One of the most important decisions you make when starting your business is how you want to structure your business entity. Of course, the tax benefits aren't the only factor to consider in choosing your entity, but minimizing your tax liability can be the difference between success and failure for your business.
Sole Proprietorships and S Corps
Sole proprietorships are the simplest form of business entity because you're essentially working for yourself. As a sole proprietor, you are totally in charge of your business, and are also subject to personal liability. However, a sole proprietorship's existence is limited to your lifetime, which can make estate planning more difficult.
An S corporation is a registered corporation that meets certain conditions and has made a special election to be taxed as a pass-through entity. This means that the S corporation income is reported as part of each shareholder's personal income tax return rather than being subject to the corporate tax. Other than the difference in taxation, an S corporation is treated the same as any other corporation, such as having limited liability and indefinite lifespan. The indefinite lifespan is useful in passing on the business to your heirs.
Read More: The Advantages and Disadvantages of Sole Proprietorships, Partnerships & Corporations
Taxes on Sole Proprietors
Sole proprietors must report all of the business income on their own income tax return as self-employment income. All income, less any business deductions, is subject to both self-employment taxes and ordinary income tax rates. The self-employment tax includes the 10.4 percent Social Security tax, which only applies to a specified amount of income, and the 2.9 percent Medicare tax, which applies to all self-employment income. Ordinary income taxes are progressive and can reach 35 percent, as of 2012.
Taxes on S Corp Income
When you organize your business as an S corp, you only have to pay yourself a fair salary for the work that you perform. Any additional income that you receive counts as capital gains income. This difference is significant because the wages are subject to FICA taxes, which total 13.3 percent between the employee portion and the employer portion, as of 2012, as well as ordinary income tax, with rates as high as 35 percent as of 2012. Capital gains income, on the other hand, is taxed at a maximum 15 percent tax rate. This is a significant advantage that may make it worth your time and expenses to incorporate and make the S corporation election.
Tax Filing Requirements
If you operate your business as a sole proprietor, you have fewer tax forms to file because you just report the income on your personal income tax return with Schedule C. With an S corporation, the business must file a Form 1120-S to document the business income and expenses. In addition, the business must file a Schedule K-1 for each shareholder to document the amount of income and expenses the shareholders must carry over to their individual income tax return. A copy of the K-1 must be sent to the IRS and the shareholder. Depending on the size of your business, any tax benefits of an S corporation may be offset by the additional costs of filing the extra tax forms.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."