There’s a lot of new water to navigate when you start a business. Some aspects you will love, others will give you a major headache. I’m guessing that for most, figuring out your business structure, taxes and other legalities will fall under that second category. After all, no one wants to lay awake at night worrying they’re paying more taxes than they need to.
When it comes to business taxes, however, the key is to know your business’ annual earning and spending. But beyond the balance sheet, your company’s business structure (sole proprietorship, LLC or corporation) impacts how you pay your taxes and how much you pay back.
Note that this reflects US federal taxes and should be considered general information. It’s not a substitute for the advice of a tax expert who is familiar with your particular situation.
Solo business owners default to the sole proprietorship. This happens when you have a business but never set up an official structure with a state.
How it Affects Taxes
In terms of taxes, a sole proprietorship business is not distinct from the owner. You report all your business income and losses on your personal income tax return and the business itself doesn’t need to file a tax return.
When it’s time to file your taxes, you will report your profit and loss information on Schedule C, along with your Form 1040. You’ll be taxed on all profits for the year, even if you decide to keep money in your business’ bank account to save up for future expenses.
If you’ve never filed taxes as a sole proprietor before, be prepared to pay self-employment taxes. As a self-employed individual, you are solely responsible for your social security and Medicare contributions. The current self-employment tax rate is 15.3% (the majority of this goes toward Social Security and has an income ceiling). Check the IRS website for the most current tax rate and income ceiling, since these numbers can change between tax years.
Ideal Structure for:
The biggest downside with the sole proprietorship is that there is no separation between the business owner and the business. In terms of liability, if the sole proprietorship business is sued, then the owner is sued personally and their personal assets are on the hook.
The LLC (Limited Liability Company) puts some separation between you and your business. If you’re sued or can’t pay business debts, your personal obligations may be protected. What’s nice about the LLC is it offers this liability protection and keeps administrative requirements to a minimum. The LLC has significantly less paperwork and formalities than a corporation.
How it Affects Taxes
By default, an LLC is considered a pass-through entity, similar to a sole proprietorship. The owners (members) must pay taxes on their share of the profits. And that’s true whether or not the money stays in the business. So, let’s say you’re the sole owner of an LLC. The business makes $80,000 in profit for the year, but you want to keep $40,000 in your business bank account to prepare for a big expense next year. With the LLC structure, you have to pay taxes on the entire $80,000 on your personal tax return.
If you’re actively working in the business (for example, you have a graphic design business and you personally do graphic design or account management work), then you will need to pay self-employment taxes on the business’ profit.
An LLC can elect S Corporation tax treatment with the IRS. An S Corporation has pass-through tax treatment like a sole proprietorship/LLC, meaning the business profits will pass along and be reported on your personal tax return.
But, there’s one key difference. With the S Corporation, you have the flexibility to separate the business’ income into two buckets: your salary and distributions. Only your salary is subject to FICA tax for social security and Medicare—the distributions are not. This allows you to take a chunk of money that’s not subject to FICA and self-employment tax. However, be cautious with this strategy. It’s an IRS requirement to pay yourself a reasonable salary for the job (and they will check!) You can’t get away with a $10,000 annual salary and $50,000 in distributions.
Like the LLC, the corporation separates the business owner from the business, helping to protect personal assets from liabilities of the company. The corporation is a separate legal entity: it can sue and be sued, it has its own credit history and rating, and it’s responsible for paying its own taxes. Unlike the LLC, company profits/losses are not passed along to the business owners; the corporation itself pays taxes on its profits.
How it Affects Taxes
In some cases, this tax structure leads to “double taxation.” This means the company is taxed on its profits, and when the owners take those profits out, they will need to report the distribution on their personal tax return. Double taxation is costly for some small business owners accustomed to taking profits out of the business.
However, a corporation can elect S Corporation tax treatment to be treated as a “pass-through” entity. Profits and losses are passed along to the owners (shareholders).
That said, in which cases does it make sense to keep your business structured as a regular corporation (and not elect S Corp status)? Simply if you want to keep some money inside the business. C corporation owners are taxed only on the actual amount they receive as distributions. By working with a tax advisor, you can allocate your business’ profits in a way to take advantage of lower income tax brackets. You won’t be taxed personally if the money remains in the business (and the corporate tax rate may be lower than your individual rate).
Ideal Structure for:
When it comes to choosing a structure, there’s no single correct answer that works for every business. You need to think about your financial situation and future plans to determine the optimal structure for your needs. As we approach the end of the year, this is a good time to get your business structure squared away. Then, you can begin the new tax year fresh with your new entity.
This is an archived post from the FreshBooks Blog and was originally published in November 2016.