Which business entity is going to save you the most money on your taxes?
Sole proprietor vs LLC vs S-Corp vs. C-Corp – which one should you choose?
Now, your tax expense can greatly vary based on the entity you select here.
And by greatly, we mean thousands if not tens of thousands of dollars.
So by the end of this post, we hope that you’re saving thousands and not paying thousands more than you have to in taxes.
Today, we are going to help you select the best entity for your business.
We typically charge this information as a part of our tax planning service, but today, you’ll get this information for free.
With that said, let’s begin.
Legal vs Tax Entity
When it comes to entity selection, there are “LEGAL” entity types and “TAX” entity types.
A legal entity is an entity that you register with your state.
Your tax entity is the entity that you elect to file as with the IRS.
For example, you can register your business as an LLC with your state for legal purposes, but elect to be taxed as an S-Corp with the IRS for tax purposes.
Meanwhile, for legal purposes, there is no such thing as an “S-Corp”.
We’ll discuss this and each type of entity in a moment, but before we do, it’s important that you understand the taxes that are involved for all entities.
Tax Differences: What Are The Taxes Involved For All Entities?
1. Pass-through Taxation
The first thing you need to understand about entity taxation is pass-through taxation.
Sole proprietors, partnerships, LLCs, and S-Corporations are taxed as pass-through entities.
This means that all income your business receives passes through to you personally.
For example, if your business made $100,000 and you owned 100% of that business, then you would be required to pay taxes on that $100,000 individually.
The exact tax you pay on that will depend on the tax bracket your total personal income falls in.
2. Double Taxation
Only C-Corporations are subject to double taxation.
Double taxation is where the company itself is taxed on all of its profits, before payments to owners are made.
And then the owners are taxed on payments they receive from the corporation.
So, you’re taxed twice.
Because of double taxation, C-Corporations are not a popular choice amongst small businesses.
But let’s discuss a major tax that most small businesses encounter as pass-through entities.
3. Self-Employment Tax
Self-employment tax is an extra 15.3% tax on your income.
It’s the government’s way of funding programs like Social Security and Medicare, which is normally deducted from your paycheck as an employee.
The only difference is, as a business owner, you’re paying both – the employer and employee portion of the tax, equaling a total tax of 15.3%.
Now here’s the thing about self-employment tax, it does not apply to S-Corporations or C-Corporations.
And because C-Corporations are subject to double taxation and S-Corporations are not, it shines a bright light on S-Corporations as a good entity choice to save on this tax.
Still, S-Corps are subject to some different rules that complicate this.
So let’s look at each entity closely so you can determine which makes the most sense for your business.
Tax Differences: Sole Proprietor vs LLC vs S-Corp
1. Sole Proprietorships & General Partnerships
If you do not register your business with your state, then you are a sole proprietor by default.
For example, if you woke-up tomorrow and started cutting people’s lawns in exchange for money, then you would be doing business as a sole proprietorship.
And if you and your friend decided to work together to do this, then you would be a general partnership.
Sole proprietorship and partnerships are both taxed the same, they just file in different places on their tax returns.
Sole proprietors report business income on their individual tax returns, or 1040. And they use Schedule C to report the business income or loss from your business.
Partnerships report business income on their partnership tax return, or 1065. Each partner must receive a K-1, which basically reports what portion of profits they are entitled to.
Both entities can deduct business expenses to lower their income. You can deduct things like your:
- advertising expenses
- car expenses
- office expenses
…and much more on your return.
Now the major taxes they are subject to are:
- Federal income tax
- State income tax
- Self-employment tax
On the legal side, the most unattractive thing about sole proprietorships and partnerships is that they carry substantial risk.
The biggest legal risk is that you have no protection of your assets.
For example, if you accidentally set your client’s house on fire, you’d be personally liable for all of the damages.
That means that if they sued you, they could go after everything you own.
To prevent this, most people decide to organize themselves as an LLC.
2. Limited Liability Company
A Limited Liability Company, or LLC, does exactly what its name says – it limits your liability for your company.
By default, there is no extra tax benefit of registering your business as an LLC. It just protects you.
So in the same example, if you accidentally set your client’s house on fire, then you would not be personally liable if they sued you.
Only your company would be liable, which means your loss will not exceed the amount you’ve invested in your company.
For this reason, LLCs are the most popular entity type amongst small businesses. They provide strong protection and are easy to set-up.
On the tax side, the forms you file are different based on if you’re a single-member LLC or multi-member LLC.
Single-member LLCs file their taxes on Schedule C like sole proprietors, and multi-member LLCs file their taxes on 1065 like in partnerships.
Now, here’s the interesting thing – as an LLC, you can elect to file as an S-Corporation for tax purposes.
This would allow you to tap into the tax benefits of an S-Corporation, without having to form a corporation.
S-Corporation is a special tax status granted by the IRS that lets corporations avoid double-taxation and pass their income through to their shareholders like partnerships.
To be clear, an S-Corporation is not a legal entity.
You must have a legal entity in order to elect S-Corp status. For example, LLCs and C-Corporations can elect to be treated as an S-Corporation for tax purposes.
You must be a domestic corporation with no more than 100 shareholders to be eligible for S-Corp status.
In order to elect S-Corp status, you must file a 2253 form with the IRS.
If accepted, then you would file the 1120S to file as an S-Corporation.
This means that you would not be required to pay self-employment taxes. This is great, but there is one major rule.
The owners of S-Corporations must pay themselves a reasonable salary for the work they do in their business, before receiving distributions of profits.
This reasonable salary must be paid like you would pay a W-2 employee, which also means that you are still paying Medicare and social security taxes to some extent.
In order to do this, you must set up a payroll system to pay yourself and submit quarterly payroll taxes.
And you also have to configure a reasonable salary to pay yourself.
The IRS provides some factors to consider, like your training and experience or what you would pay a non-shareholder employee.
But, the answer can still be unclear.
And if you get this wrong, the IRS can go back and reclassify payments listed as distributions as W-2 wages that must be taxed.
This intimidates a lot of business owners.
What is a Reasonable Salary?
According to many CPAs we know, the unofficial rule is that a reasonable salary is equal to ⅓ of the business profits.
So as long as you’re doing this as an S-Corp, we’d say you should be fine. Many people who are getting caught up with the IRS aren’t paying themselves a salary at all.
Now here’s the good news.
By setting a reasonable salary, you effectively limit your exposure to self-employment taxes.
For example, let’s say you made $100,000 in income and paid yourself $70,000 as a reasonable salary.
You’d only pay social security and Medicare taxes on the $70,000 and would not on the difference of $30,000.
$30,000 × 15% = $4,500.00
That’s $4,500.00 in tax savings just from choosing the right entity.
Sole Proprietor vs LLC vs S-Corp: Which is the Best Entity For You?
The best entity for you will ultimately depend on where you are in your business.
But here’s some very general recommendations.
When you’re just getting started, start off as an LLC.
It’s super easy to set up and it will provide limited liability for your business.
Once you start making over $50,000 per year in business income, then consider electing S-Corporation status.
This will limit your exposure to self-employment taxes as you continue to grow your business.
Contact our tax consultants today for more detailed tax advice for your specific tax needs.