When it comes to running a business, there are many factors to consider. One of the most important is understanding which type of business structure works best for you.
The Internal Revenue Service (IRS) recognizes five distinct structures for US businesses:
- Sole proprietorships
- Partnerships
- LLCs
- C corporations
- S corporations
Each business structure has its own advantages and disadvantages when it comes to taxes. That’s why it’s so important to understand the differences between them before making any decisions about how to structure your business.
In this blog post I’ll walk you through each of these five business structures in more detail, and explain what they mean for your business and your taxes.
But first, a cautionary tale.
My good friend Steve paid the IRS $100,000 more than he should have.
His business exploded in 2016, and he had his biggest year ever. Unfortunately, there was no refund coming.
This is a textbook mistake that a lot of entrepreneurs make. They don’t take the time to set up the right entities to not only protect themselves and their business, but to reduce their taxes.
And once the income rolls in and you don’t have it setup, there is no going back.
If Steve had set up an S-Corporation either prior to his business’s explosive year, or at the beginning of the year, then he would have avoided self-employment tax on a large chunk of his profits.
I’m grateful I had the right guidance when I was 22. That’s when I set up my first S-Corp.
Although at that time the tax savings were minimal since I wasn’t making that much money, it set me up for abundance. I believe that the Universe rewards us for being prepared and ready to receive greater blessings.
So once my business took off, the income that came in and grew was tax efficient.
What was also cool when I got my paperwork back, it said I had 1,000 shares!
The shares weren’t worth much at the time because my earnings weren’t strong. But over time, those shares have steadily grown in value and are now my largest asset.
I haven’t found an investment that compares to growing the valuation of your own S Corporation. And the tax advantages are insane.
Let’s now take a look at how each of the five common business structures measures up.
Table of Contents
The 5 Most Common Business Structures – And What They Mean For Your Taxes
#1. Sole proprietorships
Sole proprietorships are one of the most common types of US business entities, and for good reason. This is a great tax structure for new business owners for its simplistic nature. Income and expenses are reported on your Schedule C, which attaches to your 1040.
You definitely don’t want to stay a sole proprietor for very long though. Sole proprietors often face higher taxes than those operating under different structures. The exact rate of taxation will depend on the type of income generated and the state or local laws that apply to it.
However, in general, sole proprietors must pay both federal and state income taxes, as well as self-employment taxes and any applicable sales or property taxes.
They offer several advantages, including simple setup and operation, limited liability protection from creditors and lawsuits, and flexible income tax reporting.
However, there are also some disadvantages to consider when deciding if this type of entity is right for your business.
These include personal responsibility for any debts or losses incurred by the business as well as higher self-employment taxes than other entities such as C corporations or S corporations.
Additionally, sole proprietorships may find it difficult to raise capital due to lack of investor interest in a single owner entity.
#2. Partnerships
A partnership entity is a type of business structure where two or more people share ownership and responsibility for the company.
This type of arrangement allows partners to combine their skills, resources, and capital to create a successful venture that would not be possible on one’s own.
Again, another great tax structure for simplicity, but all income is subject to self employment (except for rental income).
Partnerships are popular among small businesses because they offer many advantages such as shared risk and rewards, greater access to resources, increased buying power, and tax benefits.
In order to ensure a healthy working relationship between all parties involved, make sure you have a legal operating agreement in place to avoid any fallout with partners.
When I formed my Partnership with my business partner Shecky for High Return Real Estate, we immediately set up an LLC. It’s simple and definitely worth the extra step, so let’s dive into that next.
#3. LLCs
Limited Liability Companies (LLCs) are a type of business structure that is becoming increasingly popular due to its flexibility and asset protection.
This means that owners are not personally responsible for any debts or lawsuits against the business, but still have the ability to report income and losses on their individual tax returns.
Limited Liability Companies (LLCs) are often popular business entities among entrepreneurs, but they offer virtually no real tax advantages.
Whereas corporations have the potential to benefit from the lower corporate tax rates, LLCs are rarely ever taxed at a different level than their owners.
Essentially, the income of an LLC is usually passed onto its members, who then have to pay taxes on it according to their individual tax brackets. This means that the profits from an LLC are typically taxed at a higher rate than if they had been earned through a corporation.
LLCs are pass-through entities and do not pay taxes on their income; instead, the owners of an LLC report profits or losses on their individual tax returns.
LLCs are great for rental property because they’re quick and easy to set up and they give asset protection. I haven’t found there to be any advantages to putting property into an S Corp for taxes.
I use LLCs for all of my investment property and for any new startup businesses, and I run my business through my S-Corp. When I see a business starting to approach the $100,000 mark, I’m meeting with my CPA and discussing if I should convert it to an S Corp taxation status.
While this structure offers many advantages, there are also some disadvantages that should be considered before deciding if an LLC is right for your company.
For example, forming an LLC is more complex than other types of businesses such as sole proprietorships or partnerships. It requires filing paperwork with the state in which you are doing business and often involves additional costs for things like setting up bank accounts or obtaining licenses.
