Which Corporate Tax Structure Is Right for Your Business?
When forming a new business, it's important to understand the different tax structures – and tax advantages – available to you.
When determining the legal structure that best suits your business, it's important to consider the tax implications. Your business's structure will determine when, how, and how much you pay in taxes.
The tax advantages of one business structure over another aren’t as straightforward as one might hope. Some entities pay more taxes (and deal with more paperwork), but enjoy flexibility in other aspects. Here, we’ll break down a comprehensive overview of different business entities and their tax advantages.
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What is a Business Legal Structure?
A business legal structure is a classification assigned and recognized by the government to regulate its various aspects, including taxation at the federal and state levels. For example, non-profit corporations pay fewer federal and state taxes and enjoy more credits than for-profit corporations. Ultimately, the legal structure you choose for your business can save you a substantial amount in taxes and other tax-related complications.
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Tax Advantages of Common Business Structures
Here is a comprehensive overview of the tax advantages of nine common business legal structures:
A sole proprietorship is the simplest business structure, but it is not a separate legal entity. Some of the most notable tax benefits of a sole proprietorship include:
- Simple paperwork – A sole proprietorship's tax returns are included in the owner's personal tax returns. The government considers the business an extension of yourself and assumes that you pocket all of the profits, effectively merging your business and personal income taxes.
- Business expenses, deductions, and tax credits – You can also deduct a wide range of business expenses from your taxes, like startup costs (think leading equipment, advertising costs, etc.) Besides deductions, sole proprietors can also qualify for R&D tax credits for small businesses.
- Self-employment tax deductions – Sole-proprietors are required to pay self-employment taxes. These are essentially contributions to Medicare and Social Security. Fortunately, they can deduct up to 50% of the contributions from their personal taxes.
A partnership is a business entity with two or more co-owners. Partnerships are categorized into two types: general partnership and limited partnership. All partners have unlimited liability in a general partnership, while only limited partners (not actively involved in the company's management) have limited liability proportional to their investment.
Some of the most notable tax benefits of a partnership include:
- Pass-through tax entity – A partnership is a pass-through entity, meaning that profits, losses, and credits flow directly to the owners. The company doesn't pay income tax. Instead, the company's owners pay taxes on their share of the profits with their personal tax returns, regardless of whether or not they take a salary.
- Tax-free property transfers – Most distributions and contributions to partnerships are usually tax-free. Family limited partnerships also allow parents to transfer limited partnership interest shares to their children at reduced gift and estate tax rates.
- Special allocations – Partnerships can split ownership and income rights in any arrangement, making it possible to reduce one partner's tax obligations. However, section 704(a) of the Internal Revenue Code has provisions against exploiting this feature for tax fraud purposes.
Limited Liability Company (LLC)
A limited liability company (LLC) essentially is a corporation formed at the state level. It is similar to a corporation in the sense that owners enjoy limited liability. However, LLCs are not classified under the IRS, enabling them to choose their preferred tax classification – LLCs can be taxed similarly to sole proprietorships, partnerships, C-Corporations, or S-Corporations.
Some of the most notable tax advantages of an LLC include:
- Tax deductions – An LLC's owners and shareholders can deduct a wide range of the company's business expenses from their personal tax returns. Unlike corporates, they are also allowed the Qualified Business Income deduction, which is 20% of the company's net income (or 20% of their share of the profits).
- Avoiding double taxation – LLCs do not pay taxes (unless you choose to have your LLC classified as a corporation). Instead, they serve as pass-through entities, whereby owners and shareholders pay personal taxes on their share of the profits.
- Avoiding corporate franchise tax – Corporations must pay a corporate franchise tax in every state in which they operate. However, LLCs can avoid this tax in some states.
A C-corporation fits many definitions. For the sake of this example, it’s any business entity that is taxed separately from its owners – essentially, it is a separate legal entity that can own property and enter into contracts. C-corps are usually publicly traded companies with shareholders.
Some of the most notable tax benefits of a C-Corp include:
- Low tax rates – The 2018 tax reform bill lowered corporations' tax rates to 21%, which is lower than most other business entities' tax rates. C-corps can also save more on taxes if they don't pay out regular dividends.
