The United States is experiencing a surge in entrepreneurship, with approximately 5.5 million new business applications filed in 2023 alone. Many entrepreneurs are taking the exciting leap to turn their brilliant ideas into a reality.
But before starting a business venture, one important decision you should make is choosing the right legal structure. The type of business entity you select can impact your operating costs, asset protection, and taxes.
While there are several factors to consider, this article discusses the tax considerations you should understand when selecting the ideal business structure for your venture.
A Breakdown of Tax Implications for Different Business Entities
Most small businesses choose between two primary options — unincorporated entities like sole proprietorships and partnerships or an incorporated business entity like a limited liability company (LLC) and corporation.
When it comes to taxes, the distinction between these business structures are significant. Below is an analysis of how they can impact your tax situation.
Sole Proprietorship
This is the most straightforward form of business anyone can start as no paperwork is required initially. However, as explained in the GovDocFiling guide, you may need some form of documentation if you intend to operate under a DBA (doing business as) instead of your name.
A sole proprietorship isn’t different from the owner. Hence, it’s categorized as a pass-through entity for tax purposes.
Pass-through entities avoid double taxation, which means you don’t have to pay business taxes separately. Your profits are treated as personal income, allowing you to pay taxes once at your personal income tax rate.
Another tax advantage of forming a sole proprietorship is that you may be eligible for a qualified business income (QBI) deduction. This allows you to claim up to 20% tax deduction.
While pass-through taxation prevents double taxation, it doesn’t exempt you from paying self-employment taxes. These refer to Social Security and Medicare taxes, which amount to a whopping 15.3% tax rate on every dollar of your business profit.
Partnership
A partnership is a business owned by two or more people who agree to share profits, losses, and management responsibilities. While there are two forms of partnership, general and limited, it’s easier for a new business to form a general partnership. It doesn’t involve a lot of paperwork or administrative complexities.
A partnership must file yearly information returns to report its income, deductions, profits, and losses, but it won’t pay income tax. Similar to sole proprietorship, the business profits or losses are passed through to its partners. Each partner reports their allocated share of income or loss on their personal tax return.
Additionally, partners are not considered employees of a business but self-employed individuals. As a result, they’re mandated to pay self-employment tax.
General partners must include their guaranteed payments and distributed share of income or losses as net earnings from self-employment. On the other hand, limited partners only pay self-employment tax on their guaranteed payments.
Limited Liability Company (LLC)
An LLC is the most common business structure in the United States, accounting for 71.7% of partnership tax returns for 2021. Depending on the number of members forming an LLC, the IRS can treat it as a disregarded entity, partnership, or corporation for tax purposes.
When you form an LLC with a minimum of two members, it’s classified as a partnership, but a single-member LLC is considered a disregarded entity. This implies that it’s not taxed separately from its sole owner. As a result, the business’ profits and losses are passed through to the owner.
When it comes to employment tax and certain excise taxes, a single-member LLC is treated as a separate entity. Whether multi-member or single-member, an LLC can file Form 8832 and elect to be treated as a corporation. While this move separates your business and personal income, it introduces double taxation.
Corporation
A C Corporation is the standard corporation structure, and the IRS treats it as a separate business entity from its owners (stakeholders). This means that the business will pay income tax on its income, and its shareholders will pay personal income tax on their dividends, resulting in double tax.
Despite the burden of double taxation, small businesses may opt for C Corp because of the level of protection it offers from personal liability as well as tax advantages. These include claiming tax credits and general business credits, recording or carrying over net operating loss, and maximizing deductions (advertising costs, health plan, legal fees, equipment).
Instead of paying taxes twice, you can opt to be treated as an S Corporation for tax purposes. An S Corp passes corporate income, profits, losses, and deductions to the stakeholders, enabling them to report those items on their personal tax returns. In addition, an S Corp may be eligible for the 20% QBI deduction.
Final Words
We’ve covered the basic tax considerations for each business entity. Sole proprietorships and partnerships pass through business income to owners, preventing double taxation.
LLCs provide a sweet spot between the tax benefits of sole props and corporations. Although the C Corp introduces double taxation, stakeholders can still benefit from various tax saving opportunities. However, stakeholders can convert to S Corp to prevent double taxation.
Author Bio:
Brett Shapiro is a co-owner of GovDocFiling. He had an entrepreneurial spirit since he was young. He started GovDocFiling, a simple resource center that takes care of the mundane, yet critical, formation documentation for any new business entity.
