Small businesses have many factors to consider when selecting their company’s structure, and the different taxes required from each business setup are no small matter. When comparing the tax responsibility of each structure, other factors to consider might include the amount of time you have for administrative duties and/or the amount of separation you would like between your business and your personal income.
Here are the most common business structures so you can get a head start on comparing tax requirements and other factors. Your business will benefit the most from a tax advisor’s guidance in order to determine the best fit for you.
Sole Proprietorship
From an administrative perspective, this is the simplest and most straight-forward structure. But sole proprietorships are not without their difficulties—in fact, in some situations this kind of structure can end up with more taxes than other setups. Here’s why: as a sole proprietor, there’s no separation between personal income and your business revenue, therefore owners must report their business profit and loss on their personal tax returns (using the IRS Form Schedule C). In addition to the normal income tax, sole proprietors will also owe self-employment taxes as well (at a rate of 15.3% for the first $117,000 of income and 2.9% of everything above that amount in 2014). This tax is the equivalent of Social Security and Medicare taxes deducted from employee’s pay (but instead of paying each pay period, the sole proprietor reports annually on Schedule SE).
C Corporation (C Corp)
C Corporations separate the owner from the business, so the business’s taxes will be filed separate from the owner’s taxes. The headache this setup often evokes is due to “double taxation” that occurs when the business’s profits are taxed on the corporate return, and then the profits that the owners take home are taxed again on their personal income tax return. On the other hand, business owners who plan to invest the profits back into the business may find the C-Corp setup advantageous. A tax advisor will help to determine if this structure is right for you.
S Corporation (S Corp)
An S Corporation does not pay tax on profits and avoids double taxation; in this setup the profits go straight to the owners/shareholders and are reported on their individual income tax returns. If the shareholder’s profits are considered a distribution, they do not owe self-employment tax on them. However, remember that if you put in work for your company you will need to pay yourself a corresponding salary. This salary is an expense to the business and you will owe self-employment taxes; the remaining profits leftover after all expenses are paid make up the distributions to shareholders. If you’re considering this option to reduce your self-employment tax, be sure to factor in the additional time and paperwork needed in the administration of an S-Corp.
Limited Liability Company (LLC)
For those who want to separate themselves from their business but don’t want the complicated paperwork of a corporation, an LLC can be a hybrid between the two with added flexibility when it comes to tax time. An LLC can be taxed as a sole proprietorship (the default), or as a C-Corp or S-Corp. This is the most common small business structure.
Before you determine which setup is most advantageous to you, decide what your future plans are and discuss your current situation with your tax advisor, who may bring other factors to consider.
