Feb 12, 2020

How Your Business Structure Affects Your Taxes

As a new business owner, you’re bound to make money mistakes with your business. Don’t let choosing the wrong business structure be one of them, though, or you could end up paying.

The alphabet soup of business structures can be confusing, but choosing whether to designate your business as a sole proprietorship, an LLC, a C-corp, or an S-corp has significant consequences on your taxes.

It’s important to make sure you understand how each business structure would impact your taxes before making a decision. Read on to learn how operating as a sole proprietor, LLC, or corporation can change the way you pay taxes.

Sole Proprietor

A sole proprietorship is the simplest business structure, and self-employed individuals are automatically considered sole proprietors until they complete the paperwork to start a different legal entity for their businesses. As a sole proprietor, there is no distinction between the business owner and the company itself.

How Your Taxes Are Affected:

Being a sole proprietor means you haven’t created a separate legal entity for your business, so your business income and losses are reported on your personal taxes. You’ll be able to deduct most business expenses from your business’s revenue, but all of the remaining profit will be taxed as a sole proprietor, even if you don’t withdraw that money as personal income. You’re subject to both income tax and self-employment tax.

Pros:

Cons:

This Structure Is Best For:

Being a sole proprietor is easy and free. Because it requires no setup and has no cost, sole proprietorship can be a good option for entrepreneurs who are just getting started, people working full-time and freelancing on the side, or temporarily self-employed people. It doesn’t make sense to go through the trouble and costs of forming a legal structure until you’re certain that you’ll be in business long-term.

LLC

An LLC, or a limited liability company, essentially combines aspects of a sole proprietorship with the limited liability of a corporation. By forming an LLC, you’re forming a legal entity for your business that is separate from you, meaning you’re personally protected from your business’s liabilities to an extent. If your business files for bankruptcy or is sued, you don’t risk losing your personal assets. At the same time, an LLC can be made up of one person who both owns and runs the business and is taxed similarly to a sole proprietorship.

LLCs require paperwork to set up and a low level of administrative maintenance. State filing fees can range from $50 to $500, and you’ll also need to pay a fee every 1 to 2 years to keep your LLC in good standing.

How Your Taxes Are Affected:

An LLC is a business structure but not a tax designation. As an LLC, you must choose how you’re classified for tax purposes, and you can choose to be taxed as a sole proprietor, a partnership, or a corporation (S-corp or C-corp).

A one-member LLC, meaning the owner is the only member of the LLC, is taxed as a sole proprietorship. In this case, the owner files taxes rather than the LLC, and all profits (income minus business expenses) are taxed. Multiple member LLCs, on the other hand, are taxed as a partnership, and each member pays income taxes on their share of the profits.

An LLC with significant retained earnings can also elect to be taxed as a C-corp and thus be taxed at a flat-rate that’s lower than some of the highest income tax tiers. Retained earnings are also not subject to income tax in a C-corp.

Finally, an LLC can elect to be taxed as an S-corp. An S-corp is a pass-through entity, which means that income passes through the corporation and is reported on each shareholder’s personal income taxes. The owners of an S-corp are called shareholders.

Pros:

Cons:

This Structure Is Best For:

An LLC is a great first step for entrepreneurs who are serious about the business they’re building. If self-employment is more than a temporary gig for you, it’s wise to consider forming a legal entity for your business to protect your personal assets. If you’re looking for a relatively simple and inexpensive business structure, an LLC might be your answer.

Corporation

Business owners also have the option to create a C corporation (C-corp) for their business, which is considered a separate legal entity, like an LLC, but is required to pay corporate income tax. Forming a corporation requires additional steps, which include creating corporate bylaws and a board of directors. It’s undoubtedly more complicated than forming an LLC, but this structure does allow for more fundraising options, especially when it comes to attracting investors.

How Your Taxes Are Affected:

The owner of a C-corp pays both corporate and personal taxes, but they’re only personally taxed on the money they withdraw from the corporation as a salary, not on overall profits. This double taxation can make a C-corp unattractive to many business owners, but it can be advantageous for business owners who plan to reinvest all of their profits.

Pros:

Cons:

This Structure Is Best For:

Forming a corporation is ideal for business owners who anticipate a high rate of growth and want to raise lots of capital. The C-corp designation makes your business more attractive for investors because they won’t be taxed on reinvested profits. The flat-rate corporate tax may be preferable for businesses in the highest income brackets, and again, owners are only personally taxed on money they withdraw as income, so a C-corp can be a good option for businesses that plan to reinvest all or most profits.

There are pros and cons to every business structure. It’s worth taking the time to research business structures and consulting your business accountant before making a decision. This choice can greatly impact your bottom line.

About the author

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Elizabeth Aldrich
Elizabeth is a freelance writer covering personal finance, business, and travel. Her writing has appeared in The Motley Fool, Business Insider, Yahoo! Finance, LendingTree, Student Loan Hero, FOX Business, and more.

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