When you’re launching your small business there are a lot of factors to consider. One of which is very important, but often neglected is the question of what corporate entity you’ll choose for your enterprise. This choice can have major tax implications — choosing the right structure for your needs can save you anywhere between 10% and 40% on the levies that you have to pay every year, according to Forbes.
Important as it is to not overpay on taxes, this is not the only concern when setting up a business. Even though one entity may be more costly than another, it could still be the right option for your situation. For instance, what do you want your personal liability to be if debt is incurred? Corporations shield you from such liability, but (depending on the type) they will be subject to other limitations. There’s a lot to take into consideration.
The real takeaway here is that you need to think very carefully before you make any decisions. The expense of consulting attorneys and accountants could be money well spent, and there are also experts available via the Small Business Administration (SBA), the Service Corps of Retired Executives (SCORE) and other low-cost or no-cost options. To get you started take a look at the guidelines below.
Tax Implications of Common Business Entities
The most common types of corporate entities are sole proprietorships, partnerships, corporations and LLCs (Limited Liability Company). Each has very specific tax regulations that make them better — or worse — suited for different ventures.
Sole proprietorships typically involve a single individual owning and operating the enterprise. Business income and expenditures are included on your Form 1040, which is your personal income tax return. You need to pay self-employment tax every year, along with quarterly estimated levies on your income.
Federal law allows you to make four equal estimated tax payments through the fiscal year, on the 15th of April, June, September and January. Your business earnings are taxed only once, unlike other structures, and you have complete control over all business decisions. The biggest drawbacks to sole proprietorships are that you are personally liable and raising funds can be challenging.
If you plan to work completely independently without bringing on any additional staff, this is a good option.
Where two or more people own and operate an enterprise, a partnership structure is a good option. The big tax advantage here is that the partnership itself doesn’t pay any income tax; all profits and losses are passed on to each partner. Everyone files a Schedule K-1 form to indicate their partnership income, tax credits and deductions.
You’ll also be required to report your business profits on your personal tax return. All told, it can add up to a lot of costly administration and paperwork, and personal liability is a concern in much the same way as it is in sole proprietorships. In fact, partnerships are riskier in some ways because all partners can act and make decisions on behalf of the partnerships, and then every partner is liable.
Corporations are the most expensive and complex business structure options, forming an individual legal identity that is separate from its owners. As such, it has more regulations and requirements imposed on it. For small business owners the biggest advantage to a corporation is the protection from liability; you’re not considered responsible for your corporation’s debt.
In addition to protecting your personal assets, organizing your business as a corporation allows you to retain some profits without paying tax. You can also sell stock to generate money, which can be a very effective fundraising tool. However, you’ll have to pay double tax on other earnings since corporations are taxed at state and federal levels and your dividends will also be taxed at individual rates.
You can avoid this double taxation by paying the money to you and other corporate shareholders as salaries, since earnings paid as reasonable compensation are not taxed. Just keep in mind that the Internal Revenue Service (IRS) has limits on what can be considered reasonable compensation, so this may not be a viable option if many corporate shareholders are involved.
There are two types of corporations named for the IRS subchapter codes that govern their federal taxation, the standard C corporation and the S corporation. Small business owners often choose the S corp, because it still provides liability protection but has some attractive tax benefits. For instance, there’s just one level of federal tax.
However, S corporations are subject to several of the same requirements as C corporations, which can add up to more administration, legal fees and tax service costs. They can also issue common stock only, thus limiting fundraising resources. With drawbacks and advantages to both corporations and partnerships, they were combined to produce the hybrid Limited Liability Company (LLC).
Limited Liability Companies
The intention of LLCs is to elevate the pros and mitigate the cons of partnerships and corporations. From a tax point of view, they’re usually your best option. With LLCs you’ll enjoy the same liability protection as with corporations, but without the double taxation since earnings and losses are passed through to the owners to be included on their personal tax returns.
This is similar to the situation with S corporations but offers even more freedom; there is no limit, for instance, on the number of LLC shareholders whereas S corporations have a ceiling of 75. Taxation on LLCs is complicated and varies across states, so you’ll need expert advice if you want to run your business in multiple states.
Review Your Business Structure Regularly
Ultimately, only you can decide what corporate entity you want to own. Your business will probably grow and change as sales improve, you gain traction in the marketplace, or pivot in new ways, As this happens, you’ll need to review the structure on a regular basis and make sure that it is still serving your needs. Specifically, how much time and money are you spending on administration, what is your risk vs your personal liability and how much are you paying in tax?
You also need to consider if all owners’ financial goals are on track and whether any changes to policy makers and power structures should be made; are those making the decisions for your enterprise the right people? It’s critical you consider how your business will be taxed when choosing a business entity. If there are two entity types that may be good fits, run some numbers to determine if you may end up overpaying in taxes.
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