Nonprofit corporations, by definition, exist not to make money but to fulfill one of the purposes recognized by federal law: charitable, educational, scientific or literary. Under state and federal tax laws, however, as long as a nonprofit corporation is organized and operated for a recognized nonprofit purpose and has secured the proper tax exemptions, it can take in more money than it spends to conduct its activities. In other words, it can make a profit. Whether a nonprofit’s income is taxable depends on whether the activities are related to the nonprofit’s purpose.

Making a profit from “related” activities
Tax-exempt nonprofits often make money as a result of their activities and use it to cover expenses. In fact, this income can be essential to an organization’s survival. As long as a nonprofit’s activities are associated with the nonprofit’s purpose, any profit made from them isn’t taxable.

Let’s take as an example a group called Friends of the Library, Inc. It’s a 501(c)(3) nonprofit (which means it has a federal tax exemption), organized to encourage the appreciation of literature and to raise money for the support and improvement of the local public library. It makes a profit from a lecture series featuring famous authors and from an annual sale of donated books.

Because these activities are educational and literary in nature, they do not jeopardize the group’s tax-exempt status, and the proceeds from them are not taxable. The organization may use this income for its own operating expenses (including salaries for officers and staff) or for the benefit of the local library. What it cannot do is distribute any of the income to the nonprofit’s officers, directors or others connected with Friends of the Library.

Making a profit from “unrelated” business activities
Sometimes nonprofits make money in ways that aren’t related to their nonprofit purposes. While nonprofits can usually earn unrelated business income without jeopardizing their nonprofit status, they have to pay corporate income taxes on it, under both state and federal corporate tax rules. (Generally, the first $1,000 of unrelated income is not taxed, but the remainder is.)

Let’s go back to the Friends of the Library nonprofit corporation for an example of unrelated income. People donate many thousands of books to Friends of the Library for an annual book sale, one of its major fund raising events. Although the sale is always successful, one year thousands of books are left over, and the nonprofit decides to sell the more valuable of these books by advertising in sources for rare and out-of-print books. The response is overwhelming, and before long the nonprofit has six employees cataloging books for sale. Soon, Friends of the Library finds itself in the business of buying books from other dealers and reselling them to the public. The nonprofit will have to report these earnings to the IRS, which will tax them as income from unrelated business activities.

In some situations, excessive unrelated business activities can also prompt the IRS to reconsider a nonprofit’s 501(c)(3) tax-exempt status. To avoid this, a nonprofit should never let its unrelated business activities reach the point where it starts to look like a regular commercial business. For instance, unrelated business activities shouldn’t absorb a substantial amount of staff time, require additional paid staff or volunteers, or produce much more income than that generated by the organization’s exempt activities.

Activities that are not taxed
Because the difference between “related” and “unrelated” activities can be confusing, the IRS has said that some activities will not be taxed, even if they aren’t related to the nonprofit’s purpose. Here’s a quick rundown of the activities that aren’t taxed:

• activities in which nearly all the work is done by volunteers
• activities carried on primarily for the benefit of members, students, patients, officers or employees (such as a hospital gift shop for patients or employees)
• sales of merchandise that has been mostly donated to the nonprofit (such as a thrift store)
• the rental or exchange of mailing lists of donors or members, and
• the distribution of items worth less than $5 as incentives for donating money (such as stamps or pre-printed mailing labels).

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A Limited Liability Company (LLC) is not a separate tax entity like a corporation; instead, it is what the IRS calls a “pass-through entity,” like a partnership or sole proprietorship. All of the profits and losses of the LLC “pass through” the business to the LLC owners (called members), who report this information on their personal tax returns. The LLC itself does not pay federal income taxes, but some states do charge the LLC itself a tax.

Income taxes
The IRS treats your LLC like a sole proprietorship or a partnership, depending on the number of members in your LLC. If you’ve already done business as a sole proprietorship or partnership, you’re ahead of the game because you know many of the rules already. If not, here are the basics:

Single-owner LLCs
The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS.

As the sole owner of your LLC, you must report all profits (or losses) of the LLC on Schedule C and submit it with your 1040 tax return. Even if you leave profits in the company’s bank account at the end of the year — for instance, to cover future expenses or expand the business — you must pay taxes on that money.