Additionally, there are restrictions on who can form an LLC – typically only individuals or entities legally allowed to do business in the chosen state can create one.
While members of the LLC enjoy limited liability protection, they may still be held responsible for any unpaid taxes or debts associated with the entity.
#4. S-Corporations
S Corporations, also known as Subchapter S corporations, are a type of business structure that is recognized by the IRS for tax purposes.
One advantage of an S Corporation is that it offers the owners limited liability protection from creditors and lawsuits.
Setting up an S corporation can be a great way to save on taxes. An S corp is a business structure that combines the limited liability of a corporation with the pass-through taxation of a partnership or sole proprietorship.
This means that profits made by your business will be taxed at individual income tax rates, rather than corporate tax rates.
This can result in significant savings on taxes for small businesses, as individuals pay lower tax rates than corporations do. Additionally, losses incurred by your business may also be used to offset any other taxable income you have from other sources such as investments or wages.
Furthermore, when you set up an S corp, you may also benefit from certain deductions and credits which are available to corporations but not to partnerships or sole proprietorships.
Let’s say Carley is self-employed and makes $100,000. So she would owe $14,130 when it comes time to pay self-employment tax.
If Carley earns the $100,000 through her S corp and pays a reasonable salary of say, $40,000, only the $40,000 in wages is subject to Social Security and Medicare taxes.
Through the S corp, her Social Security and Medicare taxes would be 15.3% (7.65% employer and 7.65% employee portion) totalling $6,120. Compared to the self-employment taxes, she would save $8,010 in taxes.
Her net gain from having the S Corp won’t be $8,010 because of the filing fees and separate tax return. A safe estimate would be $3,000 for these expenses, so she still saves $5,000.
That’s why I say you should start considering setting this up when you’re approaching a six figure business. Anything less than that, and you could be in a position where the fees you pay outpace the tax savings.
With that being said, I’d rather someone set it up a bit too early than too late.
You want to be prepared and avoid a large mistake like Steve’s.
All these factors combine together to make setting up an S corp one of the most attractive options for small businesses looking to maximize their savings on taxes.
The main disadvantage of an S Corporation is that they have more stringent rules than other entities in regards to ownership restrictions and reporting requirements.
You also have quite a bit more filing requirements and it does require a separate tax return, which can cost you several thousand dollars per year if you have a professional CPA do your returns.
If you have an S Corp, I would not try to save money here by hiring cheaper help.
There were two years where I had down years and didn’t want to pay my CPA, so I had a bookkeeper do it and they both made mistakes that ended up costing me more than the savings of hiring them.
You don’t want discount brain surgery as much as you don’t want to hire discount bookkeepers or less skilled professionals to keep your corporation running smoothly and tax efficiently.
#5. C-Corporations
I’m not going to spend a lot of time on this one, as the vast majority of you will never utilize this in your lifetime.
Although the majority of corporations in the US are S-Corps, nearly all publicly traded companies are C Corps for their shareholder flexibility (unlike S Corps). C Corps also allow for non taxable treatment of certain fringe benefits, which can be very strategic.
C-Corps do have double taxation to deal with, so it’s not typically the most favorable option for smaller business owners.
C-Corps can be beneficial to businesses that have multiple owners and/or investors as it offers limited liability protection from creditors and lawsuits.
Additionally, profits can be taxed at the corporate level which can help reduce overall taxes paid by shareholders on their individual returns.
As you’ve probably been picking up what I’ve been laying down, I’m big on S Corps.
Here’s a quick snapshot of the key advantages of S-corps when compared to the other common business structures.
Benefits of S-corps vs Sole Proprietorships
- An S corp will help protect your personal assets
- S corps have an unlimited life, which means they exist after the passing of the owner
- It’s easier to transfer ownership of the business as an S corp
- An S corp can help you save on self-employment taxes
Benefits of S-corps vs LLCs and Partnerships
- LLC members/partners cannot be employees
- S corp profits are not subject to self-employment taxes
- S corps don’t expire, while LLCs can
- You only need one person is order to form an S corporation
- S corps have more financing options, so there is more potential to scale
Conclusion
Choosing the right business structure is essential for entrepreneurs, as it can significantly affect your taxes.
The five most common business structures recognized by the IRS include sole proprietorships, partnerships, LLCs, C corporations, and S corporations.
Each entity has its own advantages and disadvantages. While sole proprietorships are simple and easy to set up, they come with higher self-employment taxes.
On the other hand, LLCs offer great asset protection, but they do not offer any real tax advantages.
S corporations are often the best choice for tax efficiency because they offer a unique tax advantage over other business structures. Unlike sole proprietorships or partnerships, S corporations aren’t subject to self-employment taxes on all of their profits.
Instead, S corporation owners can pay themselves a reasonable salary, which is subject to self-employment taxes, and then take the remainder of their profits as distributions, which are not subject to self-employment taxes.
If tax efficiency is a top priority for your business (and it should be!), an S corp may be the best choice for you. I highly recommend consulting with a qualified tax professional to figure out the best business structure for your specific situation.
Taking the time to understand each type of business structure can save you money, protect you from liability, and set your business up for long-term success.
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