Entrepreneurship is a lucrative career that can come with tax benefits.
Many entrepreneurs wonder as to whether it is worth incorporating their small businesses or not. On one hand, incorporation allows small business owners to receive some tax benefits and avoid higher taxes, but on the other hand, it comes with its own set of paperwork and tax system compliance requirements.
People with their own startups, most often form a corporation or a limited liability company (LLC) to lessen the amount of taxes they have to pay. But how do you know if one option is better for you than the other?
In this article, you'll learn all about different types of corporations and LLCs before deciding with one will serve your business best when it comes to any tax benefit.
This blog will look at whether a corporation reduces its taxes.
Sole proprietorship
A sole proprietorship is an individual business entity. It is the most common business entity for entrepreneurs and the owner of the business does not need to be a natural person.
In a sole proprietorship, the business is owned by one person and is not limited in any way. The owner of the business is personally responsible for any business liabilities, including taxes on their net income.
Partnership
A partnership is an entity that has two or more people who share in the profits and losses of the business. A partnership is not taxed, and it does not have to file tax returns. Partners may be equal or unequal in their share of the profits.
Corporations vs. Limited Liability Companies
What Is a Corporation?
A corporation is a legal entity that's wholly separate from its stakeholders. C-corporations are taxed as a separate entity from shareholders personal income.
In the United States, the branch of tax law that deals with corporations is called Subchapter-S corporation law.
Basically, it means that that those who form a C corporation must count wages as corporate income and must pay the corporate income tax rate on them as well
C corporation
Tax rates vary depending on the type of business and where it's located. For example, the standard corporate tax rate on corporate profits in the United States is 35% in 2018.
The structure of a corporation is simple: one class of stock that represents the ownership interests of the corporation and another class of stock that represents the ownership interests of the shareholders.
The corporation is required to pay dividends to its shareholders and pay taxes on any profits.
S corporation
An S corporation is a business entity that's similar to a C corporation. The main difference is that do file corporate tax returns but S corporations are taxed like a corporation, but they're taxed at a lower rate of 15%.
Often times when you elect to be taxed as an S corporation, you may still have to pay self-employment taxes.
LLC
An LLC is a type of business entity that's similar to a corporation. LLCs are taxed at a special tax rate of 15% instead of the standard corporate tax rate of 35%.
Many people believe that C corporations are only for large corporations but there is no minimum size requirement for a C or S corporation.
How do you form a corporation?
An LLC can be formed with a few simple steps. First, the business owner must register with the state of business to be formed and file a document with the Secretary of State's office that states the name of the LLC.
Taxes
You may be concerned about the taxes you would have to pay if you formed a corporation. However, you may be able to reduce your federal taxes and local taxes by forming a corporation and reduce your overall tax liability.
Here's how: By using a corporation, you can isolate your personal assets from your business assets, so that if there is any litigation or bankruptcy, your personal assets are not at risk.
In addition, you will be able to write off certain business expenses as a tax deduction for your corporation. For example, you can write off 100% of your car's mileage, which you would not be able to do if you were operating as a sole proprietor or partnership.
But the real advantage of this title comes in the form of tax benefits. LLCs offer business owners far greater tax flexibility than sole proprietorships, partnerships and other popular forms of business organization.
Make sure you have a financial plan for your small business.
An LLC is usually treated as a pass-through entity for federal income tax purposes. This means that the LLC itself does not pay taxes on business income.
LLC members pay taxes on their share of the LLC's profits. State or local governments may impose additional taxes on the LLC.
Members may elect to have the LLC taxed as a corporation rather than as a pass-through entity and this may result in tax cuts for the members. And members may be able to avoid a minimum tax penalty as well.
The Internal Revenue Service (IRS) treats jointly owned LLCs as partnerships for tax purposes. Like single-member LLCs, jointly owned LLCs do not pay tax on business income; instead, the LLC owners pay tax on their share of the profits on their personal income tax returns (with Schedule E attached).
