Small Business Taxes: What Actually Trips Up Founders Filing in the US

US small business taxes can vary depending on the business structure, the state in which the business is located, and the business owner’s tax status. LLCs are taxed differently based on the number of members. By default, the IRS treats multi-member LLCs as businesses and taxes them as partnerships. An LLC can elect to be taxed as a corporation; if it does, it will be taxed the same as a C corporation or an S corporation.

Non-resident owners complicate the already convoluted small business tax system. Non-resident owners often do not expect to pay state franchise taxes or to file Form 5472 and obtain an EIN.

Most small business owners are unable to write off losses due to high tax rates. Small business owners often incur a loss because they fail to plan for taxes or miss a tax filing deadline. Most small business owners do not know about a tax election until it is filed or they discover a tax form for the first time. Entity classification is often determined after the business has already been formed. Classifying your business is important for determining tax liability and can be done easily before a business is even formed.

How Are Small Business Taxes Determined for an LLC?

By default, the IRS treats LLCs as businesses and does not impose tax at the entity level. However, LLCs can have one or more members, and their composition will affect how the LLC is treated for tax purposes. If an LLC has only one member, the LLC will be disregarded for tax purposes, and the LLC’s profits will be reported by the member on their personal tax return. If an LLC has non-resident members and the LLC has no U.S. source income, Form 5472 will still need to be filed. Non-resident members will report the LLC’s income on a pro forma U.S. corporation income tax return.

Because of default rules for tax classification, a multi-member LLC is treated as a partnership for tax purposes and, therefore, must file Form 1065. Like a partnership, an LLC must furnish its members with a K-1 pass-through tax form. Unlike a C corporation, an LLC is not required to file a tax return on April 15th. Rather, an LLC must file its return on March 15th. Unfortunately, the March deadline often catches first-time entrepreneurs by surprise.

Because an LLC is generally classified as a partnership for tax purposes, it may choose to be taxed as a corporation by filing Form 8832. If the LLC decides to be taxed as a corporation, it may also decide to be taxed as an S corporation by filing Form 2553. Both decisions must be supported by economic reality, meaning the S corporation election must be economically justified.

What’s the Real Timeline for Getting an EIN and Filing Taxes?

Generally, the timelines for processing forms for a business to file for an EIN and for a tax return align. First-time entrepreneurs who are non-resident aliens and are typically located outside the United States cannot apply for an EIN online because they do not have a Social Security Number (SSN) or an Individual Taxpayer Identification Number (ITIN). Generally, an EIN is issued by fax. During the 2022 tax filing season, the IRS faxed EINs to non-resident aliens in approximately 6 weeks. Nonresident aliens who have an SSN or ITIN can apply for an EIN online and typically receive it the same day.

That creates an issue for founders. Founders will often create an LLC, think they can instantly open a business bank account and start sending invoices, and then face delays opening a business checking account while waiting to mail in a document. Founders need to plan ahead and obtain an EIN as soon as an LLC is created.

What Forms Catch Foreign-Owned LLCs Off Guard?

Form 5472 is the most unexpected form. Each year, a pro forma Form 1120 must be submitted with Form 5472 by single-member LLCs owned by non-resident alien individuals. This form must be submitted even if the LLC has no income and is not obligated to file a tax return.

The penalty for not filing Form 5472 is a minimum of $25,000 per year and can increase if the IRS determines the failure to file was willful. This is an information return, not a tax liability. This form is often misinterpreted by foreign LLCs as a tax liability.

Other forms may be required to be filed depending upon the situation, including:

• Form 1042-S if the LLC has underlying non-resident alien individuals and the LLC has US source income
• Form 1040-NR is used if a non-resident alien individual has US source income and the income is not in the LLC.
• Other miscellaneous forms may be required, including the FinCEN Report of Foreign Ownership (including a change in ownership) and State Tax Returns.

State Taxes: Where the Real Variation Lives

Federal tax law generally creates uniformity when defining entities. State tax laws often surprise foreign owners of US entities.

Delaware	Franchise Tax (LLC)	$300 flat annual fee
California	LLC Franchise Tax	$800 minimum annually, regardless of income
Texas	Franchise Tax	No tax below $2.47M revenue threshold, report still required
Wyoming	Annual Report Fee	$60 minimum, based on assets located in-state
New York	Publication Requirement + Filing Fee	Varies by county, can run into hundreds of dollars

The $800 California LLC Franchise Tax is the most well-known unexpected tax because it is charged regardless of revenue and applies to foreign LLCs. Many founders try to minimize costs by forming an LLC in Wyoming, but operating in California requires registering the LLC as a foreign entity and paying an $800 tax.

Publishing in two New York newspapers for six weeks to alert the public of an LLC formation costs several hundred dollars and is required by the state. Skipping this publication affects the LLC’s right to do business in New York.

Common Mistakes Founders Make With Small Business Taxes

Some mistakes happen frequently. For example, there is a misunderstanding about the difference between the state in which an LLC is formed and the state in which it does business. Many people incorporate in Delaware or Wyoming because it is faster and less expensive. If they then do business in other states, such as California or New York, and do not form a foreign LLC in those states, they will ultimately owe back taxes and be subject to penalties.

Another common mistake is thinking that a business should not have to file a report if it has not earned any revenue. There are several state and federal reports that must be filed, regardless of whether the business generated any income, such as Form 5472 and state and federal partnership returns.

Some founders think they have until the end of the year to decide how their business should be taxed. However, they must decide to be taxed as an S corporation or a C corporation early in the tax year to file the appropriate forms for that tax year.

Founders often forget to budget for a CPA to handle non-resident business filings. Losses from using the wrong CPA to file non-resident business forms and help with treaty positions can add up to significant amounts every year. Founders also often forget about state non-resident business forms.

Many first-year business owners also fail to maintain a complete separation between personal and business finances. This usually leads to lost deductions and audits.

Step-by-Step: What the First-Year Filing Process Looks Like

1. Finalize LLC paperwork in the desired state and ensure the registered agent is in order.
2. Obtain an EIN as soon as LLC formation is processed (allow 4-6 weeks for processing if the applicant does not hold an SSN or ITIN).
3. Decide how the business will be taxed (by default, the entity is disregarded; however, a formal election can make the entity taxed as a corporation).
4. Register the entity to do business in all states where it operates to keep things simple.
5. Remember to file the Franchise Tax and annual report where the LLC is operating.
6. File Form 5472 and any pro forma returns (1120 or 1120-S) if the business is owned by a foreign entity.
7. Finally, file the return(s) (1065 or 1120 or 1120-S) based on entity classification.

FAQs

Do I need an ITIN to pay small business taxes as a non-resident? Normally not. An EIN is all that is required for the business to pay taxes. It is only necessary for the owner to obtain an ITIN if they are required to file a US personal return (Form 1040-NR).

What are the consequences for failing to file a Form 5472? Each failure to file will be subject to a minimum civil penalty of $25,000. Failure to file Form 5472 after receiving a notice from the IRS will result in additional penalties. A request for relief from the penalty will require the LLC to demonstrate reasonable cause.

Are LLCs required to pay state fees if the LLC has no revenue? LLCs are required to pay state fees regardless of whether the LLC has any revenue. This is the case in California and other states as well.

Can an LLC elect to change its tax status after the first year? Yes. Generally, an S corporation tax status can be made effective for a specific tax year as long as the election is made during the first two and a half months of the tax year.

Can an LLC formed in Wyoming or Delaware be tax-free for non-resident members? No. Although Wyoming and Delaware charge lower state formation fees, those LLCs remain subject to the provisions of the Internal Revenue Code, and their members may still be required to file Form 5472.