I get it, a blog article about tax structure probably doesn’t sound very exciting. If I’m being fully transparent, it isn’t exciting… but it IS important.
When first starting out, every business owner has to make the decision regarding how their business will be taxed. While each situation is different, there are certain factors that we all must consider when making this decision. The most common tax structures are:
- Sole Proprietorship
The Sole Proprietorship option is quite common for Solopreneurs and other small business operations. When a single individual is the sole owner of the business, whether that be an LLC (Limited Liability Company) or an unincorporated business, the owner may choose to be taxed as a Sole Proprietor.
When a business is taxed as a Sole Proprietorship, the business itself does not file a tax return. The net profit or loss of the business for the calendar year simply flows onto a Schedule C that is attached to the owner’s personal tax return. In my experience, this is a really good option for many business owners when they are first starting out if they don’t know how profitable the business will be or even IF the business will be profitable early on.
Many people choose Sole Proprietorship status for the sake of simplicity, but there is also a drawback. When a business owner chooses to be taxed as a Sole Proprietorship, the individual owner pays self-employment income tax (social security) on 100% of the profits. While this may seem logical, the reality is that there are other options that can help the business owner save on taxes. I will be addressing that within this article.
If the business has multiple owners, whether it be an LLC or unincorporated, it’s common for the owners to choose a Partnership tax structure for the business. Like the Sole Proprietorship, the Partnership does not pay taxes and the net profit or loss of the business still flows to the owner’s personal tax returns.
However, the business is required to file a Partnership tax return and issue K1 Statements to the business owners. The K1 Statement shows the net profit or loss of the business and also reflects the percentage that each owner is responsible for on their individual tax return, based on their percentage of ownership in the company.
Like the Sole Proprietorship, the drawback of the Partnership tax structure is that the owners are paying self-employment tax on 100% of the profits of the business. Depending on their level of profitability, they could potentially save themselves a lot of money in taxes.
When a business owner chooses to incorporate their business, they may choose the subchapter S-Corporation tax status. This tax structure requires the business to file a corporate tax return with the IRS, but the business itself is not taxed. Like the Sole Proprietorship and Partnership options, the net profit or loss of the business flows to the owner’s personal tax return… BUT the S-Corporation provides the business owner with a mechanism to pay less in taxes.
As the operator of the S-Corporation, the business owner must pay themselves a salary. Per the IRS tax code, that salary must be commensurate with the market for operating a business of that size and scale. However, the business owner is able to pay themselves distributions of the remaining profits and the distributions are not subject to self-employment tax.
Example: Let’s say my business makes $200,000 in net profit in a calendar year. If the market calls for me to pay myself a $100,000 salary to operate the business, I am able to pay out the remaining $100,000 in profits as a distribution. This allows me to save roughly 15% in taxes on the $100,000 I paid myself in distributions.
I think most of us can recognize the benefits that come with the S-Corporation option, but it obviously requires the business to reach a certain level of profitability before the tax benefits may be realized.
Many business owners who start out as an LLC, taxed as a Sole Proprietorship, transition to the S-Corporation structure as their income grows. An LLC has the flexibility to opt for S-Corp status without changing the LLC entity structure. They simply submit paperwork to the IRS requesting that they be treated as an S-Corporation for tax purposes.
The final tax structure I will address is the C-Corporation, though I won’t spend too much time on this one. With the C-Corporation tax structure, both the business and the shareholders pay taxes on the income of the business, which is commonly referred to as double taxation.
SO WHY WOULD ANYONE CHOOSE DOUBLE TAXATION?
99% of the time the simple answer for a small business owner is, they wouldn’t. The reality is that the C-Corporation is rarely the right tax structure for a small business. That said, there are some rare instances when it makes sense.
One of the benefits of the C-Corporation tax status is that the business owner can deduct their medical insurance premiums. If standard premiums are high and the business owner doesn’t expect their profits too far exceed what they would need to pay themselves in salary, this option could be right for them.
Additionally, the C-Corporation allows the business owner to hold a significant amount of money in retained earnings. This can be a benefit to business owners who are focused on building cash reserves and/or need to hold onto cash to cover a slow season the business may have or other interruptions in cash flow.
As I stated at the beginning, it isn’t the most exciting content, but hopefully you gained a bit of insight that might be beneficial to you going forward. If you are struggling to determine which tax structure is best for your business and would like some help, I’d love to speak with you. You can reach me at firstname.lastname@example.org.
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