Each LLC member's share of profits and losses, called the distributive share, must be set out in the LLC's operating agreement. This is how most LLCs avoid double taxation.
What Does This Mean for You?
What does this mean for your particular tax situation - are LLCs really better from a tax perspective than all other types of business entities?
The IRS treats single-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS.
If the members of an LLC believe they can reduce their tax bill by being taxed as a corporation, they can file Form 8832 with the IRS and elect to be taxed as a C corporation. However, Section 351 of the Internal Revenue Code permits the assignment of all receivables and payables of a business to a newly formed Corporation or LLC so that they can be collected and paid through the Corporation or LLC.
After making the "S" election, the LLC would have to file a Corporate Income Tax Form 1120S each year.
A "C" corporation or taxable LLC may elect a tax year that extends through the December 31 individual income tax year.
An LLC completes each member's Schedule K-1 as part of Form 1065, which identifies each member's share of profit or loss over the course of the reporting period.
Since a taxable Corporation or LLC can only deduct charitable contributions up to the value of 10 percent of its taxable income, it is generally advisable for the owner to make personal charitable contributions.
The main disadvantage for owners of an LLC that is taxed as a sole proprietorship or partnership is that all taxable income, which is passed through to the owners, is treated as "earned income and subject to employment taxes". The IRS treats your LLC as a sole proprietorship or a partnership, depending on the number of members in your LLC.
Alternatively, the C Corporation or taxable LLC could purchase or lease a business automobile and include a percentage of personal use of the automobile, including travel to and from the office, on the executive's or employee's Form W-2.
A tax years may end at the end of any month within twelve months following the month in which the Corporation or LLC was formed.
What Legal Structure Should You Choose?
Choosing the right business entity is a very important decision. For example, if you're a sole proprietor, you're personally responsible for all business liabilities, including taxes.
In contrast, a corporation has shareholders who are not personally responsible for the corporation's liabilities. The corporation is taxed separately from the shareholders.
In a corporation, the shareholders' shares are non-voting shares. They do not have the right to elect or remove a board of directors.
Business Legal Structures - Which is Best for Your Business
As mentioned above, the choice of entity is often driven by personal preferences.
For example, if you want to shield your personal assets from business debts, then a C corporation is a good option. On the other hand, if you want to minimize personal liability, then an LLC is a good option.
It's important to note that there are some legal differences between the two. For example, if you operate a sole proprietorship, you can only have one legal form of business.
On the other hand, if you form an LLC and then convert it into a C corporation, then you can have both a business and personal entity.
What are the tax benefits?
As you can see, corporations are a better choice for businesses that need to pay taxes.
The reason for this is that C-corporations are not taxed as separate entities, but as part of the shareholders income.
On the other hand, LLCs are not taxed as separate entities. They are taxed on the basis of profits they make. However, C-corporations are taxed on the basis of their profits as well.
A C corporation can be used by a startup. It's the best option for a business that needs to be taxed as a separate entity from its owners.
Tax Savings
In most states, the LLC is not taxed at all. If you are using it to avoid paying taxes, it's a good choice.
Choosing the right corporation or LLC is important for a business to make the right choice. Here's what you should consider when choosing.
The price of setting up a C corporation or LLC can vary depending on your state and the type of entity you are forming.
It's usually cheaper to set up an LLC than a C corporation. The reason for this is that LLCs are not taxed.
In addition, they are not required to have a corporate office or any legal structure.
Consider tax implications
When choosing the right business entity, you need to think about your tax obligations.
In general, a C corporation is the best option for businesses that need to pay taxes. This is because corporations are subject to corporate income taxes.
LLCs are a good choice if you don't want to pay taxes because they're not taxed. This means that you don't need to pay taxes.
Conclusion
You should carefully consider all of your options when it comes to starting your business and the legal/tax structure of the business. You can use a business formation service to make the process much easier. You should decide on your business structure before forming your corporation so that there are no surprises when it's tax time.
