One of the key things to think about when selecting an entity structure for your business is deciding how you want your company to be taxed, along with personal liability protection, record-keeping needs, and how you plan to finance your operation. Your choice of entity will not only affect how and when you must submit your taxes and at what rate your business will be taxed, but it can also have an effect on a number of other aspects that will affect both you and your business.
Some of these factors include how you pay yourself, your risk of being audited by the IRS, the type of tax deductions and tax credits available to your company, and the types of strategies you can use to reduce your tax bill. That said, each entity comes with its own rules and requirements governing its tax obligations.
On that note, here we’ll provide a brief overview of the tax obligations for each type of business entity, along with some of the advantages and disadvantages inherent to each structure.
1. Sole Proprietorships
As a sole proprietor, you and your business are legally one and the same from the IRS’s perspective. This means all of the business’s assets and liabilities are reported on your personal 1040 tax return. You report your business income and expenses on Schedule C, which becomes a line item on your 1040.
From a tax standpoint, the primary advantage of a sole proprietorship is that it’s simple you don’t pay any separate taxes for your business, and you report all of your business income and losses on your personal tax return. It’s typically inexpensive (or no-cost at all) to set up a sole proprietorship, and your legal expenses are usually limited to obtaining the needed business licenses or permits, along with the necessary insurance.
2. Partnerships
A partnership is basically a sole proprietorship with more than one owner. The partners typically share equal responsibility for the business’ assets and liabilities. Like a sole proprietorship, a partnership is not a separate entity from its owners from a tax perspective.
The partnership reports its income, deductions, losses, and gains to the IRS by filing a Form 1065. However, all of the company’s profits and losses are “passed-through” to the individual partners, who report this information on their individual tax returns via Schedule K-1, and they pay taxes based on their individual tax rates.
Partnerships are generally inexpensive and simple to set up. Although because they have more than one owner, they can be more complex to set up than a sole proprietorship for the simple fact that each partner must agree on all decisions affecting the business. Like sole proprietors, owners of a partnership are required to pay self-employment taxes and submit quarterly estimated tax payments.
3. Limited Liability Companies
As a limited liability company (LLC), you have flexibility in choosing how you’ll be taxed, and your choices are based on how many owners (known as members) your LLC has. Unless you choose to be taxed as a corporation, single-member LLCs are automatically taxed as a sole proprietorship, while multi-member LLCs are taxed as partnerships.
In either case, your company doesn’t pay any taxes directly. Instead, your share of the net business income is passed through to you, and reported and taxed on your personal tax return, and you’ll pay taxes based on your personal tax rate, as described above.
Alternatively, you may elect for your LLC to be taxed as an S Corporation. In this case, you will file a tax return on behalf of the corporation, reporting all income and expenses on that return. But the entity itself will not pay taxes. Instead, the business will issue you a K-1, indicating the net profit or loss, which will be taxed as ordinary income on your personal tax return.
The main advantage of choosing to have your LLC taxed as an S Corporation is that you only pay payroll taxes on your actual payroll, not on your profit distributions from the company. Whereas, if you are taxed as a sole proprietorship or partnership, all profits are considered payroll and subject to payroll taxes up to the payroll tax limits. Additionally, as mentioned earlier, the audit risk for an S Corporation is typically less than it is for companies taxed as sole proprietorships, where income and expenses are reported on your personal Schedule C.
If your LLC is taxed as an S Corporation, you will pay income taxes on your profit distributions, but you would save roughly 15% in payroll taxes on distributions taken as profits, rather than as payroll, since you don’t pay payroll taxes on income taken as a profit distributions.
In contrast, when using an LLC taxed as a partnership or sole proprietorship, you will pay payroll taxes on all distributions to you from the LLC up to the payroll tax limits, and as discussed earlier, your risk of audit by the IRS will be higher as well.
That said, for an S Corporation election to make sense, you’ll want to have at least $60,000 or so of net income per year. If you are close to that amount and have not yet filed an S Corporation election, consult with us, so we can get you supported to do so.
4. C Corporations
A C Corporation is a separate tax-paying entity that files its own tax return, Form 1120, to report its income, as well as claim deductions and credits. Corporations taxed as C Corporations currently pay taxes at the corporate tax rate of 21% on all net income.
Post-tax profits are then distributed to the company’s shareholders as dividends. Dividends are then taxed on the shareholder’s personal income tax return at their individual tax rates. This means that the corporation itself gets taxed first, and then you get taxed again on your income from the corporation.
To avoid this system of “double taxation,” the owner of a C Corporation may elect to have the C Corporation taxed as an S Corporation, which we will cover next.
Due to the expense and complexity of creating and maintaining a traditional corporation and dealing with double taxation, very few small businesses will choose to be taxed as a C Corporation. However, once your business begins to have annual profits over $200,000 or so annually (beyond your salary and retirement account contributions), it could be worth considering a C Corporation for your entity structure.
5. S Corporations
An S Corporation is not a business entity in and of itself. Rather, the S Corporation is a special tax election made by the owner of a C Corporation or an LLC to notify the government that the Corporation should be taxed as a pass-through entity. As we wrote last week, unless you elect for your LLC to be taxed as an S Corporation, a single-member LLC is automatically taxed as a sole proprietorship, while multiple-member LLCs are taxed as a partnership.
A C Corporations can also elect to be taxed as an S Corporation, thereby avoiding the double taxation issue discussed in the prior section. Instead, when your business entity elects S Corporation status, all profits of your business entity are passed through to the shareholders via a K-1, and each shareholder reports their share of the profits as income on their personal tax return.
However, not all LLCs or C Corporations can elect S Corporation status. In order to file the S Corporation election, your business must meet the following requirements:
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- Must be filed as a U.S. corporation
- Can maintain only one class of stock
- Limited to 100 shareholders or less
- Shareholders must be individuals, estates, or certain qualified trusts
- Each shareholder must be a U.S. citizen or permanent resident alien, with a valid Social Security Number
- All shareholders must consent in writing to the S Corporation election
As we mentioned previously, in addition to these requirements, for an S Corporation election to save taxes versus reporting all profits on a Schedule C, you’ll want to have at least $60,000 of net income per year. Furthermore, to prevent business owners from avoiding payroll taxes by taking disproportionately large profit distributions, the IRS requires S Corporation owners to pay themselves “reasonable compensation” in exchange for their services.
Choose the tax treatment best suited for your business
Choosing the entity structure that’s right for your business is something you shouldn’t try to handle on your own—there’s simply too much at stake should you get something wrong.
From personal estate planning creation for your business and required administrative formalities to your ability to finance your company, we will offer you the support and guidance you need to choose the entity that’s most advantageous for every circumstance your company might face. Contact your estate attorney today.
