How the Right Business Structure Can Help Reduce Tax Liability

Your business type can play a major role in how your company is taxed. That’s why choosing the right business entity type from the outset is such an important decision.

To select the business type that will give you the best tax position possible, you need to understand what the main options are and how each can affect your business and personal taxes.

Nearly every business is required to pay some kinds of taxes at the federal and state levels. In some cases, businesses may also have to pay local taxes to the city or town in which they are operated.

The most common types of federal taxes that businesses must pay include:

• Income Taxes. The most common type of federal tax, income taxes are paid by every business type except partnerships. The way your income taxes are calculated depends on the business structure you choose. Rates are established at the federal level based on total income. States also may or may not levy income taxes on businesses; the majority do but there are few where no corporate income taxes are collected

• Employment Taxes. Any business that has employees will have to file a portion of the Social Security and Medicare taxes owed. Employers will also need to manage income tax withholding and unemployment taxes. All are calculated and paid via the employment tax

• Self-Employment Taxes. As noted above, employees typically have their Medicare and Social Security taxes withheld by their employers in their paychecks. However, those who are self-employed, including self-employed business owners, must calculate and pay for their own Medicare and Social Security taxes. While some people are exempt from self-employment taxes, most self-employed people must pay

• Excise Taxes. Businesses that make or sell certain types of products, use specific types of facilities of equipment, or take payments for some services, must pay excise taxes. The types of businesses covered by these guidelines run the gamut, from indoor tanning companies to businesses using heavy vehicles on highways

• Dividend Taxes. If you’re a corporate shareholder or the owner of a corporation, you will pay income taxes on any income you receive via dividends. Corporations determine when and if to pay dividends and how large those dividends are. They are not deemed to be earned income, meaning you may a special dividend tax rate on what you receive and record it on your personal tax return.

• Estimated Taxes. When you receive a paycheck, your taxes are withheld every period. However, businesses and the self-employed are required to pay estimated taxes at four times during the year. Income tax payments are calculated using various forms and are due on April 15, June 15, September 15 and January 15

You will also be required to file certain state and local taxes, depending on where your business entity is located. These include:

• State Business Income Tax. Most cases have a state income tax for businesses. Most use a graduated-rate tax while a few have a glad tax rate. As an alternative, some states issue a gross receipts tax instead of or in addition to an income tax

• Sales Tax. Businesses do not directly pay sales tax on products and services sold. However, if the business operates in a state where there is a state income tax, it must find a way to collect sales tax from customers. Businesses are also responsible for reporting and paying those taxes. In most states, businesses have to collect taxes on sales and send payments to the state department of revenue. Not all products are taxable in every state. The products deemed taxable, rates and schedules for when taxes must be reported vary by state

• Property Taxes. Businesses that own real property, such as a building, will likely need to pay property taxes to the city or town where the property is located. Usually, the taxes paid are based on the assessed valuation of the property. In some cases, federal taxes apply when business properties are sold, usually capital gains on the difference between the sales price and initial cost.

Four Main Business Types and Tax Implications

The business structure you choose greatly impacts what you will pay for taxes. While taxes may not be the only consideration for determining which business structure you choose, the tax implications often weigh heavily on business owners when deciding.

Here is a closer look at four of the most common business types and the tax considerations to factor in to your decision-making.

Sole Proprietorship

A sole proprietorship is the simplest business structure to consider. In a sole proprietorship, a single individual is the business owner.

With a sole proprietorship, there is no difference in the way you are taxed as a business owner versus an individual. That’s because the income or losses earned as a business owner are recorded on the owner’s personal federal and state tax forms.

There is no difference between the individual and the business. The sole proprietor is responsible for the business profits or losses and the impact on their taxes.

The sole proprietorship may be simple, but provides no tangible tax benefit. In addition, from a liability standpoint, the owner has no liability protection from lawsuits or creditors.

Partnerships

A partnership is another basic business type, with two or more people jointly owning a business. There are three subtypes:

• General Partnership. The most basic partnership is two or more partners who share in the responsibility and liability of the business.

• Limited Partnership. There is one general partner and one limited partner. The general partner is the owner and is responsible for operations and liability. Limited partners invest capital, are not involved in day-to-day operations and do not have voting rights and, therefore, do not have liability

• Limited Liability Partnership. All partners have limited personal liability and are generally not responsible for wrongdoings by other partners. All partners can be involved in the management of the business

Partnerships are similar to sole proprietorships when it comes to tax liability. Profits and losses pass through to the owners’ personal tax returns. Partnership tax returns are due on the 15th day of the third month after the end of the company’s fiscal year. Typically, that means March 15, though most partners do not pay until April 15 when personal returns are due. Partners must also provide additional forms to their fellow partners to complete personal taxes.

Limited Liability Company (LLC)

This is one of the most popular business structures for small- and medium-sized businesses, largely due to the flexibility regarding taxation. Deciding to form an LLC could be a smart move, but that will mainly depend on your business type and needs, as detailed below.

An LLC is often referred to as a hybrid entity as it takes some traits from other business structures. It has major liability protections and has great flexibility when it comes to federal tax structure.

LLC owners are called members. For LLCs that are single-member entities, the business can choose to be taxed either as a sole proprietorship or as a corporation. As discussed, a sole proprietor business is a pass-through, with profits and losses managed on the owner’s personal tax returns. With a corporation, as noted below, the corporation is a separate entity and pays taxes itself.

Multi-member LLCs also have choices when it comes to taxes. They can be taxed as either a partnership (with the pass-through taxes) or as a corporation.

Corporations

Corporations are their own legal entities. There are more regulations related to paperwork and structure. For example, corporations must have a board of directors, can issue stock, hold an annual shareholders meeting, and file detailed documentation about their structure and business. Usually, the decision to create a corporation depends heavily on your business structure and plans for growth. It’s considered less suitable for small business owners as the regulations and tax liability are more difficult to navigate in.

There are two standard corporate structures.

• C-corporation. This is the default corporate structure. However, it is also the costliest from a tax standpoint. C-corps are subject to double-taxation. First, the corporation pays taxes at the business tax rate. Second, any dividends the corporation issues are taxed on shareholders’ personal income tax returns

• S-corporation. This structure has strict standards governed by the IRS. It can have only 100 shareholders, all of whom must be U.S. residents. However, unlike the C-corp, the S-corp has pass-through taxation, meaning profits and losses are passed on to owners for filing on personal returns

Each business type has its own benefits and drawbacks, which can shape why an owner chooses that structure. However, tax considerations are considerable and can shape owners’ financial returns on their businesses.

By reviewing the different types available, and understanding their personal tax situation, owners can make the right decision for which business entity to choose.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes