circumstances.

• Whether you conduct the activity in a businesslike manner, including maintaining complete and accurate books and records.
• The expertise of the taxpayer or their advisors.
• The time and effort you expend on the activity.
• Whether you depend on income from the activity for your livelihood.
• The expectation that assets used in the activity may appreciate in value.
• Your history of income or losses from the activity.
• The amount of occasional profits, if any.
• Your financial status and whether you have other income that might fund a hobby.
• Any elements of personal pleasure or recreation derived from the activity.

The main tax difference between a business and a hobby is how losses are treated. A business can deduct its expenses, and if those expenses exceed income, the resulting loss can often be used to offset other income, subject to certain limits. For an activity classified as a hobby, you must report all income. Under the Tax Cuts and Jobs Act, deductions for hobby-related expenses are suspended for tax years 2018 through 2025.

Comparing Business Structures and Their Tax Implications

Choosing a legal structure has lasting tax consequences. Each structure dictates how profits, losses, and owner compensation are handled for tax purposes.

A sole proprietorship is the simplest structure, with the business being legally indistinct from its owner. For tax purposes, it is a “disregarded entity,” meaning the business does not file a separate tax return. All business income and expenses are reported on Schedule C, which is filed with the owner’s personal Form 1040. The net profit is subject to both ordinary income tax and self-employment taxes.

A partnership is the default structure for businesses with two or more owners and is a pass-through entity. The partnership files an informational tax return, Form 1065, but does not pay taxes directly. Profits and losses are passed through to the partners and reported on their personal tax returns via a Schedule K-1. Each partner’s share of the net profit is subject to self-employment taxes.

A Limited Liability Company (LLC) offers a flexible structure. By default, a single-member LLC is taxed as a sole proprietorship, and a multi-member LLC is taxed as a partnership. This means they follow the same pass-through taxation rules. The advantage of an LLC is that it provides liability protection without altering this default tax treatment.

A C Corporation is a separate legal and tax entity from its owners. It files its own tax return, Form 1120, and pays taxes at the corporate level. If the corporation distributes profits to shareholders as dividends, those dividends are taxed again on the shareholders’ personal returns, a phenomenon known as double taxation. Owners who work for the business are treated as employees and receive salaries, which are deductible expenses for the corporation.

An S Corporation is a tax election, not a legal structure, that an LLC or a C Corporation can make. S Corps are pass-through entities that file Form 1120-S, with profits and losses passed through to shareholders’ personal returns via Schedule K-1. Owner-employees must be paid a “reasonable salary,” which is subject to payroll taxes. Any remaining profits can be distributed as dividends, which are not subject to self-employment or payroll taxes.

Owners of pass-through entities—including sole proprietorships, partnerships, and S corporations—may be eligible for the Qualified Business Income (QBI) deduction. This allows for a deduction of up to 20% of qualified business income on an owner’s personal tax return. However, limitations apply based on income levels and the nature of the business.

Information and Decisions Needed to Formalize Your Business

Before registering your business, you must make several decisions and gather specific information. These details form the basis of your legal and tax identity.

You must select a business name that is unique within your state of registration. Most states have an online database to search for name availability. It is also wise to check if the desired name is available as a web domain and on social media platforms.

You must secure a business address, which must be a physical street address, as P.O. Boxes are not acceptable for registration documents. While some business owners use their home address, others opt for a virtual office or a commercial registered agent service for privacy. This address will be a matter of public record.

Appointing a registered agent is a requirement for corporations and LLCs. A registered agent is a person or entity designated to receive official legal and government correspondence. This agent must have a physical street address in the state of formation and be available during normal business hours. You can act as your own registered agent or hire a third-party service.

Most formal business structures will need an Employer Identification Number (EIN) from the IRS. An EIN is a unique nine-digit number that acts as a Social Security Number for the business, used for tax filings and opening a business bank account. To obtain an EIN, you must complete and submit Form SS-4. This form requires the business’s legal name, address, entity type, and information about the “responsible party” who controls the entity.

The Process of Registering Your Business Entity

After gathering your information, you file formation documents with the appropriate state agency, such as the Secretary of State, to legally create your business. The document you file depends on your chosen structure.

For a Limited Liability Company, the formation document is called the Articles of Organization, while for a corporation, it is the Articles of Incorporation. These documents formally declare the business’s name, its address, and the name and address of its registered agent.

The submission process is handled through the state’s official business filing website, where you will pay a filing fee ranging from around $50 to several hundred dollars. Most states also allow for the submission of paper forms via mail. Online filings are often processed within a few business days, while mail-in filings can take several weeks.

Upon approval, the state will return a confirmation, which may include a certificate of formation. These documents are official proof of your business’s existence and are necessary for opening a bank account.

Making an S Corporation Tax Election

After an LLC or C Corporation is legally formed, it can choose to alter its federal tax treatment by making an S Corporation election. The primary motivation for this election is often to reduce the burden of self-employment taxes on the owners’ income.

The election is made by filing Form 2553 with the IRS. This form requires information such as the corporation’s name, address, and EIN, as well as the consent of all shareholders. The form must be signed by an authorized officer of the company.

Timing is a factor for this election to be effective for the current tax year. Form 2553 must be filed no more than two months and 15 days after the beginning of the tax year the election is to take effect. For a new business, this means filing within two months and 15 days of its formation date. A late filing may result in the election not taking effect until the following tax year, though relief is available for reasonable cause.

A compliance requirement for S Corporation owners who work in the business is the payment of a “reasonable salary.” The IRS requires that owner-employees be paid a wage that reflects the market rate for the services they provide, and this salary is subject to standard payroll taxes. This prevents owners from avoiding payroll taxes by classifying all their income as distributions. “Reasonable compensation” is determined by factors like the owner’s duties and what similar businesses pay for comparable services.