The New Year brings many things: resolutions, fresh starts, goals, and…taxes. Tax liabilities can have a dramatic, or even catastrophic, effect on a business’s bottom line.
Regardless of whether your business is a sole proprietorship, a Limited Liability Company (or LLC), an S Corporation, or a C Corporation, you can always count on having to pay taxes. But when it comes to taxes, not all businesses are created equal.
So let’s dive deep and will see the most popular tax differences. Every business is different, and it is always best to talk to a tax professional about the most beneficial tax treatment for your business.
Sole Proprietorships & LLCs
Pass-ThroughTaxation: For the sole proprietor or partnership (i.e. the business is not formed as an LLC or corporation), business profits and losses are reported on the business owner’s personal tax returns. LLCs, by default, are considered pass-throughentities: business profits and losses pass through to the members (the LLC’s owners) and, like a sole proprietorship or partnership, are reported on the members’ personal tax returns.
In other words, even if the business owner pays himself 30% of the business’s income and leaves the rest in the business, he will still have to report and pay taxes on 100% of the business’s net profits.
Self-EmploymentTax: Think back to when you were younger and received your very first paycheck. You ripped into that paycheck with excitement thinking about all the things you were going to buy with your new-foundfortune, only to see that FICA, Social Security, and Medicare stole a chunk of your paycheck!
LLC members are not considered employees of the LLC, and therefore their paychecks don’t have those same withholdings. Since the government still wants their cut, members have to pay
self-employmenttaxes on their share of the LLC’s profits. The current self-employmenttax rate is 15.3% on the first $118,500, and 2.9% on anything over $118,500. So the LLC member will be subject to that self-employmenttax in addition to the income tax based on his tax bracket.
Double-Taxation: Corporations, by default, are taxed as C Corporations. C Corporations are subject to double-taxation.The corporation pays tax on its profits at the corporate rate, and the owners are taxed on the dividends that they receive. Corporate and dividend tax rates vary, but there is no self-employmenttax imposed on either.
This can be beneficial if the corporation retains most of its profits and only distributes a small portion to the owners.
- Deducting Losses: Since LLC members report the LLC’s losses on their individual tax returns, they are able to deduct those losses to offset their personal income. In contrast, a C Corporation reports profits and losses on its own corporate tax return, and the owners are not able to take those losses as personal deductions.
- Tax Election: The S Corporation is not an actual legal business entity in the same sense that an LLC or a corporation are. LLCs and corporations can elect to be taxed as an S Corporation. (And in case you were wondering, an LLC can also elect to be taxed as a C Corporation.) The S Corporation can be a
saving-graceto the LLC as it gives you the benefits of a pass-throughentity while minimizing tax liabilities.
- Reasonable Salary: With the S Corporation, the business owners must take a reasonable salary. The IRS has not specified what exactly counts as a reasonable salary, but the general consensus amongst tax professionals is that a salary of 50% of the business profit will suffice as reasonable.
The owner will pay
self-employmenttax and ordinary income tax on the salary, but the rest of the business profits will only be taxed at the owner’s ordinary tax rate. Alternatively, S Corporation owners can take their salary as payroll and take employment tax withholdings directly out of their paychecks.
- Deductions: Like the LLC, owners of an S Corporation report profits and losses on their personal tax returns, and can take those losses as deductions against their income. S Corporations are also eligible to deduct certain expenses, such as health insurance premiums, whereas LLC members can only take those expenses as itemized deductions. Additionally, S Corporation owners can reimburse themselves for expenses such as business mileage and home office expenses, and the business can take deductions for those reimbursements.
Making the Right Choice
When it comes to choosing a business and tax structure, there is no single right answer that works for every business. Every business is different, and choosing the best tax structure for your business will depend on your personal financial situation, your business’s financial situation, and your goals for the future of your business.
You can learn more about the differences between LLCs and corporations here. If you still have questions, it is best to seek the advice of a legal or tax expert.