In this blog, we’ll be exploring the best tax structure for small business owners. Whether you’re new to entrepreneurship or have been running a business for years, it’s important to stay up-to-date on tax and state laws. With constant changes, it’s essential to have a clear understanding of the tax implications of your business.
One of the biggest questions faced by business owners is choosing the right entity. To help you make an informed decision, we’ll be discussing sole proprietorships, C Corporations, General Partnerships, LLCs, and S Corporations. We’ll dive deep into the differences between these entities and what’s relevant for your individual situation. With this knowledge, you’ll be able to make confident decisions for your current business and future ventures.
Check out and learn more about the common tax structures below.
1. Sole Proprietorship
Our first focus will be on Sole Proprietorship, which is a crucial understanding for new business owners. Many people start an LLC because they think it’s necessary for tax deductions, but that’s not entirely true. Understanding what a Sole Proprietorship is will help you determine the best way to get started with your business.
For individuals with side hustles, such as Uber, a Sole Proprietorship may be the best entity. It’s simple, with no additional documents or fees, and requires only a schedule C to be filed. With a Sole Proprietorship, there’s no need to worry about keeping up with LLC organization or separate tax returns. A sole proprietorship is a type of business entity where an individual is running the business by themselves. This type of structure is suitable for new business owners, those who are testing the waters with their business, or those who have simple side hustles.
One of the benefits of a sole proprietorship is that it requires low maintenance costs and eliminates the need to hire an attorney or register with the state year after year. To get started, all you need to do is create a business bank account using your Social Security number, and register it with the state if required by your industry or city. However, it’s important to note that there may be specific city and state requirements for registering your business and to keep an eye on taxes like sales tax, and property tax. To ensure you have all your bases covered, it’s advisable to consult with your CPA and legal team. On the flip side, a sole proprietorship may not be the best option if you have a complex business or multiple businesses, or if you want to raise money from investors.
One of the biggest drawbacks of being a sole proprietor is unlimited liability, meaning that if anything goes wrong within your business, you will be held personally responsible. This is one of the reasons why experts often recommend other legal structures such as LLC, C Corp, or S Corporation. Another disadvantage to consider is that if you have a partner in your business, you are no longer considered a sole proprietor, but rather a partnership. This means you’ll have to file a 1065 tax return and comply with particular rules set by the IRS. It’s important to have a partnership agreement in place to avoid any mix-ups.
When thinking about being a sole proprietor, it’s important to consider the potential size of your business and whether you want to brand and scale it. The bigger your business becomes, the more liability you have, and this is when you may want to consider having a legal structure in place to protect yourself.
Finally, when filing as a sole proprietor on Schedule C of your individual tax return, you’ll be subject to self-employment taxes, which means you’ll pay 15.3% of your income in taxes. This can result in paying much higher taxes compared to other business structures.
Sole proprietorship comes with self-employment taxes, but it also offers many tax deductions. You can take advantage of deductions for your home office, vehicles, equipment, and other business expenses. This business structure also allows for more creativity and flexibility in using personal expenses for your business. However, it is important to consider other tax structures before choosing sole proprietorship, such as a general partnership or an LLC.
2. General Partnership
General partnership involves conducting business with another person and sharing profits, but it also exposes both partners to unlimited liability and self-employment taxes. The partnership must file a separate tax return, the 1065 partnership tax return, which has a deadline of March 15th. Additionally, each partner must also file their individual tax return, including information from the partnership’s return, with a deadline of April 15th.
3. Limited Liability Corporation (LLC)
LLCs, or limited liability corporations, are a commonly discussed entity but also come with misconceptions. It is important to understand the details of an LLC before making a decision on the best tax structure for your business.
It’s important to note that an LLC does not necessarily save you taxes like a sole proprietor, S corporation, or a C corporation can. Rather, the LLC is structured for liability protection, as its name suggests.
If you have partners in your business, an LLC may be a suitable option for you. It offers flexibility in terms of the operating agreement and allows you to allocate liability among partners. With the combination of the rules of a partnership and a corporation, an LLC provides creative options in determining profit shares, distributions, and more.
However, it’s important to note that LLCs are still subject to self-employment taxes, as they are considered a flow-through entity that is not an S corporation. This means that if you have active income within an LLC, you will be subject to self-employment taxes. On the other hand, if you are involved in passive activities like real estate investing, an LLC might make more sense for you as a business owner as you will not be subject to self-employment taxes.
It is also important to be aware that even though LLCs are one of the most common business structures many people are unaware of the self-employment taxes they are subjected to when choosing this option. When it comes to taxes and LLCs, it’s essential to know what you’re getting into before making a decision.
4. S Corporation
An S Corp is one of my favorite business entities, and one of the reasons for this is that it allows us to avoid self-employment taxes for all active types of businesses.
It’s important to note that the type of business entity you have will determine whether an S Corp is a good fit for you or not. If you have an active business, transitioning to an S Corp can help you avoid self-employment taxes. However, it’s essential to understand that there are income limits and thresholds to consider. Typically, a net income of $40,000 to $50,000 is required before making the transition to an S Corp.
When starting a business, a sole proprietorship or a regular LLC might be the best option if you don’t expect your net income to be over $40,000 to $50,000. However, once you cross that threshold and have an active business, it might be time to consider making an S Corp election. This election is done through form 2553.
If you are an LLC that is taxed as an S Corp, you will be required to pay yourself a salary. This salary must be reasonable and one of the benefits is that you will no longer be subject to self-employment taxes. Instead of paying 15.3%, you will pay approximately 7.65% on a W-2 received from your corporation, which will be deductible to your business.
An S Corp offers additional benefits, such as strategies for leveraging retirement accounts. However, for the purpose of this discussion, we will focus on the foundation. As an S Corp, you will still have protection from liability, and personal assets will not be at risk unless the corporate veil is pierced. This means that you must operate the business as a separate entity, and intermingling personal and business expenses should be avoided. It’s essential to run your operation like a business, with a separate business account.
In order to maintain the legal structure of a corporation, it’s important to hold board meetings, file yearly corporation documentation, and keep up with any necessary fees. Failing to do so may result in piercing the corporate veil, leaving you exposed to unlimited liability. If someone tries to sue and sees that you’re not operating like a corporation, they can go after your personal assets.
5. C Corporation
The C Corporation is another type of business entity with a unique feature. Unlike other entities, C Corporations have a fixed tax rate, meaning the more money you make, the higher your tax bracket will be. Currently, the corporate tax rate for C Corporations is 21%. However, if you want to take money out of the corporation, you’ll need to take a dividend which is taxable, leading to double taxation.
C Corporations also have the advantage of being able to qualify for a Health Reimbursed Account (HRA). This allows you to deduct many of your health costs from your business expenses. Additionally, C Corporations can also make an election to be taxed as an S Corporation.
In conclusion, there are five different entities you can consider for your business, including Sole Proprietorship, General Partner, S Corporation, LLC, and C Corporation. The more you understand about these entities, the more creative you can be with your tax plan. It’s crucial to understand each one of these options for your business.