What Is the Best Business Structure for Taxes?

What Is a Business Structure?

A business structure is the legal framework that defines how a business is organized, operated, and taxed. It affects liability, tax obligations, and decision-making. State laws govern business formation, while federal tax law dictates taxation.

How Does the Legal Structure of My Business Affect My Taxes?

Business structure determines your company’s taxation, available deductions, and IRS filing requirements. It also affects personal liability. Here is how common business structures compare: 

Sole Proprietorship

A sole proprietorship is the simplest business structure, ideal for solo entrepreneurs. The owner and the business are legally the same entity. All profits, losses, and liabilities belong to the owner.

Tax implications include:

• Taxes. Business income and expenses are on the owner’s personal tax return (Form 1040, Schedule C). A “pass-through” entity avoids secondary corporate tax.

• Self-employment taxes. Owners must pay self-employment taxes (Social Security and Medicare), around 15% on net earnings.

• Deductions. Owners may offset personal income and reduce tax liabilities by applying various deductions. 

  
  

A major drawback to this type of business entity is the lack of personal liability protection. Owners are personally liable for any and all business debts or legal obligations. If facing legal action, a party seeking damages can access your personal assets. A sole proprietorship is best suited for small, low-risk businesses, like freelancers, consultants, or small service providers. If you’re wondering where to start, read about tax essentials for startups. 

Limited Liability Company (LLC)

An LLC offers legal protection without the complexity of a corporation. It’s a popular choice for small businesses looking for flexibility. They also have fewer reporting requirements, meetings, and record-keeping obligations than corporations.

The main advantage of an LLC is the limited liability protection it provides. Generally, owners are not personally liable for business debts or lawsuits. Therefore, this entity protects your personal assets from being accessed by plaintiffs seeking damages, creditors, and most other business liabilities and debts.

LLC tax considerations include:

• Taxes. LLCs are taxed as pass-through entities, meaning profits and losses are reported on personal tax returns, avoiding double taxation.

• Options. LLCs can elect S corporation taxation to reduce self-employment taxes or C corp for potential tax benefits.

• Self-employment taxes. LLC owners must pay self-employment taxes unless taxed as an S corporation. The rate can be around 15% on all net earnings.

  
  

A downside is that LLCs can limit growth since they cannot issue stock, making them less attractive to investors. Additionally, state regulations and fees vary, complicating compliance and multi-state operations. 

S Corporation

An S corporation (S corp) combines the liability protection of a corporation with the tax benefits of a pass-through entity. Considerations include:

• Taxes. Income passes through to shareholders, who report it on their personal tax returns, avoiding corporate tax.

• Payroll taxes. Owners can pay themselves a reasonable salary and take additional profits as distributions, potentially lowering self-employment tax obligations.

• Deductions. Business expenses, health insurance, and retirement contributions may be deductible.

  
  

S corps are easy to form, benefit from pass-through taxation, and protect the owner from personal liability. However, more limits are placed on shareholders, and owners can only create one class of stock. You can use this S-corporation tax calculator to estimate taxes.

C Corporation

A C corporation (C corp) is a separate legal entity from its owners, offering the most liability protection but with double taxation. Owners have nearly no liability for the company’s debts. Factors to consider include:

• Taxes. C corps pay corporate income tax on profits, and shareholders pay taxes on dividends.

• Benefits. Lower corporate tax rates (21% as of recent years) and the ability to deduct employee benefits.

  
  

C corps are suitable for larger businesses planning to reinvest profits or attract investors. They can have multiple classes of stock and unlimited shareholders.

Tax Implications of Converting LLC to Corporation

There are significant tax implications when converting an LLC to a corporation, but much depends on whether you elect to become an S or C corporation. 

LLC to C Corp

Converting to a C corporation may benefit businesses seeking outside investors or planning an IPO. However, it also introduces double taxation. When an LLC converts to a C corp, it becomes a separate tax-paying entity subject to corporate income tax. This can result in double taxation. Read about key things to do after forming an LLC. 

LLC to S Corp

An LLC to S corp conversion allows business owners to reduce self-employment taxes while maintaining pass-through taxation. Owners must also follow stricter IRS rules. The IRS may also consider the conversation a taxable event, triggering capital gains tax if the LLC’s assets appreciated in value. Consult a tax professional or other financial advisor before converting your LLC to a corporation. You should also consider working with a registered agent for your LLC.

How Do I Change My Business Structure with the IRS?

If your business needs a different tax structure, the IRS allows you to change it by filing the appropriate forms. Some relevant forms include:

• LLC to S corp—file Form 2553 to elect S corp taxation

• LLC to C corp—file Form 8832 to elect to be taxed as a corporation, a partnership, or an entity disregarded as separate from its owner

• S Corp to C corp—file a letter with the IRS to revoke the S corp election

  
  

Changing your business structure has additional various state and federal requirements. It can also have long-term tax and legal consequences. Seeking professional guidance is advisable.

Choosing the Best Business Structure for Taxes

Selecting the best business structure for taxes is crucial to your financial success and depends on your specific financial situation, growth plans, and tax-saving strategies. Considerations of personal liability, tax obligations, growth goals, and filing ease can all help you make an advantageous determination.

Whether you are considering forming a new business or converting an existing one, consulting with a tax professional can help you optimize your tax savings and compliance. 

Bizee can help streamline your business’s formation or conversion process. We have helped over 1,000,000 entrepreneurs jumpstart their businesses—and we would be happy to help you, too.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.