Choosing which business entity is right for your particular business can be tough! New entrepreneurs want to know which business entity is best. And the business entity definitions you find online don’t paint the full picture.
In previous posts, we’ve explored sole proprietorship, partnership, S-Corporation, and C-Corporation business entities and how they affect the owners of an e-commerce bakery. Today we’ll review a few last considerations for choosing a business entity.
What about LLCs?
One of the most popular business structures is the Limited Liability Company (LLC). Wondering why we haven’t reviewed them yet?
An LLC is a legal structure, but the IRS doesn’t recognize LLCs as tax structures. The members of an LLC can choose to be taxed as a partnership, an S-Corporation, or a C-Corporation. In fact, if an LLC has only one member, the business can be taxed as a sole proprietorship.
So, if you start your business as an LLC, you still have to decide how you want to be taxed.
What’s the Right Business Entity for My Business?
Let’s cut to the chase – which entity type is the best?
Unfortunately, the answer is not very satisfying. It’s the answer that you will hear from accountants when you ask them almost any general question. “It depends.”
There are legal reasons why you might choose one entity type over another. For example, if you are trying to raise money from investors or setting up the business for a future sale. However, our focus is on the year-to-year income tax differences and why “it depends.”
Impact of Other Sources of Income
If a business owner’s only source of income is their business, it’s easier to quantify the impact of different entity types. We can calculate the potential self-employment tax savings from an S-corporation or the benefits of the Qualified Business Income deduction.
However, those calculations can change drastically when a business owner has other sources of income or a spouse with significant income. If a business owner has another W-2 job separate from their business, they might not see any self-employment tax savings by choosing an S-corporation.
Additionally, if a business owner has high income – either from the business or from other sources – they might lose the QBI deduction altogether.
It’s not uncommon to have two different business owners with the same type of business, earning the same amount of profit, come to different conclusions on the best entity type to save on taxes.
Benefits vs. Added Costs
Many small business owners are told they should set up a separate business entity because they can save money on taxes. They worry about missing out on “special” deductions for businesses. And S-corporations, in particular, are often sold as great tax-saving devices.
Let’s start with the first part: special deductions for businesses. It’s true that business owners can deduct some expenses that W-2 employees cannot. But, these deductions aren’t limited to businesses that have set up specific entities.
With very few exceptions, any deductions available to corporations are also available to sole proprietors.
Still, there are some tax savings that can occur when a business sets up a separate entity. One of those is the self-employment tax savings for an S-corporation.
Depending on your tax situation, you might pay lower taxes as a C-corporation compared to a sole proprietorship. But don’t ignore the additional costs that come with a separate business entity.
It can cost several thousand dollars to set up a business entity (if you do it right). Many business entities have separate filing fees that need to be paid each year. And the cost of filing a separate tax return for a business entity is usually much more expensive than filing a Schedule C on a personal tax return.
Sometimes, setting up a separate business entity may save someone $1,000 in taxes but cost $2,000 every year in tax preparation and filing fees. So, it’s not always advantageous.
Bottom Line
As we have shown in our business entity selection series, the entity you choose affects how you report your income, when and how you pay taxes, and even how you pay yourself as a business owner. There are also pros and cons for each business entity to consider, depending on your unique situation.
At the end of the day, if the cost of a separate business entity would outweigh the tax savings, business owners may prefer a sole proprietorship or partnership instead.
While we’ve focused on tax implications for each business entity, remember there are also legal and logistical implications. That’s why there’s no way to say which business entity is best (in every situation). As always, when in doubt, consult a professional for advice.
We hope this business entity series has been helpful! In case you missed the previous business entity articles:
Business entity series part 1: Sole Proprietor
Business entity series part 2: Partnership
Business entity series part 3: S-Corporation
Business entity series part 4: C-Corporation
