Tax concerns are usually at the top of the list when it comes to selecting an operating structure. Here’s a quick overview of a few tax benefits for the most common business entities:
A Sole Proprietorship is the default structure if you’re operating on your own and haven’t officially registered your business as a corporation, LLC (Limited Liability Company), or Non-profit. A sole proprietorship is NOT a legal business entity: you pay personal income tax on your earnings (as well as self-employment tax), can subtract some expenses as itemized business deductions on your tax return, and you’re personally liable for all of the debts the business incurs.
Why it might be a good idea
- You’re only taxed once on your earnings from the business
- There’s no need to file a separate tax return for the business
- Net losses can be “carried” to prior or later tax years to offset tax liability
- Hidden tax perks, like healthcare reimbursement arrangements and provisions for hiring family members abound
A traditional Partnership is also a “pass through” business entity, and is sometimes seen as the default structure when multiple parties run a business without forming an official entity (like an LLC or corporation). Just like a sole proprietorship, capital gains and income are taxed to the business owners, typically at a higher rate than they would be for some other business structures.
Why it might be a good idea:
- Partners are only taxed once on business earnings
- Partners can “assign” property, income, or debt to other partners, allowing for a tremendous tax savings in many cases.
- Assets can be more easily transferred out of the business to the owners without “property disbursement” taxes
The two main types of corporations are S-Corporations and C-Corporations.
First, it’s important to understand that corporations are considered a C corp when they are formed. With the Secretary of State, there is no distinction. To them, you are just “a corporation.” Period. Not S or C. This is a distinction made by the IRS and honored by state tax boards.
An affirmative action (making an election to be taxed as a small business corporation: IRS Form 2553) is needed to change your “C” corporation to an “S corp.”
A C-corporation files corporate tax returns and pays taxes on its profits. Then, from what remains after taxes, a corporation may distribute earnings to shareholders in the the form of dividends. Shareholders are then taxed on dividends, which means that the owners effectively pay taxes on the same earnings twice- once at the corporate level, and then as individuals. This is known as “double taxation.”
For some situations, a C corp can be preferable. Most of our clients are small businesses and prefer to make the S election.
An S-Corp works like a sole proprietorship or general partnership, where income passes through and is taxed to individual shareholders. Typically, profits and losses are allocated proportionally to ownership share.
Why an S-Corp might be a good idea:
- No self-employment tax, resulting in considerable tax savings in many cases
- Pass-through taxation means that losses can be deducted on your personal income tax return
Why a C-Corp might be a good idea:
- Corporate tax rates are often lower than top-bracket personal tax rates
- Special incentives for hiring, purchasing equipment, and other expansion-based activities (including deductions for start-up costs)
Limited Liability Companies and Limited Liability Partnerships
LLCs and LLPs are statutory business entities where rules can vary from state to state. Generally, both LLCs and LLPs can elect to be taxed as much like S-Corporations or general partnerships, where income “passes through” the entity directly to the owners. This avoids the double-tax issue faced by a traditional C-Corporation.
Why it might be a good idea:
- Typically considered flexible in terms of taxation
- Flexibility in profit distribution means that owners can assign income and losses in the most advantageous way for tax purposes
Though tax savings is an important consideration, the type of entity most suited to your business will depend on a variety of factors. We always recommend that you consult with a professional tax adviser to find the appropriate entity for your situation. If you’d like assistance in finding a great CPA or attorney for guidance on these issues, contact Formation Solutions. Also talk with other business owners, and do your research before making a decision. If you’ve got any tax tips for new business owners, comments, or questions please share ‘em with us!