One of the first steps to optimizing your tax, is to choose the best tax structure for your business. Although I’d like to say there’s a ‘one-size-fits-all solution’, it really comes down to sizing up your business’ unique profile, then pairing it with a proper fit.
Before we size up your business, however, let’s be sure to distinguish between “legal structures” and “tax structures”.
Legal structure vs. Tax structure
It’s not unusual to get confused or even mis-informed as you browse the web for information (especially tax law). One of the common errors we see online surrounds whether you should be an LLC or an S-corporation. The truth is, you can be both, because they aren’t mutually exclusive. The reason is, that they describe two different traits of your business: the first its legal structure and the second its tax structure.
- Legal structures are defined by the state(s) you do business in, and typically include options such as Corporation, Professional Corporation, General Partnership, Limited Partnership, Limited Liability Company, Sole Proprietorship, and a host of others (depending on the particular offerings of your state). Your legal structure determines your status in the eyes of the law for purposes of lawsuits, state registrations, ownership rights, and the like.
- Tax structures are defined by the IRS separate from what the state calls you, and there are only four options for businesses: C-corporation, S-corporation, Partnership, or Sole Proprietorship. Your tax structure determines how your business’ tax is calculated, and the tax compliance requirements you’re subject to. Practically speaking, tax calculations on the whole are the same between structures (e.g., office supplies are always going to be deductible regardless), but there are certain critical differences that can make a big impact.
So to revisit our LLC example, a single-member LLC (legal structure) is classified as Sole Proprietorship for tax purposes (tax structure), but can elect to be treated as an S-corporation or C-corporation instead. And a multi-member LLC (legal structure) is classified as a Partnership for tax purposes (tax structure), but can also elect to be treated as an S-corporation or a C-corporation instead. As you can see, a LLC can actually be any one of the four different tax structures, depending on the situation.
Sizing up Your Business
Now that we’ve untangled legal structures from tax structures, we can start sizing up your business to see which one fits you:
- What level of record keeping are you prepared for? Sole Proprietorships are the easiest and most forgiving since you aren’t required to have a separate bank account, or even a full set of double-entry books (we’d recommend keeping books though). It does mean that if personal expenses are paid through the business account (or vice versa), it can be easily sorted out at tax time, the details get summarized on your personal tax return, and you’re on your way. C-corporations, S-corporations, and Partnerships each file their own separate tax return, however, and proper balancing books and clean bank accounts are needed. This is so much easier when you automate your finances, but be aware that the dividing line between you and the business is more defined, so you can’t just easily move things back and forth at tax time.
- How many owners are involved, and how do they expect to share in the business? If there’s more than one owner, obviously Sole Proprietorship is out as an option. If the multiple owners are happy to keep sharing ratios in a simple proportional formula, S-corporations can be a good option. If you need to break proportional sharing (e.g., differences between profit, loss, ownership, or profit draw ratios), or if you need different classes of ownership, then you’ll likely need to look at Partnerships. C-corporations allow you to exceed the 100-owner limit imposed by S-corps, but profit draws are limited to dividends paid at a flat rate on every share.
- What are your future profit/loss expectations? If you’re forecasting more than around $60k in profits off the bat, Sole Proprietorships may lead to higher taxes, but the flip side is that losses may be more easily claimed in bad years. Higher profits often favor becoming a S-corporation, because the non-compensatory part of those profits can avoid the self-employment tax paid by Sole Proprietors. The flip side here, is that your ability to claim losses may be limited in an S-corp when you’ve borrowed other people’s money, so that could be a downer. Partnerships generally work similar to Sole Proprietorships for purposes of profits, and similar to S-corps for purposes of losses. C-corporations are the only structure of the four to actually pay tax itself (the others are taxed on the owner personal returns), which means profits can be double-taxed (once by the business, and again as dividend income when distributed to the owner). C-corp losses have to stay within the company.
- Are you expecting to setup benefit plans? Health plans, retirement plans, and other fringe benefits can vary considerably between structures. For example, a Sole Proprietor whose spouse is the only employee can qualify for a very beneficial health plan that effectively makes personal health costs fully deductible against the business. S-Corporations and Partnerships have some limits on the ability of owners to participate in fringe benefits, but can still participate in retirement and health plans. One of the places C-corporations shine, is their ability to provide owners with a wide range of fringe benefits, but this may not be enough to offset other downsides.
Tax Entity Comparison™
For less complicated circumstances, a run through the four key areas above can enable you to identify the right fit for your business. But for situations with more moving parts, or for the benefit of breaking things down into black-and-white, we’ve developed our Tax Entity Comparison™ tool — we go into deeper questions, examine further nuances of operational impact, and run bottom-line tax calculations for each scenario. To benefit from this analysis, just contact our team.
Whether you use the basic or advanced analysis, choosing the best tax structure for your business is the first step to shaving off part of your tax bill, and turning your annual tax filings into a non-event.