Forming a business entity is a significant milestone. After you’ve finalized your business idea and plan, the next step is to select your business entity. There are several business entities that you can choose from, each with its own set of advantages regarding tax savings.
Here is a description of each major business entity and its tax benefits.
A C-Corporation, or C-Corp, offers several tax benefits to its members or shareholders.
Corporate shareholders don’t pay taxes on corporate income. Instead, they receive dividends, which are then taxed. The type of taxation will depend on whether it is short-term or long-term.
Corporate tax rates are lower than in previous years. As of the tax year 2018, the corporate tax rate decreased from a maximum of 35% to a fixed rate of 21%.
For most shareholders, the capital gain tax rate will never be over 15%, and if the capital gain is under $78,750, the taxable income is 0%. Individuals earning more than this amount will pay 20% as a capital gains tax rate.
The second benefit of C-Corp tax rates is state tax rates. Some states no longer have a corporate tax requirement. Since the year 2012, states have ended the requirements. As of 2020, more states have made tax rate cuts.
For tax purposes, the IRS considers single-member LLCs a disregarded entity, which means that the IRS will consider your LLC separate from you as an individual for tax purposes.
If you’re part of an LLC with multiple members, then you can elect to have your LLC taxed as a:
- S-Corp (must use Form 8832)
- Sole proprietorship (must use Form 1120-S)
LLCs can also pay taxes as a corporation if they select this process.
A partnership offers several tax benefits for partners. They offer advantages not only with income tax but also with health care premiums and tax deductions.
Health care premiums can be deductible on an individual partner’s tax return. Health Care Tax Credits are also available for partnerships.
These tax credits can apply for up to 35% of individual premiums contributed to employee health care premiums.
Partnerships qualify for tax deductions, such as the Self-Employed Persons Individual Retirement Account (SEP-IRA). As of the tax year 2020, the SEP-IRA limit is $57,000, and these contributions are tax-deductible.
Members of an S-Corp, and LLCs electing taxation as an S-Corp, will experience pass-through taxation. Pass-through taxation means that shareholders will receive a Schedule K-1 and pay their share of federal income taxes on their personal tax return.
S-Corp shareholders may be eligible for income deductions. As of the tax year 2018, shareholders can apply for a Qualified Business Income deduction. The Qualified Business Income deduction allows for up to a 20% deduction on top of any other eligible deductions.
Like partnerships, sole proprietorships offer tax deductions. Sole proprietors will use Schedule C to determine their expenses for income tax, including:
- Business operations
- Business training
- Costs of goods sold
Sole proprietors can also claim deductions for small business expenses, such as home office space costs. Sole proprietors can also contribute to their SEP-IRA, with the same limit of $57,000 for the upcoming tax year. However, sole proprietorships, again, like partnerships, have 100% tax-deductible contributions.
Like partnerships, sole proprietorships are also eligible for the same health care premiums, income tax benefits, and other deductions. Sole proprietorships also allow individuals to use their personal tax returns to pay individual taxes.
Work With the Professionals
Choosing the right business entity for your small business is a crucial step towards establishing your business legally. Rather than doing it on your own, consult with professionals who can guide you through the process. Tax professionals can answer all of your business entity questions and do the heavy lifting when preparing your small business taxes.