When you have your annual tax returns sit in front of you, have you considered which types of taxes you can optimize?
Do you know your business structure impacts your bottom line?
Outside of legal considerations for asset protection, or financial consideration for fund-raising, what you want the business to do determines the best tax strategy for it.
Purpose #1 – Start a business
When you start a business, most likely there are more expenses than revenue at the beginning. Setting yourself up as a sole proprietorship in the first year or two will probably be sufficient. Minimal or no profit means no taxes, so using Schedule C (on your personal tax returns) for your sole proprietorship is probably adequate in those early years.
However, when your income grows, the profits are subject to both self-employment taxes and income taxes. If your personal tax returns show both of these, then it is time to pay close attention. Make sure you have adequate insurance to protect assets from loss, or against liability.
You may want to consider single-member limited liability company (LLC) for such concerns.
Purpose #2 – Hold assets
When your business involves real estate or other passive income generation, by yourself or with partners, you might want income and expenses to flow through to your personal level to aggregate with your overall financial situation.
Real estate can generate passive loss and those losses can be used to offset your active income. When you start using a legal business structure, there are administrative tasks, and depending on the state, minimum franchise tax, to consider. There is a balance you have to weigh between time, money, energy, risk, and reward.
Again, be sure to have adequate insurance on the asset.
Purpose #3 – Earn income
As your business and income grow, consider structuring a S-corporation to pay yourself; then have the remainder profits as pass-through income. Pass-through income is not subject to self- employment income, unlike in sole proprietorship mentioned above. Specifically a reasonable compensation is needed to pay yourself, as not 100% of net profits can be pass-through and therefore claimed to avoid the self-employment taxes.
However, when you start to consider taking the business to the next level by raising capital among investors, you may want to re-evaluate if S-Corp is still good for you.
Purpose #4 – Offer benefits or split income
Very often small businesses grow to the level of needing more owners and employees. At the same time, the owners want to offer benefits and keep the profits to grow the business further. Benefit plans such as 401K, health insurance, medical reimbursement plan. C-Corp in this regard has more flexibility than all the other structures.
Yes, C-Corp structure could have the double-taxation issue.
However, in our experiences, a study evaluating the owners’ overall taxation under either S-Corp or C-Corp often reveal a different picture than commonly held beliefs assume.
All in all, given competing legal, financial and taxation considerations a business inevitably runs into, a careful study should be done to evaluate whether C-corporation is the best structure. In conclusion, your goal for your business is your ultimate guide on what legal entity to use. Lastly, life and by extension your business is not static. So it ‘s perfectly okay to change the structure when it is time to do - just make sure you are working with advisors who have worked with business owners, or better yet, they are business owners themselves.
For your benefit, we have developed a handy comparison of different business structures and tax implications, and as always, should you have any questions or concerns regarding your tax situation or concern, please feel free to consult us.