First and foremost, tax preparation requires compliance. Legal deductions are best recognized with upfront planning and timely execution.
Over the years, our experience in tax preparation surprised us. We find the vast majority of our clients are not interested in aggressive, arcane, or risky tax deductions. Not that people are looking to pay more taxes than they should, but most understand that some level of taxation is necessary to support legitimate public services we enjoy, like police, schools, infrastructure, and military protection.
Rather, on balance, the number one client concern is noncompliance. Clients want to avoid even an appearance of impropriety, which may later lead to IRS inquiries or an audit. In some cases, clients might be considered “over-conservative,” where persuasion is required to convince them as to their rights in taking ordinary, run-of-the-mill deductions.
At Ohio Tax Preparation, we strive to make “getting your taxes done” easy and educational. Below, we discuss the types of income tax returns we most frequently encounter in this division.
Description of income tax returns
The five types of income tax returns we elaborate on in this section are: (1) Form 1040 U.S. Individual Income Tax Return, (2) Form 1065 U.S. Return of Partnership Income, (3) Form 1120S U.S. Income Tax Return for an S Corporation, (4) Form 1120 U.S. Corporate Income Tax Return, and (5) Form 1041 U.S. Income Tax Return for Estates and Trusts. In addition to these federal returns, we also prepare your state and local income tax returns.
Form 1040 U.S. Individual Income Tax Return
How old were you when you filed your first federal tax return with the IRS? The basic (two page) form 1040 matured in complication over the years. Certain deductions are taken directly on form 1040. With respect to other deductions, taxpayers choose between taking a standard deduction or itemizing deductions on schedule A. Common itemized deductions include medical and dental expenses, state and local taxes, real estate taxes, home mortgage interest, and charitable donations. The vast majority of form 1040 tax returns are electronically filed, and tax preparation firms, like Ohio Tax Preparation, are required to e-file, unless you elect to paper file.
Schedule B of form 1040 lists interest and ordinary dividends received in the tax year. Schedule D sets forth capital gains and loss. Schedule E addresses supplemental income and loss. Landlords use schedule E to report rental income, while partners and shareholders use this schedule to include income or loss from partnerships or S corporations. Finally, income or loss from an estate or trust is also accounted for on schedule E.
Sole proprietors report profit or loss from a business directly on their personal tax returns using schedule C. A sole proprietorship is a business owned by a single person, where, for tax purposes, the business and taxpayer are not separately identified. Many sole proprietors establish a single-member LLC, which provides them limited liability protection, but for tax purposes, the business and owner are still one and the same. Because sole proprietors are owners and not employees, and thus not subject to payroll taxes, they must pay self-employment tax, which is reported on schedule SE, to account for their required social security and medicare contributions.
Form 1065 U.S. Return of Partnership Income
When two or more owners start a business, partnership is the default tax classification. A partnership reports profit or loss on form 1065, but this return is used for informational purposes only. The partnership entity will not pay income tax on the profit; rather, owners report their share of the profit or loss on their personal tax returns (form 1040, schedule E). To facilitate this reporting, the partnership must send each partner schedule K-1 (form 1065) after the partnership tax return is prepared. Like sole proprietor income, partnership income is subject to self-employment tax.
Form 1120S U.S. Income Tax Return for an S Corporation
One of the biggest mistakes we witness among small businesses is electing S corporation classification too soon. Commonly, CPAs and other tax practitioners recommend the S corporation, because in certain situations it can reduce an owner’s social security and medicare tax liability. But, owner-operators of an S corporation are employees of the corporation, and this status of “employer” triggers a host of additional legal and financial responsibilities, like payroll taxes. (For more information, visit Ohio Payroll Services.) Also, in recent years, the IRS is cracking-down on the ability of an S corporation owner-employee to avoid social security and medicare taxes, by requiring the officer to take “reasonable compensation.”
A brief note on social security: we always remind clients that social security works like a pension. Your social security benefit is determined, in part, by your contributions into the system. In our discussions with employees at social security, we’ve heard of stories where new retirees complain about not receiving a social security benefit. But, the response is always, you paid no (or very little) money into the system, why should you receive a benefit?
S corporation shareholders report income or loss on form 1120S. Like a partnership, the S corporation does not pay earnings tax. Rather, the shareholders report their share of the profit or loss on form 1040, schedule E. The S corporation must send each shareholder schedule K-1 (form 1120S). S corporation income is not subject to self-employment tax, which is the major tax advantage and reason why this form is favored by advanced practitioners.
Form 1120 U.S. Corporate Income Tax Return
In tax lingo, the traditional corporate form is referred to as the C corporation. If you ever purchased a stock through a brokerage firm, you probably bought ownership into a C corporation. Nearly all publicly-traded companies operate in this form. When an entity gets to a certain number of owners, it’s simply not practical to “pass-through” the income or loss.
C corporations pay income tax at the entity level. The tax disadvantage, known as “double taxation,” occurs when a shareholder is also personally taxed on dividends and capital gains.
We rarely recommend the C corporation form, but that’s because our client base consists of smaller, family-owned businesses, who are not in a position to raise major capital, or who are not interested in giving up the control that may follow from taking on numerous investors. A lot of our clients are in the “early stages,” and paying the double tax makes little sense.
C corporations report income or loss on form 1120. Owner-operators of C corporations are, of course, employees and, thus, subject to payroll taxes.
Form 1041 U.S. Income Tax Return for Estates and Trusts
Estates and certain trusts are separate taxable entities and report income or loss on form 1041. An estate is automatically created when a person dies, consisting of all assets subject to probate. If an estate earns gross income of $600 or more for the tax year (before the assets are distributed to beneficiaries), the estate must file an estate income tax return. The estate income tax is often confused with the “estate tax,” the latter also known as the death tax. The estate tax is rarely imposed today, as the basic exclusion amount is $5,490,000 for an individual or twice that amount for married couples. But, many estates that are not required to pay estate tax are still subject to estate income tax, because investments held by the estate earn income in the interim period before they are distributed to beneficiaries.
Another misconception is that all trusts need to file a separate income tax return. The opposite is true with most revocable trusts. In these situations, taxpayers report the trust income directly on their personal tax return (form 1040), as if the trust was not in existence.
However, a fiduciary will need to file form 1041 if any taxable income, or gross income of $600 or more, is earned by an irrevocable trust. These trusts are commonly used in medicaid planning. After a look back period, assets transferred to an irrevocable trust are not considered “countable resources,” and the settlor (the person funding the trust) can qualify for medicaid nursing home benefits without a requirement to spend down the trust assets.
Albert Einstein famously said, “The hardest thing in the world to understand is the income tax.” But, good news: the lay person is still trying. A lot of our clients, without needing to grasp technicalities, yearn to comprehend the basic, fundamental principles behind the tax law. We try and meet each year with our tax clients to prepare returns, and this meeting serves as an opportunity for each client to ask questions, not only about the tax code, but more generally, on matters concerning personal finance. We welcome the opportunity to earn your business and trust. Give us a call today at (513) 460-7691 and schedule an appointment for preparation of your next tax return.