How did you feel when you saw your tax bill this year? Delighted by how little you owed or appalled by how much you needed to fork over to Uncle Sam?
Did you know that the legal structure you choose for your business affects how much you pay in taxes?
Some small business owners start to wonder whether their business is properly designated for legal reasons and whether that might help to ease their tax burden.
Let’s look at the most common types of business structures, how each one is taxed on income, and which businesses are required to pay self-employment tax. We’ll also take a look at an owner’s personal liability exposure under each designation.
First, we’ll simplify with a chart, and then we’ll explain each type of business structure in detail.
Types of Business Structures
A business structure, or business entity, refers to how a company is legally organized. The classification you choose will affect how much you pay in taxes, what paperwork you need to file, and how much of your personal assets are at risk.
Choosing the right business structure is one of the most important decisions to make when starting a business. Changing to a different business structure later can be expensive and time-consuming. However, in the long-run, it may be beneficial to make a change if it results in reduced personal liability and tax savings.
1. Sole Proprietorship
A sole proprietorship is the simplest business structure. It’s easy to start, since there’s no paperwork to file or government fees to pay. As the sole owner, you have complete control over your business decisions. You get all the profit, but you also personally risk all the debt, as you have no liability protection. A sole proprietorship is easy to start and easy to end – you can dissolve it at any time with no formal paperwork.
Since a sole proprietorship is not a separate legal entity, business income and expenses are simply reported on a personal income tax return, using Schedule C (Form 1040).
If your net earnings from Schedule C are greater than $400, you will need to pay self-employment tax. Self-employment tax is your contribution to Social Security and Medicare. It is calculated on Schedule SE.
If you’ve ever been an employee of someone else, you’ve shared this cost with your employer. They’ve deducted 7.65% from your wages: 6.2% for Social Security + 1.45% for Medicare. Your employer has paid another 6.2% on your wages for Social Security and 1.45% for Medicare.
Now that you’re generating your own earnings, you’re stuck with it all – 12.4% for Social Security (on the first $147,000 of your 2022 earnings) and 2.9% for Medicare (on the entire amount of your earnings).
However, you get to reduce self-employment earnings by half of the self-employment tax before applying the tax rate. So in effect, you pay 15.3% on only 92.35% of your net earnings from self-employment. Another great thing is that you can deduct 50% of what you pay in self-employment tax on Form 1040, even if you don’t itemize deductions. So good news! You’re not saddled with the entire 15.3%.
A partnership forms when two or more people own and operate a business. Similar to a sole proprietorship, a partnership is relatively easy to start. You would apply to the IRS for an EIN (Employee Identification Number). Some states also require certain forms to be filed, depending on the type of partnership. Some people choose to have an attorney review the partnership agreement, which adds to the start-up expenses.
Like sole proprietorships, partnerships lack liability protection. Therefore, each owner’s personal assets are at stake should the business run into trouble with creditors. On the other hand, business loans are often more easily obtainable, since banks can consider two or more credit histories versus just one.
There are three types of partnerships: general partnership (GP), limited partnership (LP), and limited liability partnership (LLP).
General partnership (GP)
A general partnership is composed of two or more individuals. It is not necessary to register a GP with the federal or state government. Unless otherwise specified in a partnership agreement, each person shares equal rights and responsibilities in managing the company, as well as an equal share of profits and losses. There is no liability protection with a GP, so each partner is financially liable for the decisions of the other partner(s).
Limited partnership (LP)
Limited partnerships are more structured than general partnerships and are registered with the state. One person must be designated as a general partner, who retains control of business decisions, but is also personally liable for the debts and obligations of the business. A limited partner has no personal liability up to the amount of his or her investment in the business, and he or she does not participate in management decisions.
Limited liability partnership (LLP)
In a limited liability partnership, some or all partners may choose to limit their liability. In this case, they are not personally responsible for another partner’s decisions or for the debts and obligations of the business. An LLP must be registered with the state and all the names of all limited partners are disclosed. Many states restrict LLP status to certain types of professional service businesses, such as accountants, lawyers, doctors, architects, etc. Most states also require the partners to carry liability insurance for each partner providing services.
A partnership itself is never taxed at the federal level. However, an annual information return is filed to report income, deductions, gains and losses. Income from the partnership will “pass-through” to each partner who reports their portion on their individual income federal tax returns using Schedule K-1 (Form 1065).
Some states, however, tax LLPs as non-partnerships which may be subject to different tax rules.
Since the partnership itself pays no taxes at the federal level, the partners will need to cover the self-employment tax, just like sole proprietors do, by using Schedule SE.