Multi-owner LLCs
The IRS treats co-owned LLCs as partnerships for tax purposes. Co-owned LLCs themselves do not pay taxes on business income; instead, the LLC owners each pay taxes on their lawful share of the profits on their personal income tax returns (with Schedule E attached). Each LLC member’s share of profits and losses, called a distributive share, is set out in the LLC operating agreement.

Most operating agreements provide that a member’s distributive share is in proportion to his percentage interest in the business. For instance, if Jimmy owns 60% of the LLC, and Luana owns the other 40%, Jimmy will be entitled to 60% of the LLC’s profits and losses, and Luana will be entitled to 40%. If you’d like to split up profits and losses in a way that is not proportionate to the members’ percentage interests in the business, it’s called a “special allocation,” and you must carefully follow IRS rules.

However members’ distributive shares are divvied up, the IRS treats each LLC member as though s/he receives her/his entire distributive share each year. This means that each LLC member must pay taxes on their distributive share whether or not the LLC actually distributes the money to him/her. The practical significance of this IRS rule is that even if LLC members need to leave profits in the LLC — for instance, to buy inventory or expand the business — each LLC member is liable for income tax on her/his rightful share of that money.

Even though a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure the LLC members are reporting their income correctly. The LLC must also provide each LLC member with a “Schedule K-1,” which breaks down each member’s share of the LLC’s profits and losses. In turn, each LLC member reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.

LLCs can elect corporate taxation
If your LLC will regularly need to retain a significant amount of profits in the company, you (and your co-owners, if you have any) may be able to save money by electing to have your LLC taxed as a corporation. For details, see “Can Corporate Taxation Cut Your LLC Tax Bill?” at the end of this article.

Estimating and paying income taxes
Because LLC members are not considered employees of the LLC, but rather self-employed business owners, they are not subject to tax withholding. Instead, each LLC member is responsible for setting aside enough money to pay taxes on his/her share of the profits. The members must estimate the amount of tax they’ll owe for the year and make payments to the IRS (and usually to the appropriate state tax agency) each quarter — in April, June, September and January.

Self-employment taxes
Because, again, LLC members are not employees but self-employed business owners, contributions to the Social Security and Medicare systems (collectively called the “self-employment” tax) are not withheld from their paychecks. Instead, most LLC owners are required to pay the self-employment tax directly to the IRS.

The current rule is that any owner who works in or helps manage the business must pay this tax on their distributive share — his or her rightful share of profits. However, owners who are not active in the LLC — that is, those who have merely invested money but don’t provide services or make management decisions for the LLC — may be exempt from paying self-employment taxes on their share of profits. The regulations in this area are a bit complicated, but if you actively manage or work in your LLC, you can expect to pay the self-employment tax on all LLC profits allocated to you.

Each owner who is subject to the self-employment tax reports it on Schedule SE, which s/he submits annually with his/her 1040 tax return. LLC owners pay twice as much self-employment tax as regular employees, since regular employees’ contributions to the self-employment tax are matched by their employers. The self-employment tax rate for 2002 for business owners is 15.3% of the first $84,900 of income and 2.9% of everything over $84,900. You’ll need to research the current year’s rate.

Expenses and deductions
As you no doubt already know, you don’t have to pay taxes — income taxes or self-employment taxes — on money that your business spends in pursuit of profit. You can deduct (”write off”) your legitimate business expenses from your business income, which can greatly lower the profits you must report to the IRS. Deductible expenses include start-up costs, automobile, travel and entertainment expenses and advertising and promotion costs.

State taxes and fees
Most states tax LLC profits the same way the IRS does: The LLC owners pay taxes to the state on their personal returns; the LLC itself does not pay a state tax. A few states, however, do charge the LLC a tax based on the amount of income the LLC makes, in addition to the income tax its owners pay. For instance, California levies a tax on LLCs that make over $250,000 per year; the tax ranges from about $1,000 to $9,000.

