You’ve done it! You’re a self-made entrepreneur!
After all of your hard work, you’ve even managed to get enough customers in your first year of business to turn a small profit. Now is the time to focus on growing into a steam-rolling machine and take over the industry, right? Almost.
There is one area that desperately needs your attention before you’re stuck with a large tax bill:
What entity structure should your company adopt?
Almost all companies begin as a sole proprietorship, however, few companies remain that way after the business takes off due to the high taxes assessed on the income.
Income from your sole proprietorship will be reported on your individual income tax return (IRS Form 1040, Schedule C). This first $118,500 of income will be subject to self-employment taxes of 15.3% (2.9% thereafter), as well as income taxes, which range from 10-39.6%, depending on what bracket your income falls in.
In addition, since the implementation of the Obamacare act, self-employment income in excess of $250,000 is subject to an additional Medicare surtax of 0.9%.
There is little difference in taxation if your business is formed as a partnership (including limited liability companies). The income will be subject to self-employment tax, income tax, and the Medicare surtax. Additionally, you will be required to file a partnership income tax return (IRS Form 1065), which comes with costs of its own, both for tax preparation and for the California franchise tax assessed.
Limited liability companies are assessed an LLC Fee by the California Franchise Tax Board, which can range from $900-11,790, based on the gross income of the entity. Limited partnerships and limited liability partnerships are assessed an $800 franchise tax. General partnerships are not subject to a franchise tax. Business owners typically form a partnership for liability protection or due to the flexibility in how the profits and losses can be allocated between partners.
Corporations can take two different shapes. The first of which, S-Corporation, is taxed similarly to sole proprietorships and partnerships. S-Corporations file their own income tax returns (IRS Form 1120S). The income from the S-Corporation is reported to the owner on a form Schedule K-1, which then is reported on their individual income tax return. The income is subject to only income taxes, and escapes the reach of self-employment tax and the Medicare surtax.
The owner is required to pay himself a reasonable salary, which will differ based on the type of business and how much income is generated. The wages paid to the owner will be subject to self-employment tax (the employer portion paid through the entity and the employee portion paid from the wages).
C-Corporations are their own being that must file its own tax return (IRS Form 1120). The income is subject to corporation tax rates of 34% for federal and 9.3% for California. The income does not flow through to the owner’s individual income tax return. As with the S-Corporation, any wages paid to the owner would be subject to self-employment tax with the business paying the employer portion.
Additionally, any income the owner receives from the business that is not subject to payroll taxes will be double-taxed (in the corporation and on the owner’s individual income tax return).
See the chart below which compares the tax implications of different entity structures for a married taxpayer with $1,000,000 of gross income, $200,000 of net income, and $100,000 of wages from their company. In the C-Corporation case, the $200,000 of net income was paid out as a dividend to the shareholder to reflect the availability of net income funds represented in the other scenarios.
|Self-Employment Tax (on personal return)||$8,094||$8,094||$0||$0|
|Federal Income Tax (including personal and business returns)||$66,395||$66,395||$67,731||$102,687|
This article only addresses the tax implications of your business’s entity structure. There are many legal reasons for choosing one entity structure over another that may be more imperative to your business than the taxes you will owe.
The examples used are oversimplified and are provided to present a general comparison.
Contact a certified public accountant to assist you with evaluating the tax implications based on your specific situation, as many other items of income may drastically change the comparison. This article was written by Emily Banks Accounting Manager at Clark & Company, Certified Public Accountants based in Irvine, California.