How to Choose the Right Business Structure

If you’re thinking about starting your own business, there are a few things to consider.

You’ll want to understand the different business structures available, the existing tax classifications, and which one is right for your business. You’ll also have to decide your business’s tax classification when you apply for an EIN.

Continue reading to learn more about choosing the right business structure.

Businesses and Taxes

All businesses are expected to pay taxes. Depending on your business and its location, you will be responsible for different forms of taxes (ie. sales tax, user tax, etc.), but there are two important ones that apply to every business that we will focus on:

1. Employment tax
2. Income tax

What Are the Different Business Structures and Their Tax Benefits?

The different business structures include sole proprietorships, Single-Member LLCs (SMLLCs), Multi-Member LLCs (MMLLCs), partnerships, and corporations.

Most people choose to organize their businesses as sole proprietorships, Single-Member LLCs, Multi-Member LLCs, or partnerships. These company structures all have pass-through taxation, meaning that the company doesn’t pay taxes, but the individual owners do from the company profits, either quarterly or at fiscal year-end on their personal tax return.

Single-Member LLCs and Sole Proprietorships

For tax purposes, Single-Member LLCs and sole proprietorships are viewed as “disregarded entities,” meaning that the owner and the company are viewed by the Internal Revenue Service (IRS) as one single entity.

Keep in mind that the separation of an LLC and its owner still exists for liability purposes; however, for tax matters, the owner pays all taxes on the company profits (earned company income minus expenses) on his or her personal tax return — just as in a sole proprietorship.

Essentially, after the company expenses are paid, the owner is responsible for paying both income tax and employment tax on profits

If you’re interested in reinvesting your money into the business within the same tax year, you’re better off staying with a standard LLC structure or a sole proprietorship; this is because the money you’ll use for purchases toward your business will then be considered an expense. Essentially, you’re converting profits into expenses, and profits are taxed, but expenses are deductions (not taxed).

Let’s recap disregarded entities:

• The IRS considers the company and its owner to be one single entity for tax filing purposes
• Single-Member LLCs pay taxes on total company profits (after expenses) on their personal tax return
• Sole proprietorships pay taxes on total company profits (after expenses) on their personal tax return
• Employment tax and income tax are both paid on the business’s profits by the owner (or member) when taxes are filed.

Multi-Member LLCs and Partnerships

Multi-Member LLCs and partnerships are taxed the same, meaning that their profits (and losses) are split between the owners based on the percentage of ownership they each have in the company. Once profits or losses are split, they file taxes for these on their personal tax return.

*Note: Multi-Member LLCs and partnerships are not disregarded entities, but have pass-through taxation, meaning that profits get split into distributions for each member rather than the company paying taxes itself.

S Corporation vs. C Corporation

Whether you have an LLC (SMLLC or MMLLC) or a corporation, you can select to be taxed as an S corporation (S corp) or a C corporation (C-Corp). This is because both S-Corp and C-Corp should be viewed as tax classifications and not actual business structures. You can choose to have either your LLC or corporation taxed as a C-Corp or an S-Corp depending on what you plan to do with your business’s profits.

S Corporation

Here are the key points when electing S-Corp status:

1. You will be saving money on employment taxes
2. The owners/members are considered employees of the company and are paid a “reasonable salary” (ie. $50,000 salary each)
3. A reasonable salary can be found on glassdoor.com based on your title and industry.
4. You already have payroll expenses and are paying around $1,000 to $1,500 on those, and are already expected to deal with the extra paperwork involved.
5. You are not reinvesting the money into the business and are instead taking the rest of the money out of the business within the same tax year.

How will I save money on my LLC or corporation with an S Corporation status?

If you choose to function as an S-Corp, the owners or members are expected to work for the company itself as employees. As a regular employee would receive a reasonable salary, so do the owners/members in an S-Corp.

Once the owners’ salaries are established, they will be responsible for paying both taxes on their personal tax return:

1. Employment tax (since the owners or members are considered employees)
2. Income tax

The difference is that you will not owe employment taxes on the leftover money (profits) after the salary and operating expenses are subtracted. The remaining profits are then taxed, but only as:

1. Income tax

Essentially, you are saving money on employment tax, since the profits after salary and other expenses accounted for are only taxed once as income tax. The employment tax doesn’t apply on the remaining amount, since these profits are not considered part of the salary.

Example: Company makes $70,000, but expenses are $2,000. After expenses including a $50,000 reasonable salary, the profits are ($70,000-$50,000-$2,000) = $18,000. The $18,000 profits only pay income tax. The salary of $50,000 pays both employment and income taxes.

When is it worth it to become an S-Corp?

• If you already have employees and are paying expenses including payroll
• If you make at least $10,000 in profits (after salary, payroll, and other expenses)

You want to ensure that becoming an S-Corp is not costing you more in the end. If you don’t have employees and don’t want to deal with the extra paperwork and expenses that payroll imposes on a company, an S-Corp may not be the right choice for you.

As an S-Corp, the IRS will keep a close eye on your business to ensure that you’re paying yourself a reasonable salary; if you don’t comply, it could result in paying back taxes, hefty fines, and the loss of your company’s S-Corp status.

Additional requirements for an S Corporation

There are other expectations imposed on any company with S-Corp status. In addition to ensuring its owners or members are on the employee payroll, an S-Corp must meet the following criteria:

• May have up to 100 shareholders, but no more
• Shareholders cannot be a private corporation or partnership
• Shareholders cannot be foreign, nonresident alien
• May offer only one type of stock
• All owners have to agree on S-Corp status

What Is a C Corporation?

C-Corp status is different from the other business structures in that it is not considered a disregarded entity and it does not have pass-through taxation. Depending on the current tax law, the business itself is taxed at a flat rate on its earned income after company expenses have been taken out. The current corporate tax rate on these company profits is 21%.

Once the corporation is taxed at the current tax rate, each individual is taxed on their earned dividends — both employment and income tax will have to be paid.

When does it make sense to have a C-Corp?

If you’re interested in reinvesting profits into the company over the course of more than one year, then a C-Corp is the right choice for you.

Let’s recap C-Corp:

• Company only pays a 21% flat tax on business earnings
• Shareholders, members, and employees pay both taxes on dividends/wages:
  • Income tax
  • Employment tax
• The fact that the company is taxed twice at the corporate and shareholder level is why C-Corps are best known for double taxation.

Final Recap:

• Standard SMLLCs, MMLLCs, sole proprietorships, and partnerships
  • Pass-through taxation - profits go directly to owners or members
  • Owners pay employment tax and income tax on all profits known as distributions
  • Good for those interested in reinvesting profits into the business within the same tax year
• S-Corp status (LLCs or corporations)
  • Pass-through taxation - profits go directly to owners or members
  • Pay employment and income tax on owners’ salaries
  • Pay only income tax on the profits after salary and other expenses are taken out; hence why they save money on employment taxes
  • Pay the least in taxes when compared to other business types
• C-Corp status (LLCs or corporations)
  • Corporation itself is taxed at current corporate flat rate
  • Employment and income tax are paid on all dividends; hence double taxation