In addition, some states (including California, Delaware, Illinois, Massachusetts, New Hampshire, Pennsylvania and Wyoming) impose an annual fee on LLCs, called a ” franchise tax,” an “annual registration fee” or a “renewal fee.” In most states, the fee is about $100, but California exacts a hefty $800 fee per year from LLCs, and Illinois, Massachusetts and Pennsylvania charge $300, $500 and $330, respectively. Before forming an LLC, find out if your state charges a separate LLC-level tax by visiting the website of your state’s Revenue or Tax Department, or by giving them a call.

Can corporate taxation cut your LLC tax bill?
If you regularly need to keep a substantial amount of profits in your LLC (called “retained earnings”), you might benefit from electing corporate taxation. Any LLC can be treated like a corporation for tax purposes by filing IRS Form 8832 and checking the corporate tax treatment box on the form.

After making this election, profits kept in the LLC are taxed at the separate income tax rates that apply to corporations; the owners don’t pay personal income taxes on profits left in the company. (Unlike an LLC, a corporation pays its own taxes on all corporate profits left in the business.) Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to most LLC owners, this can save you and your co-owners money in overall taxes.

For example, if your retail outfit needs to stock up on expensive inventory at the beginning of each year, you might decide to leave $50,000 in your business at year’s end. With the regular pass-through taxation of an LLC, these retained profits would likely be taxed at your individual tax rate, which is probably over 27%. But with corporate taxation, that $50,000 is taxed at the lower 15% corporate rate.

Once you elect corporate taxation, however, you can’t switch back to pass-through taxation for five years, and if you do switch back, there could be negative tax consequences. In other words, you should treat the decision to elect corporate taxation as seriously as you would the decision to convert your LLC to a corporation.

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Corporations are taxed differently than other business structures: a corporation is the only type of business that must pay its own income taxes on profits. In contrast, partnerships, sole proprietorships and limited liability companies (LLCs) are not taxed on business profits; instead, the profits “pass through” the businesses to their owners, who report business income or losses on their personal tax returns.

Understanding corporate taxation
Because a corporation is a separate legal entity from its owners, the company itself is taxed on all profits that it cannot deduct as business expenses. Generally, taxable profits consist of money kept in the company to cover expenses or expansion (called “retained earnings”) and profits that are distributed to the owners (shareholders) as dividends.

Tax-deductible expenses
To reduce taxable profits, a corporation can deduct its business expenses — basically, any money the corporation spends in the legitimate pursuit of profit. In addition to start-up costs, operating expenses and product and advertising outlays, a corporation can deduct the salaries and bonuses it pays and all of the costs associated with medical and retirement plans for employees. To be sure you don’t miss out on important tax deductions, see the Business Taxes area of Nolo’s Legal Encyclopedia.

Corporate tax payments
The corporation must file a corporate tax return, IRS Form 1120, and pay taxes at a corporate income tax rate on any profits. If a corporation will owe taxes, it must estimate the amount of tax due for the year and make payments to the IRS on a quarterly basis — in April, June, September and January.

Shareholder tax payments
The corporation’s owners, if they work for the corporation, pay individual income taxes on their salaries and bonuses, like regular employees of any company. Salaries and bonuses are deductible business expenses, so the corporation deducts those costs and does not pay taxes on them.

Tax on dividends
If a corporation distributes dividends to the owners (rare for small corporations where the owners work for the corporation), the owners must report and pay personal income tax on these amounts. And because dividends, unlike salaries and bonuses, are not tax-deductible, the corporation must also pay taxes on them. This means that dividends are taxed twice — once to the corporation and again to the shareholders.

S corporation taxes
The scheme of taxation described in this article applies only to regular corporations, called “C corporations.” By contrast, a corporation that has elected “S corporation” status pays taxes like a partnership or limited liability company (LLC): All corporate profits or losses “pass through” the business and are reported on the owners’ personal income tax returns. To learn more about S corporations, see S Corporation Facts.

Benefits of the separate corporate income tax
Although reporting and paying taxes on a separate corporate tax return can be time consuming, there are some benefits to having a separate level of taxation. Here we explain a few of them, but you should see a tax expert for a complete explanation of the pros and cons of corporate taxation as it applies to your situation. This is a very complicated area, and for some companies — especially those that may experience losses, are involved in investing or may soon be sold — corporate taxation can be a real disadvantage.

