One question business owners frequently ask is which legal structure is right for their business. So which is best for you? Let’s take a quick look.
Sole Proprietorships and Partnerships
There isn’t necessarily anything wrong with operating your business as a sole proprietorship or partnership, but you need to be aware that you will have unlimited liability for business debts. In other words, if your business is sued for any reason, the plaintiff will be able to come after your personal assets, not just business assets.
First, there are no tax advantages (or disadvantages) to forming an LLC. In fact, forming an LLC won’t change a thing for federal income tax purposes. Single-owner LLCs are taxed just like sole proprietorships, and multiple-owner LLCs are taxed just like partnerships.
You should, however, be aware that forming an LLC might subject your business to additional state taxes. Certain states (California for instance) subject LLCs to “franchise taxes” in addition to a typical income tax.
S-Corporations have the ability to provide some tax savings as a result of the fact that profits from an S-Corp are not subject to self-employment tax. However, before you’re allowed to distribute any profits, you are required to pay any owner-employees a “reasonable salary.” This salary will be subject to Social Security and Medicare taxes (which total the same amount as the self-employment tax). As such, the tax savings only take effect once the business has a pretty sizable income.
Also, you should be aware that S-corporations are significantly more complicated from a tax and legal standpoint than LLCs. So if you form an S-corp, know that you’re going to be spending a great many more billable hours with your accountant/attorney.
Unlike most other business structures, C-corporations are taxable entities. This means that the corporation itself is taxed on its income (as opposed to other structures which simply pass the income along to the owner(s), who are then taxed on it).
If you don’t plan to distribute all of the profits from your business, you might benefit from forming a C-corp and utilizing a strategy known as “income splitting.” The idea is to split the business’s income so that part of it is taxable to the corporation and part of it is taxable to the corporation’s owner(s), thus putting them each in a lower tax bracket than they’d be in if either one was earning all of the income.
The big disadvantage to C-corp taxation is that distributions of profits (known as “dividends”) are subject to double taxation. In other words, the corporation is taxed once on its income, and then the shareholders are taxed upon any dividends they receive.
Also, like S-corporations, C-corporations are more complicated from an accounting/tax/legal standpoint than sole proprietorships, partnerships, or LLCs. As such, C-corp owners tend to incur fairly high legal and accounting costs.