How does your business structure affect your business taxes?

“You’ve put a tremendous amount of blood, sweat and tears into starting your small business, so make sure you spend some time really thinking which business structure will be the best fit.BananaStock/Jupiterimages/Thinkstock

There’s nothing simple about starting and owning a business. Choices are everywhere — in business plans, company names, pricing, employees, benefits and office space. But first, in order to register your company with state and federal agencies, you’ll need to choose a business structure, and this choice can have ramifications that are not immediately clear.

A business’s structure is basically the way it’s organized. It answers questions like who’s in charge, how profits will be distributed and whether owners are responsible for debts accrued by the business. The most common IRS-recognized business structures include the following [source: IRS]:

• Sole proprietorships, which have one owner. That owner takes home all of the business’s profits as personal income. The company and the owner are the same legal entity; the owner is personally liable for any business debts.
• Partnerships, which are structured like sole proprietorships except with an unlimited number of owners.
• C corporations, which have an unlimited number of shareholders. Each shareholder owns part of the company. Profits are distributed (as dividends) among all owner-shareholders. C corporations and their owners are separate legal entities; owners are typically not personally liable for business debts.
• S corporations, which are structured like C corporations except that the number of shareholders is capped at 100.

Clearly, choice of structure affects how a business operates. Perhaps less clear, it also affects how much a business and its owners pay in taxes, sometimes dramatically so.

The U.S. tax code is quite detailed, and there are countless tax ramifications of selecting any particular business structure. But there are a few basic tax differences we can rely on to help us decide.

Federal business taxes break down into four main categories:

1. Income taxes, which are taxes on a business’s profit
2. Employment taxes, which are employees’ Medicare and Social Security contributions
3. Self-employment taxes, which are self-employed individuals’ Medicare and Social Security contributions
4. Excise taxes, which are special taxes applied to particular products or services (such as tobacco, alcohol, gambling and some vaccines)]

Excise taxes, for one, are applied regardless of business structure. But for income tax and employment/self-employment taxes, how much businesses and their owners end up paying is directly related to structure.

Business Income Taxes

Most large U.S. companies are structured as corporations, which are separate legal entities from their owners [source: McGraw-Hill Higher Education]. They are also separate tax entities: To the IRS, the corporation is a person to be taxed like any other person. In terms of tax filing, this means a lot of complicated paperwork, and owners often shell out cash to have tax pros deal with it. This can be a significant expense.

Even more significant, in terms of business income tax, it means profits are often taxed twice.

Since the business is a tax entity unto itself, it pays its own income tax on any profits it earns. Then, when those profits are distributed to shareholders as dividends, those shareholders pay income tax on it through their individual tax returns. This double taxation is one of the main tax drawbacks to the corporate business structure.

On the upside, a corporation doesn’t have to distribute every last penny. It’s allowed to keep some of its profits in the company, typically (or ostensibly) to cover post-filing expenses or to put toward future growth [source: Laurence]. This can be a tax advantage: While that undistributed money is still taxed a second time, it’s taxed at the corporate income-tax rate, which is often lower than the owners’ personal rates [source: Laurence].

To avoid double taxation on profits, and to reduce the (potentially expensive) complexities of tax filing, many smaller businesses choose to organize as one of the pass-through tax entities. Sole proprietorships, partnerships and S corporations are all pass-through entities; they and their owners are the same tax entity in the eyes of the IRS, so income tax is only levied once [source: SBA]. All profits "pass through" the business to its owners, who pay income tax on that money when they file their personal tax returns.

Pass-through entities can potentially save a lot when it comes to income tax. It’s single versus double taxation. Easy decision, right?

Not always. Pass-through entities can get slammed when it comes to Medicare and Social Security.

Limited Liability Companies

In a sole proprietorship or partnership, owners are personally responsible for any business liabilities. This drawback can often be resolved, however, by organizing as a limited liability company. LLCs are basically sole proprietorships, partnerships or S corporations that are separate legal entities from their owners [source: SBA]. This is only a state-recognized entity, though; for federal taxes, an LLC has to file as a sole proprietorship, partnership or corporation (C or S) [source: SBA].

Self-employment or Employment Taxes

In the United States, most businesses are pass-through entities [source: Tax Foundation]. And when it comes to income tax, "passing through" the profits is a huge benefit. In the case of the sole proprietorship or partnership, however, it has a significant downside: self-employment taxes.

Social Security and Medicare contributions, collectively known as employment taxes, are calculated based on a person’s income. When you work for a company as an employee, your income is the wages you take home, and you and the company split the cost of your employment taxes [source: IRS]. When you work for yourself, your income is your business’s entire net profit, and no one is splitting anything [sources: IRS, Dratch].

Self-employment taxes can be a huge drain. For this reason, many self-employed small-business owners choose the S corporation structure. In essence, S corporations combine the income-tax benefit of passing through profits with the employment-tax benefit of being employed by someone else.

In corporations, both C and S types, owners also can be employees. The business pays them wages just like any other employees. And as employees, those business owners pay employment taxes only on their wages, not on their companies’ entire profits [source: Piper].

This can mean significant savings. Self-employment tax is 15.3 percent for the 2015 tax year [source: IRS]. If a sole proprietor’s business profits total $75,000 for 2015, he pays 15.3 percent of $75,000, or $11,475, for Social Security and Medicare.

If an S corporation brings in $75,000, and out of that $75,000 the owner pays herself a salary of $40,000, she pays 15.3 percent of $40,000, or $6,120. That’s a savings of $5,355.

Of course, this may not work out to an overall savings of $5,355. Since tax filing is a lot more complex for an S corporation, the owner will be spending more time on tax paperwork, and time is money.

Ultimately, which structure is most beneficial depends on the specifics of the company and the corresponding minutiae of the U.S. tax code. But, in short: If you’re mostly looking for tax simplicity, a sole proprietorship or partnership is a good bet. If you’re mostly looking for tax savings and have fewer than 100 owners, an S corporation might be the right fit.

If you’ve got 1,000 owners, simplicity is probably not in the cards, and the S corporation isn’t an option. C corporation it is.

The Minutiae

Once you move beyond the basics of income and employment taxes, things get a lot more complicated. Figuring out which structure will result in the greatest tax savings means looking at industry-specific tax breaks, legal tricks like income-splitting and gifting profits to family members, the difference between corporate and individual tax rates, number of employees and the available deductions and credits for your business type. It ain’t pretty, but it could be worth it.

Lots More Information

Author’s Note: How does your business structure affect your business taxes?

When I went into business for myself, I chose to structure as an S corporation, and this did save me considerable cash. I was paying self-employment taxes on 20 percent of my profits instead of 100 percent. However, it’s worth noting that after a few years, I learned I wasn’t paying myself enough. Apparently, the IRS isn’t stupid, and the organization expects S corporation owners to pay themselves a reasonable salary. I learned that audits of S corporations were increasing in recent years due to owners paying themselves a pittance and therefore getting away with paying almost nothing into Medicare and Social Security. So now, I pay myself a salary that’s 50 percent of my profits. But hey, it’s still a savings.

Related Articles

• 10 Tax Tips for Small Businesses
• How LLC Taxes Work
• What is a Section 179 deduction?
• How Itemized Deductions Work
• How Tax Credits Work

Sources

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• Entrepreneur. "The Basics of Sole Proprietorship." May 12, 2005. (Nov. 10, 2014) http://www.entrepreneur.com/article/77798
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