In many ways, starting a business is like becoming a new parent. From the very beginning, you have to spend a lot of time caring for the business to help it survive. You find yourself continually sacrificing your own wants to give it a better chance to succeed. Even when you try to spend some time away from it, you can’t resist calling the “babysitters” to check on it.
Another thing new parents and business owners have in common is price shock. No one mentioned all of the hidden costs. “Formula is how much?!?” “Why do I pay all of these payroll taxes?!?”
A cost that many new business owners underestimate is the cost of income taxes. After all of the stress and long hours that go into making a business profitable, the instant you attempt to reward yourself, Uncle Sam is there with a hand out. Fortunately, there are (legal) ways to pay lower taxes. One strategy is to carefully consider the type of business structure you set up.
As mentioned in a previous blog (Corporation vs. Proprietorship) if you hope to grow your business, there are advantages to being incorporated. Incorporating can improve the business’s chances of finding investors. Potential investors have limited liability which means they can only lose amounts they’ve invested in the business. As a corporation is a separate entity, other people can invest in the business and the business won’t cease to exist if one owner can’t continue working with the business. Although there are advantages to incorporating, it isn’t necessarily the best structure for tax purposes.
Most large corporations are what as known as “C corporations” (the “C” relates to the part of the Internal Revenue Code that describes them). A C corporation has one big tax disadvantage for business owners called “double taxation”. When a C corporation is profitable, it pays high tax rates. During 2010, most C corporations were taxed at 35%. But the taxing doesn’t stop there. After the corporation pays taxes on these earnings, owners receive part of the remaining earnings as dividends. The owners then have to include these earnings on their individual tax returns where most pay a special 15% federal tax. After state taxes are considered, less than 50 cents of every dollar earned by the business can be used by the owners.
Based on this, it doesn’t seem worth incorporating merely to achieve limited liability and the other benefits. To pay lower taxes overall, business owners can utilize different legal formations and still obtain the advantages of incorporating while avoiding the double taxation of a C corporation.
There are business structures which have limited liability and the other advantages of a corporation that pass through the business’s earnings directly to the owners. Rather than taxing the profits at the entity level, the earnings are passed through directly to the owners, who then pay the related taxes on their individual returns. The end result is that lower taxes are paid on the business’s earnings. There are various pass-through entities with the advantages of corporations, such as limited liability companies (LLC’s). The most popular structure for small businesses is the S corporation.
The “S” in S corporation doesn’t stand for “small”, although the structure seems designed for small companies. There are many qualifications to being an S corporation but most won’t be an issue for the majority of small businesses. Qualifications include having a maximum of 100 shareholders who are United States’ citizens or residents.
Setting up a business as an S corporation or other pass through entity can help the business succeed. By paying less taxes, owners have more money available to invest in the business. When the business is profitable, the earnings will only be taxed on the owners’ individual returns. When a business isn’t profitable, the losses are also passed through to the owners. In most cases, this offsets the owners’ other income and reduces their individual taxes. In a C corporation, losses accumulate in the corporation and owners aren’t able to immediately benefit from them.
In conclusion, you should take the time to determine which legal formation will help your business succeed. Unless you’re one of those eccentric people who enjoy boasting about the large amount of taxes you pay, you should consider using a business structure that passes earnings through to the owners.