General partners are responsible for paying self-employment tax on their share of business income from the partnership, whether it’s distributed or not. Limited partners are subject to self-employment tax only on guaranteed payments for services they provided to the partnership. Other distributions from the partnership are not subject to self-employment tax, since they have no management authority and are similar to passive investors.
3. Limited Liability Company (LLC)
A limited liability company (LLC) can be thought of as a hybrid between a partnership and a corporation.
Unlike an LLP which requires at least two owners, an LLC may be formed by only one, or more, owners. LLCs are favored by small businesses who may not qualify for LLP status.
In LLCs, business owners are called members. There is more flexibility in decision-making and how the business is managed, which is detailed in an operating agreement. Members are protected from personal liability for the debts and obligations of the business in excess of their monetary investment.
If the LLC is treated as a sole proprietorship or partnership, the income passes through to owners as income on their personal tax return – which avoids double taxation. An LLC may elect to be taxed as a corporation, or may even be required to under federal tax laws. In this case, members will pay personal taxes on any salary they are paid through W-2 wages. Depending on whether they elect S-corp status or not will determine if profits from the operations of the corporation are held in the corporation or flow through to the personal tax return.
A single member LLC is treated the same as a sole proprietorship by the IRS, so they must pay self-employment taxes on their earnings.
If the LLC is treated as a partnership, the member must pay self-employment taxes on their their entire share of the LLC’s profits, even if they do not take the entire distribution of all profits earned.
Members of LLCs that have elected to be taxed as a corporation do not have to pay self-employment tax on the net income of the corporation. The corporation covers the employer’s share of Social Security and Medicare on their salary amount, and the member’s portion is withheld from their salary.
Still with us?
Let’s move on to the alphabet soup that is corporate entities!
The law regards corporations as entirely separate from its owners. A corporation can be sued, own and sell property, and sell stocks. Therefore, shareholders have the strongest protection against claims on the business.
Forming a corporation is more complex and expensive than other business structures, as there are more regulations, record-keeping, and tax requirements to comply with. It is ideal for businesses further along in their growth.
One advantage of corporations is that they often have an easier time raising large amounts of capital from multiple investors through the sale of stock.
4. C corp
Unless a business designates itself as a B Corp or non-profit (we’ll cover those soon), a corporation is designated as a C corp.
Because it is an entity independent of its owners, a C corp must pay income tax on profits. When dividends are paid to shareholders, those individuals must pay taxes on that amount on their personal tax return. This is called “double taxation.”
Self-employment tax is not applicable for the net income of a C corp. Since a corporation hires employees to complete the work of the business, they cover the employer portion of Medicare and Social Security on the employees’ wages and deduct the employees’ portion from their paychecks.
5. S corp
An S corp is unique in that it is actually a tax classification, not a business entity. For instance, either an LLC or a corporation may choose to be taxed as an S-corp. However, certain requirements must be met to qualify for this status.
S corps are not taxed at the corporate level. Profits, and some losses, pass through to the owners’ personal income, much like partnerships and LLCs, thereby avoiding the double taxation that comes with C corps.
States do not necessarily recognize an S corp the same way the federal government does. Some states simply treat all corporations as C corps, but other states tax an S corp only on profits above a certain limit.
An S corp allows a person to classify some income as salary and some as a distribution. Shareholders MUST be paid a “reasonable salary.” Self-employment tax is paid on the salary portion only. The excess profits may be taken as distributions and are not subject to the self-employment tax. This is the largest appeal and advantage of an S corp, since you can save 15.3% in tax!
6. B corp
Benefit corporations are for-profit, yet are also committed to corporate social responsibility (CSR). CSR encourages companies to look not only at factors that encompass profit, but also people and the planet.
For tax purposes, B corps are treated the same way as C corps, with the company taxed on income and the shareholders taxed on income from dividends or distributions only on their personal returns.
Just like a C-corp, self-employment tax is not applicable for the net income of a B corp.
7. Nonprofit corporation
The purpose of a nonprofit corporation, or 501(c)(3), is to use its funds to benefit the public by charity, education, religious, literary, or scientific work. Because the goal is not to turn a profit, they can receive tax-exempt status.
To receive a tax exemption, nonprofits must file with the IRS. There is another process to receive tax-exempt status from a state. There are also special rules that dictate how a nonprofit uses its funds.
Just like C corps and B corps, self-employment tax is not applicable for a nonprofit’s net income, since they hire employees.
Has this onslaught of information got you feeling like this?
We know it’s a lot of information to sort through and comprehend! The good news is, we’ve helped many businesses through the process of choosing the right classification and we’d be happy to help you, too. Contact us today!