Switch Your Structure, Transform Your Taxes

December 23, 2020

Are you forming a business? Thinking of switching your structure? There are pros and cons to each option, so understand which will help you meet your goals and pay less tax.

The structure of a business can make a big difference come tax time. How can you best shape your enterprise for optimum tax efficiency? In addition to taxes, there are crucial venture capital and operational considerations to take into account, too.

Let’s dive into the different business structures, how they impact your taxes, and other pros and cons of each one. Here’s what we’ll be covering:

  • Sole proprietorships
  • Partnerships
  • LLCs
  • Cooperatives
  • C Corporations
  • S Corporations

Sole proprietorship

If you run a business on your own, you are likely operating a sole proprietorship. This means that you and your business are one and the same, financially speaking. When you pay taxes each year, all of your business income is reported on your individual tax return. Keep in mind that this means you are responsible for business liabilities since you and the organization are the same entity.

To file taxes, you’ll use Schedule C and Form 1040. You’ll probably have to pay self-employment tax, which comprises the amounts of social security and Medicare taxes typically covered by an employer.

And a final, important note about sole proprietorships: estimated taxes. When you don’t receive a W-2 from an employer, you have to pay estimated taxes quarterly, in addition to the annual return.

Pros:

  • Low tax rate when compared to other business structures
  • Easy and inexpensive to form and run
  • Only file one tax return

Cons:

  • Personal liability
  • Estimated taxes

Partnership

A partnership is created when two or more people share ownership of the business. You can have a general partnership, where everything is divided equally, or a limited partnership or limited liability partnership.

The partnership itself is not a taxable entity. However, it still must file an annual return to report operations information, though it does not pay income tax. Instead, business income is reported as pass-through income to partners, and they are taxed on that income through their individual tax returns.

Pros:

  • Easier to get capital than with a sole proprietorship
  • Share the financial burden
  • A partnership doesn’t pay income taxes

Cons:

  • Partners are personally liable for other partners’ debt

Limited liability company

A limited liability company (LLC) is a common business structure because it’s somewhere between a partnership and a corporation. The business owner could be a single member, or it could have multiple members.

As with a partnership, members report their business income on their personal tax returns, but they may still have to pay self-employment taxes.

Pros:

  • Income is passed through
  • Some liability protection
  • More opportunities to raise capital
  • Income that’s considered surplus is not taxed

Cons:

  • Members may have to pay self-employment tax

Cooperative

Cooperatives, or co-ops, are legal entities that are operated by the people they serve. Members vote on business decisions by owning shares, and they all benefit from the profits. Even though co-ops are operationally similar to corporations, income is still passed through to the members, and they pay taxes on their personal returns.

Pros:

  • Surplus earnings are not taxed
  • May apply for government grants
  • Pass-through tax structure

Cons:

  • Owners may not see as much profit

C corporation

Many people decide to form a corporation to take advantage of the limited liability benefits, meaning that the entity protects the owners from both legal and monetary responsibility.

Unlike the other business structures, corporations have to pay income taxes on profits since they are taxable entities. This fact can lead to double taxation for owners in some instances—the corporation pays taxes on profit and then again when shareholders receive dividends.

Pros:

  • Liability protection
  • Easier to get funding
  • Corporate taxes can be lower than individual taxes

Cons:

  • Double taxation
  • Individuals don’t have as much control

S corporation

S corporations are separate legal entities, but they are treated like a partnership or LLC in that they are not taxable themselves. Income is passed through to owners who report the income on their personal returns.

Pros:

  • No double taxation
  • Liability protection
  • Owners are separate from the company

Cons:

  • Cannot have more than 100 shareholders
  • Not as attractive to investors as C corporations

Find the right fit with the help from a tax professional

There are numerous options when forming a business. You have to consider how you’ll generate capital and whether it’s essential if a structure will attract investors. And each possibility is treated differently when tax season rolls around, so it’s important to weigh the pros and cons.

If you’re unsure what’s right for you, work with the team at Provident CPA and Business Advisors. We’ll provide guidance on structuring a business in the most tax-efficient manner possible.

Contact our team of professionals to get started.

Posted in Taxes