Choosing the Right Business Entity for the Best Tax Advantage
Key Highlights
- Sole proprietors must make estimated tax payments to avoid penalties
- LLCs offer liability protection and require formal registration
- S-Corporations are pass-through entities with restrictions on shareholders
- C-Corporations are separate taxable entities, facing double taxation but providing unlimited shareholders and multiple stock classes
A business’s entity structure plays an important role in how it is taxed. Understanding the differences and tax implications of the different strategies will facilitate a business’s tax planning and thus its ability to minimize its tax liability. It is important to note that as a business navigates through different stages, certain business structures will be more beneficial at different times, which may require an entity change as the business grows and evolves.
Seeking the advice of a financial professional can help business owners to better understand the tax implications of each type of entity structure as their business progresses through different stages of growth.
Let’s explore a few of the entity structures and the tax implications of each.
Sole Proprietor
As a Sole Proprietor, the business and the owner are legally the same. The owner will be personally responsible for any obligations arising as a result of the business operations. The business income taxes are filed as part of the owner’s individual income tax returns (form 1040) on a Schedule C. The owner can take distributions but he or she is not on the payroll.
The owner should understand that profits from business operations are classified as pre-tax income, which means income taxes will be calculated and are due when taxes are filed. In some cases, estimated taxes will be required throughout the year. Failure to make the required estimated income tax payments can result in ‘"failure-to-pay" penalties.
Estimated IRS income tax payments are required on the following dates:
• April 15 for income from January 1 to March 31
• June 15 for income earned from April 1 to May 31
• September 15 for income earned from June 1 to August 31
• January 14 for income earned from September 1 to December 31
Consult your tax professional as to whether you are required to make estimated tax payments.
LLCs
A Single Member Limited Liability Corporation (LLC) has one owner. The entity must be registered with the Department of State and requires a formal operating agreement. This structure offers liability protection to the owner. The income taxes are filed on Schedule C as part of the owner’s personal income tax returns (Form 1040). Estimated income tax payments may be due based on the owner’s previous year’s tax liability and are due on the dates referenced above.
When two or more members exist in an LLC, the IRS treats the LLC as a partnership. Just as in a Single-Member LLC, in a Partnership the members’ personal assets are protected from legal action. A Partnership is required to file a Form 1065 each year and prepare a Form K-1 to report each member’s share of the year’s profit or losses.
Partnerships should have an operating agreement that outlines the ownership percentages and the division of profits and losses among other provisions.
S-Corporations
An S-Corporation, like an LLC and partnership, is considered a pass-through entity. This means the entities do not pay federal income tax; instead the income, deductions, profits and losses are passed onto the owner and partners and reported on their personal income tax return. In an S-Corporation the profits and losses are reported on a Schedule K-1 to the shareholders who would then report the information on their personal income tax return(s).
An S-Corporation must first be formed as a C-Corporation or LLC and then IRS form 2553 must be submitted to elect the S-Corporation status. Some of the features of an S Corporation include the following restrictions:
• Must not have more than 100 shareholders
• Shareholders must be US citizens
• Can issue only one class of stock
• Cannot be owned by corporations or partnerships
Unlike the owner and partners in an LLC and Partnership, respectively, the owner-employees of an S-Corporation must be paid a responsible salary. One of the major benefits of an S-Corporation is that the profits can be taken as distributions which are not subject to self-employment tax. Another major benefit is the avoidance of double taxation which occurs in a traditional C-Corporation.
Depending on the shareholders’ personal tax situation(s), they may be required to make estimated tax payments. Shareholders should contact their tax preparer for more specific guidance.
A C-Corporation is its own entity. Shareholders are not personally responsible for the debt and other obligations of the company. The shareholders’ liability is limited to the amount invested in the corporation.
C-Corporations pay their own taxes. The IRS form required to file the annual income tax return is Form 1120. One of the biggest criticisms of C-Corporations is double taxation. This is due to the income taxes paid by the corporation on profits and the income taxes paid by shareholders on dividends they receive from the corporation.
Other features of the C-Corporation include unlimited shareholders, multiple classes of stock, and perpetual existence.
Consult Your Tax Professional
The tax implications of each corporate entity are extensive and expand way beyond the scope of this article. Use the information provided to start the conversation with your business partners and tax advisors as to what will prove to be the most beneficial entity structure for your contracting business.