Although there are numerous decisions that small business owners must make on a daily basis, from when to hire new employees, how much inventory to stock up on or whether to obtain a working capital loan, one of the choices that might be overlooked involves which business structure to utilize. There are several types of corporate structures, and each one has its own pros and cons when it’s time to pay taxes. It’s important that as a business owner, you understand which structures give you the best opportunity to reduce your tax burden.
Creating or changing a business structure involves filing the appropriate paperwork with the Secretary of State’s office in the state where your company is located. While it is important to always speak with an expert before deciding on whether to alter your company’s business structure, it never hurts to do some initial research before hand.
This is the most basic business type, and it is the default formation if you never actually file for a formal structure. If you have a sole proprietorship, there’s no legal separation between your company and your person, which means you report all business income on an IRS Form Schedule C for your personal tax returns. Business owners who have a sole proprietorship must also pay self-employment tax on the company’s profits, akin to Medicare or Social Security taxes typically taken out of most employees’ earnings.
While this is the simplest and easiest structure in terms of legalities and filings, you will still have a responsibility to ensure your business and personal expenses are separated, and all the appropriate taxes are paid for self employment. Sometimes this can lead to a larger tax burden for the owner.
If you decide to incorporate the business, there are two options, a C Corp and an S Corp. The Corp creates a separate legal enterprise for the business. However, now that the business and you personally are distinct entities, you will be required to file a personal and a business tax return. This can lead to a double taxation scenario, wherein you first pay taxes on the company’s profits and then also pay taxes if you decide to take profits as your personal income. While this can increase the tax burden, you are also able to invest the profits back into the business to avoid the double taxation.
Much like the C Corp, an S Corp is also a separate legal entity. However, unlike the C Corp, this structure is not taxed on its profits, since these are passed through to the owner and other shareholders, who then report the earnings on their personal income taxes. Since the IRS considers this a distribution, you do not have to pay any self-employment taxes on these earnings. While this structure eliminates the double taxation associated with a C Corp, there is considerable paperwork, legal filings and other administrative responsibilities associated with the S Corp structure. Further, there are also restrictions that apply to forming an S Corp, such as the fact that shareholders must be legal residents of the U.S.
Limited Liability Corporation
An LLC is taxed similar to a sole proprietorship, but offers the personal liability protection associated with a corporation. Under this structure, your company does not pay taxes on any profits, however you will need to report any profits on your personal tax return. The structure of the LLC does allow you to choose if you want to be taxed a sole proprietor, a C Corp or an S Corp, which makes it uniquely flexible for tax purposes.
Regardless of which business structure you choose to use, it’s always best to speak with a tax expert before making this major decision. Changing the structure will also not retroactively alleviate a previous tax burden either. If you do not have sufficient capital to pay off back taxes, you should consider obtaining a small business loan from an alternative lender. Since there’s not a lot of paperwork or a cumbersome application process, these loans are quick and easy to obtain.