Retained earnings
Often a corporation will want or need to retain some of profits in the business at the end of the year — for instance, to fund expansion and future growth. If it does, that money will be taxed to the corporation at corporate income tax rates. Because initial corporate income tax rates (15% – 25% on profits up to the first $75,000) are lower than most owners’ marginal income tax rates for the same amount of income, a corporation’s owners can save money by keeping some profits in the company. (This does not apply to professional corporations, however, as they are taxed at a flat rate of 35%.) In contrast, owners of sole proprietorships, partnerships and LLCs must pay taxes on all business profits at their individual income tax rates, whether they take the profits out of the business or not.

The IRS will allow you to leave profits in your corporation up to a point: Most corporations can safely keep a total of $250,000 (at any one time) in the corporation without facing tax penalties (some professional corporations may not retain more than $150,000).

Fringe benefits
Another benefit of forming a C corporation is that the company can deduct the full cost of fringe benefits provided to employees — almost always including the business’ owners. For example, a corporation can adopt a health plan and pay 100% of its employees’ insurance premiums. These costs are tax deductible to the corporation.

This provides shareholders with a slight edge over other types of business owners: limited liability companies, partnerships and sole proprietorships are not allowed as many fringe benefit deductions. For instance, sole proprietors and owners of partnerships and LLCs could deduct only 60% of their health insurance premiums in the year 2001. This limit increased to 70% in 2002, and from 2003 and beyond, owners are able to deduct the full cost of their health insurance premiums.

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For many small businesses, paying income tax means struggling to master double-entry bookkeeping and employee withholding rules while ferreting out every possible business deduction. For partnerships, paying taxes also involves understanding difficult terms like “distributive share,” “special allocation” and “substantial economic effect.” Here, we explain the basics of how partnerships are taxed.

How partnership income is taxed
Generally, the IRS does not consider partnerships to be separate from their owners for tax purposes; instead, they are considered “pass-through” tax entities. This means that all of the profits and losses of the partnership “pass through” the business to the partners, who pay taxes on their share of the profits (or deduct their share of the losses) on their individual income tax returns. Each partner’s share of profits and losses is usually set out in a written partnership agreement.

Filing tax returns
Even though the partnership itself does not pay income taxes, it must file Form 1065 with the IRS. This form is an informational return the IRS reviews to determine whether the partners are reporting their income correctly. The partnership must also provide a “Schedule K-1″ to the IRS and to each partner, which breaks down each partner’s share of the business’ profits and losses. In turn, each partner reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.

Estimating and paying taxes
Because there is no employer to compute and withhold income taxes, each partner must set aside enough money to pay taxes on his/her share of annual profits. Partners must estimate the amount of tax they will owe for the year and make payments to the IRS (and usually to the appropriate state tax agency) each quarter — in April, July, October and January.

Profits are taxed whether partners receive them or not
The IRS requires each partner to pay income taxes on her/his “distributive share.” This is the portion of profits to which the partner is entitled under a partnership agreement — or under state law if the partners didn’t make an agreement. The IRS treats each partner as though s/he receives his or her distributive share each year. This means that you must pay taxes on your share of the partnership’s profits — total sales minus expenses — regardless of how much money you actually withdraw from the business.

The practical significance of the IRS rule about distributive shares is that even if partners need to leave profits in the partnership — for instance, to cover future expenses or expand the business — each partner is liable for income tax on her or his rightful share of that money. (If your business will regularly need to retain profits, you should consider incorporating — corporations offer some relief from this tax bite. To learn more, see “Incorporating Your Business May Cut Your Tax Bill,” below.)

Establishing the partners’ distributive shares
Unless business partners make a written partnership agreement that says otherwise, state law usually allocates profits and losses to the partners according to their percentage interests in the business. This allocation determines each partner’s distributive share. For instance, if Andre owns 60% of a partnership, and Jenya owns the other 40%, Andre will be entitled to 60% of the partnership’s profits and losses, and Jenya will be entitled to 40%. (In addition, state law assumes that each partner’s interest in the business is in proportion to the value of his/her initial contribution to the partnership.)

If you’d like to split up profits and losses in a way that is not proportionate to the partners’ percentage interests in the business, it’s called a “special allocation,” and you must carefully follow IRS rules.

