Tax Efficiency 101: Choosing the Right Business Entity for Your Goals

Have you ever thought of starting your own business?? If the answer to this is yes, then there are some things you should consider when deciding what kind of business you want to start.? Now I’m not talking about what goods or services you want to provide; I mean what kind of business entity you should create to help you achieve your business goals.

Choosing what kind of business entity to create for your business is an important decision that needs you to consider your company's size, industry, growth prospects, and long-term objectives. Understanding how this would affect your taxes is crucial for maximizing your tax advantages and mitigating the disadvantages.?

Obviously, I would recommend talking to a tax professional before making any decision, but here is a very simplified explanation of some advantages and disadvantages of different business entities.? For tax purposes, you need to decide between four different types: C Corporation, S Corporation, Partnership, or Disregarded Entity.

C Corporation:

Most people will tell you that C Corporations are usually more suitable for larger companies and those planning to reinvest profits and this is generally true but it’s a bit of an oversimplification.? C corporations are the only entities that are taxed at the business level.? All the other entities pass their income and losses through to their owners and the owners are taxed instead.? Because of this, you need to consider exactly what you want from your business before deciding to form a C corporation. ?

? Tax Advantages:

o?? Shareholders are not taxed for the corporation’s income.

o?? C Corporations may have a lower tax rate than the individual shareholders.

o?? Earnings can stay within the company to be reinvested or expand the business.

o?? Employee shareholders are eligible for tax-free employee benefits.

? Tax Disadvantages:

o?? Double taxation: The corporation pays an income tax and then when it is distributed to the shareholders, it is taxed again as income to the shareholders.

o?? C Corporations have complex compliance requirements and record-keeping obligations.

o?? C Corporations are subject to employment taxes as well as income taxes for employee shareholders.

S Corporation:

Generally, S Corporations are best for people who want to create a small to mid-sized business.? However, it still depends on your situation. Income from S corporations passes through to the shareholders instead of staying within the business, but they also have a lot of the advantages of C corporations. For example:

? Tax Advantages:

o?? Pass-through taxation, meaning business income and losses "pass-through" to shareholders who report them on their individual tax returns.

o?? No double tax on income earned by the S corporation.

o?? Avoidance of double taxation, as only individual shareholders pay taxes.

o?? Employee shareholders are not generally subject to self-employment tax.

o?? Shareholders can use business losses to offset personal income.

o?? Employee shareholders are eligible for tax-free employee benefits.

? Tax Disadvantages:

o?? Strict eligibility criteria and restrictions, such as having fewer than 100 shareholders, one class of stock, and a U.S. residency.

o?? Limited flexibility in allocating profits to shareholders.

o?? S corporations are subject to employment taxes as well as income taxes for employee shareholders.

o?? Shareholders are personally liable for the S corporation’s tax liabilities.?

Partnership:

Partnerships are an old business structure but aren’t generally used as much anymore.? Generally, partnerships are ideal for business owners who need a more flexible structure in the business.? S Corporations and C corporations are highly regulated meaning if your business partners have a complex business relationship, a partnership might be a better option for you.

? Tax Advantages:

o?? Pass-through taxation enables profits and losses to flow through to the individual partners.

o?? No double tax on income earned by the partnership.

o?? Profit distribution is flexible because it is based on the partnership agreement.

o?? No employment taxes for partners that perform services for the partnership.

o?? Partners can use business losses to offset their personal income.

? Tax Disadvantages:

o?? Partners are personally liability for the partnership’s taxes.

o?? Management of the partnership and the partnership agreement can make things pretty complex.

o?? Partners are subject to self-employment tax.?

Disregarded Entity:?

A Disregarded Entity is an excellent choice for small business owners and sole proprietors who value simplicity and direct control over their business operations. Disregarded entities are essentially partnerships but with only one owner.? In the tax world, you can picture it as if the business were your right arm, meaning it is seen as a simple extension of you and taxed accordingly.

? Tax Advantages:

o?? Simplicity in business structure, as it's not treated as a separate entity for tax purposes.

o?? Pass-through taxation, where profits and losses flow directly to the owner's individual tax return.

o?? Flexibility in decision-making and management.

? Tax Disadvantages:

o?? Unlimited personal liability, as there's no legal distinction between the business and the owner.

o?? Limited options for retirement savings and benefit plans.

Bonus Tip

One question that always comes up when I talk to clients is “But what if I want an LLC?” And this is a legitimate question.? To this, I always say that you can have both an LLC and choose which tax entity is best for you.? It’s one of those rare times in life where you get to have your cake and eat it too.?

An LLC is a state business designation and has a lot of business advantages if you have a small business, but it isn’t a tax designation.? If you form an LLC, you still need to choose whether you want your LLC to be taxed as a C corporation, S corporation, partnership, or disregarded entity. You simply need to “check the box”.

The decision to opt for a C corporation, S corporation, partnership, or disregarded entity should be based on your unique business needs and financial goals. I would suggest, as I always do, that you consult with a tax professional to see which is the best choice for you and your business. This way you can maximize your tax benefits and minimize any potential drawbacks.