Use the Appropriate Tax Status for Your Business Phase and Entity.

The words “entity” or “status” of your business may be used in two ways:  (1) to describe the legal entity of your business (sole proprietor, partnership, LLC, S-Corporation, C-Corporation) or, (2) to describe status of your business for tax purposes (pass-through or corporation).  In the following post we will be discussing which legal entity is appropriate for your business for asset protection purposes; here, we are evaluating what status you should be using for tax purposes. 

Generally, either a business is a pass-through tax entity or it is taxed as a corporation.  If a business is pass-through, the profits or losses are passed-through to the tax return of the owners.   The owner owes taxes for any profits, even if those profits are not actually taken home by the owner.

If the business is taxed as a corporation, the corporation files its own tax return and pays taxes on its profits.  Money may be paid to owners as salaries for work performed and the owner will pay taxes on his/her salary, just like any employee.  Other money may be paid to owners as dividends on their stock and the owner will pay taxes on dividends, just like any dividends received on stock. 

Some legal entities can be treated as either a pass-through or a corporate tax entity.  For example, a Limited Liability Corporation (LLC) with one owner can be a pass through tax entity (Schedule C on a 1040) or can be taxed as a corporation (owner-as-employee get a W-2, and business files a separate corporate tax return).

Determining an appropriate tax status depends upon where you are in the development of your business. 

• Does your business make a profit, or it is still in the start-up (unprofitable) phase? 
• Is your business paying you about the same as you would make as an employee, or are you now making profit on top of what a salary would be? 
• Are you on the edge of going from five figures to six figures or more in the next tax year?
• Will you be distributing the profits of the business to yourself (and your partners), or will you be reinvesting funds back into the growth of the business? 

If your business is unprofitable, then you want a pass-through tax entity for your business so you can deduct the loss against your earned income from your employer, other businesses, or your spouse’s income.  In that case, if you are a one-owner business, you want a sole proprietorship, an LLC, or an S-corporation.  If you have two owners, you should elect a partnership, LLC, or S-corporation.  To use the loss as a deduction against your other income, you must be materially participating in the business, and must satisfy other requirements. 

If your business pays you an amount that would be a typical salary or less for someone in your profession, then you may be well off with an LLC.  Using an LLC, under current rules, your income will be subject to both income tax and self-employment tax (the replacement for social security and FICA usually paid by an employer).

But if your business is paying you profits more than what you would be paid as a salary in your profession, you may want to use an S-Corporation.  As an S-corporation, under current rules, you will be able to distribute your above-salary profits as a stock dividend, and will not pay self-employment taxes on those profits.   

If your business makes a profit, and you want to retain some of the profits inside of the corporation for growth and expansion, you may want to use a C-corporation instead of a pass-through tax entity.  The profits a C-corporation keeps inside the business are subject to corporate tax, but not to personal income tax or self-employment tax.  If a business keeps too many profits inside the corporation, the retained profits may be subject to additional taxes. 

Once your business graduates from an unprofitable pass-through tax entity to a profitable & growing business, you will want to retain a CPA or other financial or tax advisor to help you choose the entity that is the most appropriate for your specific tax needs and goals.

The above article is an excerpt from Grow Up! Strategies:  The 7 Legal & Financial Strategies You Need to Up-Level Your Small Business (2008).

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