Entrepreneurs face countless decisions on a daily basis, some are routine but some can have a significant impact on the bottom line of a businesses. Selecting a structure that is the best fit for your business is one of the most important decisions that will impact your business now and in the future.
When it comes to choosing the right business entity structure, 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?
In making a final decision, you should consult with legal and tax advisors familiar with your particular situation, but here’s a starting point in understanding how each of the common business structures could impact 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 from a legal angle, and owners report their business income on their personal tax returns which profits are typically subject to self-employment and income taxes.
That’s right, sole proprietors pay self-employment tax on their net profits in addition to income tax calculated at your individual tax rate. Self-employment tax rates are similar to the Social Security and Medicare taxes that are withheld from the pay of most wage earners.
The bottom line: The sole proprietorship has minimal legal formalities but it doesn’t provide legal separation between you and your business and it can end up costing you a higher overall tax bill due to self-employment taxes.
C Corporation (C Corp)
Unlike the sole proprietorship, a C Corp is a separate legal entity from the business owner(s) and is required to file and pay income taxes.
When people talk about small businesses and C Corps, something called “double taxation” usually enters the discussion. Here’s what it is: Let’s say you’re a shareholder of a C Corp. 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 shareholders decide to take some of those profits, you’ll have to distribute profits and pay taxes on those dividends on your personal income tax return.
The bottom line: C Corps require more formalities and paperwork because it’s a separate legal entity. The also file and pay their own income taxes so the issue of double taxation should be carefully considered. However, a C Corp may still be a good fit, especially considering that the Tax Cuts and Jobs Act of 2017 reduced the top tax rate from 35% to one flat rate of 21%. C Corp may also be a good structure if you plan on investing the profits back into the business.
S Corporation (S Corp)
To avoid double taxation, a C Corporation can opt for something called an “S Corporation” election. With this election, the company is still required to file an annual income tax return but doesn’t pay income taxes at the corporate level. Instead, profits and losses are passed along to the individual shareholders and are ultimately reported on their individual income tax returns.
Additionally, the IRS requires that shareholders that are actively involved in the business operations be paid a “reasonable” salary. This isn’t so bad considering that net profits from an S Corp are not subject to self-employment taxes.
The bottom line: The S Corporation avoids the issue of double taxation, and can also be a way to lower self-employment tax. However, keep in mind that a corporation (whether it’s a C Corp or an S Corp) means you have added paperwork and administrative requirements compared in comparison to 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 liability protection of a corporation with less 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 should 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. Speak with a trusted advisor to determine what’s best for your business.