- Writing off bonuses and salaries – C-corps' shareholders can draw salaries and bonuses from the company like ordinary employees. Shareholders' salaries are subject to payroll taxes, but the C-Corp can deduct its share of payroll taxes. Interestingly, C-Corps can pay its employees enough so that it doesn't have taxable profits remaining by the end of the fiscal year.
- Carrying profits & losses forward and backward – Unlike LLCs and S-Corps, C-Corps can determine their preferred fiscal year by deciding when to pay taxes on bonuses or deduct losses. Thus, they can reduce their tax bills and shift their income to free up cash flow.
- Deductions – C-Corps can deduct 100% of their medical premiums and other benefits as long as they are equally available to all shareholders and employees. They can also write off charitable donations.
An S-Corp is not a business legal structure or separate legal entity. Instead, it is a tax status that LLCs and some corporations can choose. Some of the most notable tax advantages of an S-Corp include:
- Pass-through taxation – This means that the company and its shareholders can avoid double taxation. Shareholders can draw tax-free dividends.
- Shareholder benefits – Shareholders can also pay themselves reasonable salaries for services rendered to the company. Interestingly, shareholders can reduce their tax liability by drawing more dividends than salaries.
- Accounting for cash – S-corporations enable the cash method of accounting, making this tax status ideal for businesses that deal mainly with cash.
A close corporation is a privately-held corporation owned by a limited number of shareholders. Essentially, close corporations are state-specific statutory entities. Interestingly, most close corporations are formed to ease the tax requirements set on other business legal structures. Close corporations can elect to be taxed as C-corporations or S-corporations, enabling them to enjoy either tax status's benefits.
Benefit Corporation (B-Corp)
A benefit corporation (B-Corp) is a corporation whose main objective is to benefit the environment or society. B-Corps must pass a certain social and environmental standards in order to gain this distinction. They must also meet additional standards around accountability and transparency for most aspects of their business, from employee benefits to supply chain management.
This type of corporate structure has gained popularity in the past few years, especially as more mission-based businesses opt to practice what they preach. Not to be confused with non-profits, B-Corps are still for-profit companies and are taxed accordingly. They do not enjoy any special tax benefits compared to other business legal structures; instead, B-Corps are subject to thorough audits into their finances and ethical standards. However, you can elect an S-Corp tax status for your benefit corporation.
Certification as a B-Corp is less about tax advantages and more about cementing a business’s legal status as a company committed to doing good.
As the name suggests, a non-profit corporation is an organization whose primary goal isn't to make a profit. Instead, such organizations exist to achieve community-related goals, such as housing the homeless or environmental sustainability.
Some of the most notable tax advantages of non-profit corporations and organizations include:
- Tax exemptions – Non-profit corporations and organizations are exempt from most federal, state, and local taxes. For example, non-profit organizations that operate for the community's benefit are exempt from corporate income taxes at the federal and state levels.
- Tax credits & deductions – Non-profit organizations are still subject to some taxes at the federal, state, and local levels. Fortunately, they are also eligible for many tax credits and deductions that can drastically lower their due taxes. For example, qualifying for the R&D tax credit is especially easy for non-profit corporations engaged in scientific research.
Essentially, a cooperative is an enterprise founded and run much like a democracy. It is owned by a group of people who pool their resources to form an enterprise that benefits their common interests. The cooperative's leaders are elected through a one-person-one-vote system.
The main tax benefit of a cooperative is that its members are subject to limited income tax. This means that members are not charged income tax on profits drawn from the cooperative unless it exceeds a certain amount. However, it is worth noting that cooperatives that operate to make profits are taxed like ordinary businesses.
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Every Entity Has Its Own Tax Advantages
Most business entities have their share of tax benefits. Ultimately, the legal structure you choose for your business will depend on your tax preferences. Perhaps you want to form a sole proprietorship to avoid paying separate personal and business taxes. Maybe an LLC is more suitable if you want to enjoy lower tax rates and the ability to carry your profits and losses forward.
Interestingly, all business entities are eligible for tax credits. Unfortunately, up to 97% of startup tax credits usually go unclaimed. This is where MainStreet comes in. We help simplify the process of identifying and claiming credits on your behalf. We take on the qualification and claim process while passing the savings onto your business.