Choosing the right business entity allows an entrepreneur to reduce liability exposure, minimize taxes, and ensure that the business can be financed and run efficiently. It also provides business owners with a mechanism for ensuring that the business operations will continue, rather than being automatically terminated, upon the death of an owner. Formalizing the business clarifies the ownership of all participants in the venture.
When selecting the type of entity for a business, it Is important to recognize that there is no single “best” option. The decision involves weighing the advantages and disadvantages of different entity types based on factors that are unique to each business. Over time, as your business grows and evolves, you may find that it Is beneficial to change your entity type or its tax classification to better fit your needs. With that in mind, let’s explore the key entity types available and the tax considerations for each.
A single owner may operate as a sole proprietor, a corporation, or a limited liability company. If there are two or more owners of the business, by definition, it cannot be a sole proprietorship – but it can be a corporation, limited liability company, general partnership, limited partnership, or, in certain situations, a limited liability partnership.
Pass-Through Taxation
Pass-through taxation refers to businesses that generally do not pay federal taxes at the entity level. Instead, the income passes to the owners of the business who pay personal income taxes for their share of the business. Pass-through taxation typically applies to sole proprietorships, partnerships, and S-corporations if no exception applies. This is opposed to either traditional corporations or C-corporations, in which the company itself pays corporate taxes on income the corporation earns and later gets taxed on the owner level whether through sale of stock or dividend distributions.
States often have similar pass-through taxation regulations as the federal government, but some states may require documentation or taxation from the entity-level where the federal government would not. In some circumstances, an entity eligible for pass-through taxation may be able to be taxed as a corporation should the owners choose.
The double taxation is, perhaps, the single greatest disadvantage to operating a business as a C corporation. However, S-Corporations may avoid much of this double taxation.
Self-Employment Tax: LLC vs. S-Corp
Self-employment taxes exist solely to fund the Social Security and Medicare programs. Employees pay similar taxes through employer withholding, and employers must make additional tax contributions on behalf of each employee. The self-employed are required to pay all these taxes themselves. However, a portion of the self-employment tax payments you make are deductible. You can deduct between 50 – 57% of your self-employment tax payments. The precise amount depends on how much self-employment income you earn.
If you create a corporation or a limited liability company, making an S-Corp election with the IRS might present some opportunities to reduce your self-employment tax liability. With an S-Corp, you generally pay yourself a reasonable salary out of earnings. You can distribute any remaining profits to yourself and any other shareholders or partners or leave the money in the business. In certain situations, the money in excess of your salary is subject to income tax but not employment taxes.
For example, if you operate your business as a sole proprietorship and you earn $100,000 for the year, self-employment tax is due on the entire amount. However, under the appropriate circumstances with an S-Corp, the amount that exceeds the reasonable salary you make is NOT subject to self-employment taxes.
Qualified Business Income Deduction
The Tax Cuts and Jobs Act created an important Qualified Business Income Tax Deduction which reduces the income an owner of a pass-through business must report on their personal income taxes up to 20%, if they qualify. The law limits deduction for certain types of service-based businesses and includes limitations based on the owner’s total taxable income, qualified property, and W-2 wages.
Of course, tax benefits aren’t the only factor in selecting a business entity. But it is an important factor to be considered alongside liability of owners and shareholders and the organization’s ability to raise funds. Sometimes, a combination of entity types and having businesses under different companies rolled under an umbrella might be an option. For that reason, it’s important to consult with an attorney and/or your CPA tax advisor before settling on a particular business structure.
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