Before founding a company, your first step would be determining its structure. It lays the foundation for long-term growth and impacts your day-to-day business operations. Since the right business structure also affects your taxes, this blog will explore the tax implications of each one.
Tax Implications and Benefits
Taxes play a huge role in the day-to-day operations of any company. The best legal structure can help you minimize your tax liability.
1. Sole Proprietorship
In a sole proprietorship, the owner is not legally separate from the company and is responsible for all the debts incurred. Sole proprietorships are one of the simplest business structures to set up and maintain, and they often have lower start-up costs.
- Pass-through Taxation: Sole proprietorships are not taxed separately from their owners. Business income and losses are part of the owner’s tax return, which can result in lower overall taxes.
- Deductions: Owners can deduct business expenses such as office supplies, travel, and equipment purchases from their taxable income.
- Self-Employment Tax: Owners must pay self-employment tax on their net earnings, including Social Security and Medicare taxes. However, deductions and other tax benefits can offset this.
- Personal Liability: Owners are personally liable for all business debts and legal issues, which means their assets could be at risk.
- Limited Growth Potential: Reducing taxes by attracting investors may be challenging because of the lack of separation between owner and business.
- Record-Keeping: Owners must keep accurate business income and expense records to report taxes and avoid penalties.
Partnership structure is similar to sole proprietorships, but they have two or more owners. They can be one of the most flexible structures for companies owned by multiple parties as they allow different levels of control.
- Pass-through Taxation: Partners can avoid double taxation since business income is only taxed once at the personal level.
- Flexibility: Partnerships offer flexibility in ownership and management structure, allowing partners to split taxes in various ways based on their business agreement.
- Shared Tax Burden: Each partner is responsible for an equal share of the business’s taxes. With more partners, each will have a potentially lower tax liability.
- Shared Liability: Since partners share equal liability, each one is liable for the actions of the others. Choosing the right partner is crucial to minimize the risk of tax-related legal issues.
- Decision-making: Partners must convene to make essential business decisions together. Therefore, taxation decisions can be challenging if there are disagreements among partners.
- Tax Filing: Partners must accurately report their share of the business’s income, deductions, and credits on Schedule K-1 (Form 1065) to avoid penalization.
3. Limited Liability Company (LLC)
An LLC is a hybrid business structure combining a corporation’s benefits and a partnership or sole proprietorship. An LLC can have one or more owners and offers legal liability and pass-through taxation support for the owner(s).
- Limited Liability Protection: LLC owners receive protection from liabilities as they are not personally liable for business debts and obligations. There are no separate taxes levied for LLCs since they are pass-through entities.
- QBI Deduction: LLC members could take advantage of the Qualified Business Income deduction and save up to 20% of their taxes.
- Membership Units: If an LLC issues membership units to investors in exchange for capital contributions, the owners can reduce their tax liabilities by sharing the LLC’s profits or losses.
- Self-Employment Taxes: LLC members must pay quarterly self-employment taxes on their share of the business’s profits.
- State Franchise Taxes: Some states require LLCs to pay annual franchise taxes or similar fees. You can contact a reputed tax consultant to learn more about your state’s franchise tax.
- Limited Life: The owner(s) might have to dissolve LLCs in states where they have a limited life span. Therefore, you must rework the tax considerations based on the new structure.
4. Corporation (C-Corp and B-Corp)
C-Corps are separate legal entities from their owners (shareholders). Shareholders can buy, sell, and transfer shares of stock. They elect a board of directors to make business decisions and manage day-to-day operations. B-Corps, or benefit corporations, are relatively new business entities prioritizing social and environmental goals over pure profit. You can run the B Corp as a C-Corp or S-Corp for taxation purposes.
- Perpetual Existence: A C-Corp can exist indefinitely even if its owners or shareholders change, which allows for a permanent tax system.
- Qualified Small Business: If a C-Corp qualifies as a Qualified Small Business, shareholders may be able to exclude up to 100% of the gain from the sale of their stock from their taxable income.
- Tax Deductions: A C-Corp may be able to deduct certain expenses, such as employee salaries, benefits, and business-related expenses, from its profits, thereby reducing the total taxable income.
- Double Taxation: C-Corps are subject to double taxation. A shareholder must pay taxes for business profits and their individual income or capital gains.
- Increased Regulations: A C-Corp must adhere to more regulatory requirements, such as holding regular shareholder meetings and filing annual reports with the state.
- Complexity: Setting up a C-Corp can be more complex and expensive than other business structures, requiring specialized tax considerations and liabilities.
5. Corporation (S-Corp)
S-Corps allow shareholders to enjoy all the benefits of the corporation structure but avoid double taxation. To qualify as an S-Corp, the company must meet specific eligibility requirements set by the IRS.
- Pass-through Taxation: S-Corps pass profits and losses to individual shareholders, so the corporation has no separate taxation.
- No Self-Employment Taxes: Unlike C-Corps, shareholders do not have to pay self-employment taxes on dividends.
- Liability Protection: Like a C-Corp, an S-Corp provides limited liability protection for its owners.
- Shareholder Limitation: An S-Corporation will have a limited number of shareholders, who can be individuals, estates, trusts, or tax-exempt organizations.
- Strict Eligibility: S-Corporations must follow strict formalities like holding regular meetings and maintaining accurate records. Failure could result in loss of S-Corp status.
- Complexity: While S-Corporations offer pass-through taxation, shareholders must navigate complex rules to allocate income, losses, and deductions.
A good business structure can help you save money on taxes and limit liability, so consider partnering with an experienced tax consultant like Exact Tax Inc. As California’s leading tax consultants, we’ve helped several individuals and corporations make smart tax decisions. Contact us today to manage your tax obligations!