Have you chosen the right entity for your business? Did you know that a wrong choice can cost you 15% or more in tax?
Entity choice is one of the most common mistakes I see among small business owners. Often, entrepreneurs don’t even realize they have a choice or that it makes a difference. They just want to start a business and get moving.
If you are a one-person operation, you will be a sole prop by default, according to the IRS.
You are required file a Schedule C with your individual tax return, showing the income and expenses that you incurred during the year. If you have a net loss, it is deductible from any other income that you have. If you have a net profit, it is taxable in several ways.
First, it is subject to self-employment tax, which is roughly 15%. Since you are considered both an employer and an employee, you must pay both the FICA that would normally be deducted from a paycheck you received from an employer and what your employer would pay on your behalf. There is a deduction for a portion of it, and over a certain amount of income the rate reduces, but to keep thing simple lets just use the 15% figure.
The second tax on this income is your federal income tax, which is a progressive rate based on your income bracket. There are a whole bunch of factors that decide what bracket you are in, so I can’t even venture a guess as to what the amount will be, but it ranges from 10% to nearly 40%.
Finally, if you live in a state with an income tax, you will also pay state tax on the income. I live in Maryland, where the combined state and county rate is about 8%. So if you are a married person in Maryland and together your taxable income is $75,000 a year, business income that you add to that will start out being taxed at about 48%. Ugly, isn’t it?
If you are a two or more person operation, you will be a partnership by default.
You are required to file a Form 1065 Partnership return, which is a completely separate return, and claim your portion of the income on your individual return.
In most cases, assuming you are an active participant in the business, your taxes will be just as high as they would be as a sole prop, but now you are at least splitting the income among several people. You also have no liability protection as a basic general partnership, so each partner would personally assume liability should anything go wrong.
Limited Liability Company (LLC)
Here is where things get a little more confusing.
An LLC is a very common choice these days as a business entity, but it is formed at the state level, and is not recognized by the IRS as a type of entity. So if you form an LLC with your state, you have to make an additional choice at the federal level as to how you are going to file taxes.
There is usually a nominal cost to set up an LLC, $150 or so, and it provides liability protection to the owners, should the business run into legal trouble. The “limited liability” basically means that only assets in the name of the business can be considered part of a lawsuit, not the assets of the owner or owners. This is not something people think they will ever have to deal with, but for the small cost, it is worth it to have the protection.
Because an LLC is either a sole prop or partnership by default, you can never “accidentally” become an s-corp, it’s an election that must be actively made and accepted by the IRS.
There are several requirements to become one, but they are fairly minor, and it costs nothing. There are also several benefits not available to the other entity types.
First of all, you can (and are usually required to) give yourself a paycheck, so the FICA taxes are deducted through payroll instead of being due with your tax return. This isn’t an actual tax savings, but it does improve cash flow and reduces the chances of miscalculating what is due at year end.
If you have trouble setting aside money to pay taxes, this entity is for you. You are not able to issue a paycheck to an owner in either a sole prop or a partnership. You do have to file a separate tax return, a form 1120-S, and your portion of the profit of the business is taxed on your personal return.
Although it is probably the most well known entity, a c-corporation is not a common choice for a small business.
Although it does offer significant liability protection, ownership flexibility, and fringe benefits that are not available in any other entity, the costs and complexity are often too much unless you are planning to become very large or to accept investors. There are additional costs to set up the entity and various meeting and filing requirements each year.
C-corp income is subject to “double taxation”, adding up to perhaps the highest amount of tax of any entity. This happens because a c-corp pays tax on its profit when it makes it and cannot deduct payments made in the form of dividends to the shareholders. Then the shareholders pay tax on the dividends they receive, as well as on any capital gain if they decide to sell any stock during the year.
Also, losses cannot be deducted against any other income of the owners like they can in the other entity types. If a c-corp loses money, it can only apply that toward gains made in other years at the entity level, so if it runs into trouble and then has to close, often those losses are never able to be deducted by anyone!
There are several other choices that are available, and keep in mind that this information is generalized and does not cover all the possible tax options. Your unique situation may lend itself to one or another entity for different reasons than what I noted here.
However, these are by far the most used entities by small businesses and one is likely the best option for your company. Now that you know what is available to you, ask your tax adviser what they think might benefit you the most. The consequences of a wrong decision can really cost you and the benefits of a good one can save a lot of money and stress.