Does the chosen business structure impact taxes?
Determining which entity is the best for your business will require careful consideration. In addition to a review of liability protections and the ease of operation, it is also important to consider potential tax obligations.
What type of taxes should business owners prepare to pay?
Under the eyes of the Internal Revenue Service (IRS) the most common business structures are sole proprietorships, partnerships and corporations. State statutes recognize limited liability companies (LLC), not federal. Federal tax treatment of an LLC depends on how it operates. The IRS could tax the LLC as a sole proprietorship or corporation.
In most cases, federal tax obligations for any one of these business entities breaks down into four main categories: income, employment, self-employment and excise. The IRS generally takes income taxes from the business’ profits. If self-employed, self-employment taxes cover the individual’s Medicare and Social Security contributions. If not, employment taxes cover the employee’s Medicare and Social Security contributions. Excise taxes are not applicable to all business practices but apply if the business operates using certain products or services. Common examples include the sale of alcohol or tobacco. In most cases, the chosen business structure does not impact excise taxes — the tax generally applies the same whether it is a sole proprietorship or corporation. However, the chosen business structure will impact income and employment or self-employment tax obligations.
It is also important to note that additional state tax obligations may also be present.
How does the chosen structure impact the business’ tax bill?
When it comes to federal income tax obligations, sole proprietorships, partnerships and certain corporations (S corp) use a pass-through tax scheme. This means the IRS views the owners and the business entity as one taxable entity. As a result, the income of the business is passed to the owner and the owner pays the tax bill. In contrast, when it comes to most other corporate structures, the IRS considers the corporation itself a taxable entity. As such, the business pays a tax bill. The business then distributes the profits and the individuals who receive payment from the business also pay an additional income tax bill. Tax experts call this double taxation.
The same does not hold true for self-employment or employment taxes. This tax bill is generally calculated using the individual’s income. Those who work as an employee owe a percentage of the wages as employment taxes — often taken out by the employer. Those who work for themselves pay a percentage of the business’ net profit. This means that if the business makes a lot of money, it can be advantage to incorporate as a corporation.
Which business entity is best for my business?
The answer will depend on the details of your business plan. An attorney experienced in incorporation can review your plan and discuss the pros and cons that come with each option.