There are a lot of decisions to make when starting a new business, but with so much on your plate, your legal business structure may have not made the list. If you don’t select a form of business, you’ll become a sole proprietorship by default. However, that’s not necessarily the most advantageous structure when it comes to taxes.
Should you remain a sole proprietorship, or does incorporation offer tax advantages?
What’s the Difference?
The most common and simplest form of business formation is a sole proprietorship. The business is owned and managed by an individual proprietor. Paperwork for filing taxes is simple: The owner pays taxes on income from the business as part of his or her personal income tax payments. On the downside, that also means the owner is personally responsible for all debts and liabilities incurred by the business.
A corporation is a legal entity of its own, separate from its owners. The corporation makes its own income and suffers its own losses. While the paperwork involved in filing corporate taxes is more complex, the rules for corporations are stricter and the costs of incorporating and maintaining the corporation are higher than for a sole proprietor, the advantages of a corporate structure are enticing for many business owners.
The most common reason business owners establish a corporation is for the liability protection it offers. Because the corporation is a separate entity from the owners and shareholders, owners and shareholders cannot be held responsible for any debts or lawsuits brought against the company.
Consequently, corporations file taxes separately from the business owner/s. Unless you receive dividends from the corporation, as owner you will not be taxed on the company’s profit, nor can you take advantages of its losses. Because corporations are formed under the laws of each state, they are subject to corporate income tax at both state and federal level.
The IRS requires all officers and owners of a corporation to earn a “reasonable” salary comparable to what they’d make at a similar business. This is true even if the company is not making a profit, which could be problematic for new businesses.
As a sole proprietor, you are not an employee of the business; you’re considered “self-employed” by the IRS. You report the business income and any other income as total income for the year. The same goes for your business losses. Although you do not have to pay payroll taxes on your income or withhold income tax from your pay, you do have to pay self-employment taxes—Social Security and Medicare taxes.
There are two options for incorporating: S corporation or C corporation. The C corporation allows you to attract an unlimited number of investors and shareholders and offer stock plans to employees. Besides the many business deductions available, you can also lower your tax rate by splitting profits and losses between the business and the owners to create an overall lower tax rate. Check with your tax expert to see if this makes sense for your situation.
S corporations do not pay any federal income taxes. Instead, the business’s profits and losses are passed through to the shareholders and reported on their personal tax returns. This is referred to as “single taxation,” unlike C corporations that undergo “double taxation”—the business pays federal income tax, and any dividends paid to shareholders are also taxed.
Whichever business structure you choose, be sure to keep your business and personal expenses and bank accounts separate. For corporations, this separation maintains the corporate shield that protects your personal assets. For sole proprietorship, separation protects you in case of an IRS audit by documenting your legitimate business expenses and income.