There are countless decisions to be made daily in the course of running a business, some trivial and some significant. Selecting a business structure is one of the most important decisions that will impact your business today and for years to come.
When it comes to choosing the right business entity, taxes are usually front and center on a new business owner’s mind. What structure will give you the best chance to lower your taxes? How can you lower your self-employment taxes? What are the downsides, if any, of incorporating?
While it’s smart to talk to a tax advisor about your own particular situation, here’s a starting guide to understand how each of the common business structures impacts your taxes:
The simplest business structure — the sole proprietorship — is the default if you don’t actually file for a formal structure. As a sole proprietor, there’s no separation between you and your business, and owners report their business income on their personal tax returns (using the IRS Form Schedule C).
One key thing is that sole proprietors need to pay self-employment tax on their profits. This is similar to the Social Security and Medicare taxes that are withheld from the pay of most wage earners. For the 2013 tax year, a self-employed person owes SE tax at a 15.3% rate for their first $113,700 in profit. You can then deduct half of self-employment tax from your total income.
So, if you’re a sole proprietor who made $60,000 in profit, you’ll first need to pay your self-employment tax on the full amount, and then calculate your taxable income at your individual tax rate.
The bottom line: The sole proprietorship is the simplest business structure and leaves you with the smallest amount of paperwork and legal formalities. But it doesn’t separate your personal and business finances or help protect your personal assets. And, in some cases, a sole proprietor is going to end up with a higher overall tax bill due to self-employment taxes.
C Corporation (C Corp)
Unlike the sole proprietorship, a C Corporation is a separate business entity from the business owner. This means that a C Corp business will need to file its own tax returns. As an owner of a C Corporation, you’ll need to file a personal tax return and business tax return each year.
When people talk about small businesses and C Corporations, something called “double taxation” usually enters the discussion. Here’s what it is: Let’s say you’re a part-owner of a C Corp business. First, the business will be taxed on its profits when it files its corporate tax return for the year. Then, if you or the other owners decide to take some of those profits home, you’ll have to distribute those profits and pay taxes on those distributions on your personal tax return.
The bottom line: This double taxation issue can lead to higher taxes for small business owners that want to take home the company profits. But, the C Corporation can be a good structure if you plan on investing the profits back into the business. You should talk with a tax advisor before choosing the C Corp for your small business.
S Corporation (S Corp)
To avoid double taxation, a C Corporation can opt for something called “S Corporation” election. This means that the company does not pay income taxes on any profits. Instead, profits are going to be passed along to the owners/shareholders and reported on their own personal income tax returns.
Let’s say you own 50% of a business that has elected S Corporation tax treatment. You’ll have to report 50% of the company’s profits on your own tax return. Note that since this is considered a distribution, you won’t have to pay self-employment tax on it. However, also take note that if you actively work in the business, you need to pay yourself a reasonable salary for what you do and you will need to pay self-employment tax on this. A distribution is made from whatever profits are left over after all expenses (including salary payments) are made.
The bottom line: The S Corporation avoids the problem of double taxation, and can also be a way to lower what you pay in self-employment taxes. However, keep in mind that a corporation (whether it’s a C Corp or an S Corp) means you have added paperwork and administrative demands compared with a sole proprietorship. In addition, there are certain restrictions for who can form an S Corporation; for example, shareholders need to be legal residents of the U.S.
Limited Liability Company (LLC)
The LLC is often considered a hybrid between a sole proprietorship and corporation. It’s a popular choice for small businesses because it offers the personal liability protection of a corporation with a minimum of paperwork and formalities.
By default, an LLC is taxed similar to the sole proprietorship — meaning that the company doesn’t pay income taxes on profits, but you report any profits on your own tax return. What makes an LLC interesting is that it offers a lot of flexibility for how you want to be taxed. You can choose to be taxed as a sole proprietor, a C Corporation, or an S Corporation.
The bottom line: The LLC is a great option for small business owners who want to separate themselves from the business, but don’t want to deal with all the formalities of a full-blown corporation. You can speak with a tax advisor to determine the best way for your LLC to be taxed.
Keep in mind that not all small businesses and business owners have the same situation, needs, and future plans. What’s right for one small business isn’t necessarily right for another. You’ll want to do some research, and speak with a trusted advisor or resource, to see what’s best for your business.