Self-employment taxes
If you are actively involved in running a partnership, in addition to income taxes, the IRS requires you to pay “self-employment” taxes on all partnership profits allocated to you. Self-employment taxes consist of contributions to the Social Security and Medicare systems, similar to what employees must pay.

There are some differences between the contributions regular employees make and the contributions partners must make. First, because no employer withholds these taxes from partners’ paychecks, partners must pay them with their regular income taxes. Also, partners must pay twice as much as regular employees, because employee contributions are matched by their employers.

The self-employment tax rate for 2002 was 15.3% of the first $84,900 of income and 2.9% of everything over $84,900. You’ll need to research the current year’s rates. Partners report their self-employment taxes on Schedule SE, which they submit annually with their 1040 income tax returns.

Expenses and deductions
You may be wondering, after paying income taxes, Social Security taxes and Medicare taxes on your share of business income — even if you don’t withdraw it out from your business — just how you will survive! Luckily, you don’t have to pay taxes on just about any money your business spends to make a buck.

You and your partners can deduct your legitimate business expenses from your business income, which will greatly lower the profits you have to report to the IRS. Deductible expenses include start-up costs, operating expenses and product and advertising outlays, as well as business-related meals, travel and entertainment expenses.

Get expert help
If you’re confused by partnership taxes, you’re not alone. A good way to learn the basics is to read Tax Savvy for Small Business, by tax attorney Fred Daily (Nolo). Then, plan to get the help you need from a tax advisor who specializes in partnership taxation — to make sure you comply with the complex tax rules that apply to your business and stay on the good side of the IRS.

Incorporating your business may cut your tax bill
Unlike a partnership, a corporation is a separate entity from its owners and pays its own taxes on all corporate profits left in the business. Owners of corporations pay income taxes only on money they receive as compensation for services (salaries and bonuses) or as dividends.

While many small businesses would rather not file a more complicated corporate tax return, incorporating can offer business owners a tax advantage over a partnership’s “pass through” taxation. This is especially true for businesses that expect to retain profits in the business from year to year.

If you need to keep profits (called “retained earnings”) in your business, you may benefit from lower corporate tax rates, at least for the first $75,000 of profits per year. For example, if your retail outfit needs to stock up on expensive inventory, you might decide to leave $30,000 in your business at the end of a year. If you operate as a partnership, these retained profits will likely be taxed at your marginal individual tax rate, which is probably over 27%. But if you incorporate, that $30,000 will be taxed at a lower 15% corporate rate. To get a better idea of whether you should incorporate to reduce taxes, see How Corporations Are Taxed.

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As a sole proprietor you must report all business income or losses on your personal income tax return; the business itself is not taxed separately. (The IRS calls this “pass-through” taxation, because business profits pass through the business to be taxed on your personal tax return.)

Here’s a brief overview of how to file and pay taxes as a sole proprietor — and an explanation of when incorporating your business can save you tax dollars.

Filing a tax return
The only difference between reporting income from your sole proprietorship and reporting wages from a job is that you must list your business’ profit or loss information on Schedule C (Profit or Loss from a Business), which you will submit to the IRS along with Form 1040.

You’ll be taxed on all profits of the business — that’s total sales minus expenses — regardless of how much money you actually withdraw from the business. In other words, even if you leave money in the company’s bank account at the end of the year — for instance, to cover future expenses or expand the business — you must pay taxes on that money.

You can deduct your business expenses in the same manner as any other type of business. You are allowed to write off any money you spend in pursuit of profit, including start-up costs, operating expenses and product and advertising costs, as well as business-related meals, travel and entertainment expenses. But you’ll need to keep accurate records for your business that are clearly separate from your personal expenses. One good approach is to keep separate checkbooks for your business and personal expenses — and pay for all of your business expenses out of the business checking account.

Estimated taxes
Because you don’t have an employer to withhold income taxes from your paycheck, it’s your job to set aside enough money to pay taxes on any business income you bring in over the year. To do this, you must estimate how much tax you’ll owe at the end of each year and make quarterly estimated income tax payments to the IRS and, if required, to your state tax agency.

