How Do These 5 Business Structures Affect Your Income?
Updated: Sep 1, 2019
If you are planning to start a new business and you are thinking about what type of business structure to operate under, you are wise to do a little research first. Choosing a business structure depends mainly on two things: Your tolerance for risk to personal assets and how you want the IRS to tax your business’ profits. Choosing the correct business structure could save you thousands!
You don’t have to file anything to register with the state as a sole proprietor.
You simply bring in income, pay out expenses, and file taxes all under your given name. You don’t even need to file a separate tax return – it will just go on Schedule C of your individual tax return at year end.
BUT, just know that you have no legal protection if someone were to sue. That means that if your customer blames you for their loss of a big client because you didn’t get work completed on time, they could take everything you own: both business AND personal: Including your home, your car and even your personal checking account.
Operating as a sole proprietor is a great place to start if you have few assets (business or personal) or are just starting out. But as you grow, you’ll want to move on to one of the following.
LIMITED LIABILITY COMPANY (LLC)
Most individuals register as an LLC soon into their business for one reason:
Operating your business as an LLC means that if that same client sued you, they could only go after your business assets, not your personal assets. There is a fee to register as an LLC with your state, but it’s pretty inexpensive. And if you’re the only one running the show, you can still just run your income and expenses through your individual tax return, so you won’t have to pay for a separate business return.
Starting your business with a partner? Then forming a partnership would be a great starting point. This business structure also protects your liability in the same way that an LLC does, limiting your liability to your business assets. However, you do have to file a separate return when structured as a partnership. The income is still pass-through, though, meaning you will pay the taxes on any profit on your individual tax return, not through the company.
So, if you make $20,000 and you and your partner split the profits evenly, you both will claim $10,000 on your individual returns at the end of the year.
A note on partnerships: make sure you have a sound written agreement in place. Have a written plan for how much profit gets allocated to each of you for taxes, how much you can contribute or receive in distributions; know up front whether the company pays for each partner’s taxes, if someone is getting a salary, and what will happen if someone passes away or decides to leave the business.
If your business has grown to the point that you are ready to pay yourself a nice sized salary, you should consider structuring as an S Corp to get some serious tax savings.
The previous business structures that we have discussed involve paying self-employment taxes on any salary you pay yourself through the business. But with an S-Corp, you only have to pay half.
So, if you paid yourself $100,000, as an LLC, you’d have to pay $15,000 in self-employment taxes. As an S Corp, you’d pay $7,500.
The benefits to a C Corp are that the company operates independently of its owners and can raise money much easier by issuing stocks.
However, it’s got one big drawback: Double taxation.
C Corps are not pass-through entities, so they do pay taxes on anything they earn. If they do pay out money to shareholders (which would be you), they are deemed dividends, and you have to pay taxes on your individual income tax return on those as well.
For this reason, most small businesses (especially new ones) shy away from this structure.
Paying taxes once is plenty!
Starting a new business includes so many tasks: there is the website, the marketing, the branding and the list goes on. Choosing your business structure is one of those tasks that is not nearly as exciting, but the decision you make can have a BIG impact on your business in the future.