Many small business owners start with a sole proprietorship to avoid the costs of forming a corporation or LLC. This is a wise decision as statistics show that most small businesses lose money for the first several years.
What about when the business starts to make a profit? There are several decisions that can be made about the type of legal entity one can form, and the tax ramifications differ as well. A general rule of thumb is to determine which entity will save the most money in taxes.
Suppose you are self-employed and your business makes a $20,000 profit for the year. The tax rate for this type of business is 15.3% in addition to the regular income tax calculated on the tax return. Once the profit is determined for the year, there are no further deductions that can be taken to reduce the tax due. Using the scenario listed above, 15.3% of $20,000 is $3,060. That amount can only be reduced if estimated tax payments are made. Let’s say we have a single taxpayer with no children, no mortgage interest and other itemized deductions. So far the tax due is $3,060.
Now we calculate if there is any income tax due. Assuming for the moment that no other income exists, we calculate taxable income by taking the profit from the business ($20,000) and subtract the standard deduction (which is $5,950 for 2012) less the exemption deduction (which is $3,800 for 2012). The taxable income would then be $20,000 – $5,950 – $3,800 which equals $10,250. Based on tax law the additional income tax due for this person would be $1,099. So, the total tax bill for this taxpayer would be $1,099 + $3,060 for a total of $4,159.
Making estimated tax payments while a wise decision, can also take money from your pocket and give it to the government unnecessarily. Suppose you were to take that $3,060 and divide it equally amongst the 4 estimated payments required to be made annually. That comes to $765 each quarter. We are not considering State estimated taxes as the rates vary widely. Many accountants and tax preparers would have you make estimated tax payments this year based on your profit and tax bill from last year. As was already stated, that is a good idea which has a downside. Suppose you have a year that is not nearly as profitable as last year and by the end of September you have actually lost money. If you have paid the three payments of $765 each in April, June and September, you have given the government a loan of $2,295. However, your business has run a loss for the year, so you won’t have a tax bill which means that the $2,295 is an overpayment. You can get that money refunded during tax season, but meanwhile that’s money you don’t have to take care of expenses. My preference is to review the profit or loss of each client business quarterly and then determine if any estimated tax payment is due.
Getting back to the decision of which legal entity to choose, let’s take each one separately. The most common form of legal entity is the corporation. There are two basic forms, C Corp and S Corp. A C Corp pays tax based on its profit for the year and then any dividends paid to shareholders is also taxed. Hence the term double-taxation. An S Corp however works differently. The S Corp pays no tax on profits. The profit flows through to the shareholders who then pay tax on that money. The big difference here is that the 15.3% self-employment tax does not apply. So, by forming an S Corporation, your business saves $3,060 for the year on a profit of $20,000. The income tax still applies, but I am sure someone would rather pay $1,099 than $4,159. That is a huge savings.
Another angle to consider: suppose your business takes a loss for the year. As a C Corp there is no tax on the loss, however there is also no flow-through to the shareholders as with an S Corp. The loss will not help your personal tax return at all. A loss from an S Corp will reduce taxable income, provided there is other taxable income to reduce. If not, then there is no income tax due.
The next popular business entity is the LLC. There are many advantages to the LLC. Keep in mind; if you are a single member LLC, then your business will be taxed as a sole proprietorship, meaning that 15.3% self-employment tax comes back into play. Unless you like paying higher taxes, a single member LLC is not the way to go. A husband and wife LLC is considered in community property states to be a single member LLC and is taxed the same as a regular single member LLC.
If the LLC is owned by a corporation or partnership, it is also considered to be a single member LLC. The income and expenses are added to the income and expenses of the Corporation or partnership and taxed accordingly.
Multiple member LLCs are taxed as a partnership. The profit or loss is distributed to each member according to the LLC agreement. This distribution is taxed the same as a sole-proprietorship, so here comes the 15.3% tax again. LLCs are great due to limited liability for each member, however for tax purposes, the tax benefits are not the same as for an S Corp.
The other legal entity is the partnership. This is an entity made up of two or more partners who start a business and bring a certain amount of money or other asset to the partnership. Each partner is entitled to a distribution from the partnership based on their percentage of ownership. Again, the income tax rate is 15.3% on partnership distribution plus the income tax calculated on the tax return.
Which entity is right for you? Only you can decide. You should consider all avenues before making a decision. If you wanted limited liability, the then LLC would be right. If you want to pay the least amount of taxes, the Sub S Corporation is the best. Requirements for recordkeeping for a corporation are more involved than an LLC, but they are not so overwhelming as to be a burden.
Costs involved in forming a legal entity as stated in this article varies by state. Each state has its own filing fee. You do not need an attorney to create an LLC or Corporation. You can find a variety of web sites that offer the service and their fees for handling the filing for you can also vary.
My personal choice I believe has been given herein. An S Corporation pays the least amount of taxes. In addition, forming an S Corp in Nevada avoids any state income tax as it does not exist. If you want more information, feel free to contact me via my website.