Self-employment taxes
Sole proprietors must make contributions to the Social Security and Medicare systems; taken together, these contributions are called “self-employment taxes.” Self-employment taxes are equivalent to the payroll tax for employees of a business. But while regular employees make contributions to these two programs through deductions from their paychecks, sole proprietors must make their contributions when paying their other income taxes.

Another important difference between employees and sole proprietors is that employees only have to pay half as much into these programs because their contributions are matched by their employers. Sole proprietors must pay the entire amount themselves.

The self-employment tax rate for 2002 was 15.3% of the first $84,900 of income and 2.9% of everything over $84,900. You’ll need to research the current years’ rate. Self-employment taxes are reported on Schedule SE, which a sole proprietor submits each year with his 1040 income tax return and Schedule C.

Incorporating your business may cut your tax bill
Unlike a sole proprietorship, a corporation is considered a separate entity from its owners for income tax purposes. Owners of corporations don’t pay tax on money earned by the corporation unless they receive the money as compensation for services (salaries and bonuses) or as dividends. The corporation itself pays taxes on all profits left in the business.

While more complicated, corporate taxation can offer business owners some tax advantages. Corporate owners who need or want to leave some profits in the business can benefit from lower corporate tax rates, at least for the first $75,000 of profits. For example, if your Web design company wants to build up a reserve to buy new equipment or your small label manufacturing company needs to accumulate valuable inventory as it expands, you may choose to leave money in the business — let’s say $50,000. If you operate as a sole proprietor, those “retained” profits would be taxed at your marginal individual tax rate, which is probably over 27%. But if you incorporate, that $50,000 would be taxed at the lower 15% corporate rate.

To learn more about how incorporating can reduce your tax bill, see How Corporations are Taxed.

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As you develop your business plan, you’ll need to estimate the taxes you will owe.

Simple assumption

For planning purposes these are based on simple mathematics. Your estimated tax (usually in the profit and loss) is the product of multiplying pre-tax profits by your anticipated tax rate. This simple, powerful estimator is excellent in most cases. You could make it a lot more complex with lookup functions for graduated tax rates, or formulas to change tax treatment in different countries, or for loss situations. Still, this is about planning, not accounting, and simple is good. The estimated tax rate is easy to understand and easy to apply. You get a lot more planning power from a simple and obvious estimated input than from a complex, hard-to-follow formula.

However, if you have a string of steady losses, it requires special attention. In that case, you need to be aware of tax treatments. You have a potential problem if you leave everything in default mode: you’ll end up with a projection that treats taxes as if the government pays you back when you lose money.

Exception to the rule

The illustration below shows an example of a company that projects losses through the first two years of the plan resulting in negative taxes. The problem is that the government doesn’t pay companies to lose money. A negative tax rate could end up showing in the tables.

Illustration: Negative taxes

Recommended solution

The solution to this potential problem is the tax rate assumption as shown in the illustration below, and your own follow up.

Specifically, to handle taxes for a business plan that has a long string of losses: Set the tax rate to zero for the period of losses.

If your plan projects making a profit later on, then you’ll have a loss carried forward tax advantage that will reduce the tax rate when there are profits. This should be a simple educated guess. Take whatever your tax rate would have been, and make it lower.

Illustration: Zero tax rate for loss periods

More detailed solution

If you insist on detailed mathematical calculations—and only because you insist—here’s more detail:

1. Take the sum of the losses.
   (Example: $100K).
2. Multiply the sum by your estimated tax rate (25%) when you make profits, and call that the loss carried forward.
   (Example: $100K * .25 = $25K).
3. Subtract that amount ($25K) from the tax estimate of the first profitable year.
   (Example: if the tax estimate was $50K at 25% rate, $50K – $25K = $25K).
4. Change your estimated tax rate in the profitable year so the estimated tax is now equal to the reduced amount.
   (Example: if estimated tax was $50K at 25%, and your target tax is $25K, then make your tax rate 12.5% for that first profitable year).
5. Explain the adjustment in text accompanying your General Assumptions or Profit and Loss table. The explanation can be this simple:
   “Taxes are set at zero during the loss periods. The loss carried forward impact reduces the estimated tax rate during the profitable periods.”

Treat your negative tax situations carefully. If your financial tables inadvertently treat a negative tax liability as cash coming in to your business, or as cash not spent the real impact on your business will come as a rude surprise.