Starting a business involves making many decisions. One of the most significant is choosing the right business formation.
Each type of business structure has its own tax implications, which can greatly impact your finances.
1. Tax treatment of profits and losses
Taxes vary for different businesses when it comes to profits and losses. For example, sole proprietorships and partnerships are pass-through entities, meaning the profits and losses “pass-through” to the owners and are part of their personal tax returns. This can simplify tax filing and potentially result in lower overall taxes. On the other hand, taxes are separate for corporations from their owners, potentially leading to double taxation.
2. Self-employment taxes
Self-employment taxes, which fund Social Security and Medicare, can be a significant burden for business owners. Sole proprietors and partners are subject to self-employment taxes on all business income. However, owners of corporations may be able to minimize self-employment taxes by paying themselves a reasonable salary and taking the remainder of their income as dividends, which are not subject to self-employment taxes.
3. Fringe benefits
The type of business structure you choose can also affect the availability and tax treatment of fringe benefits, such as health insurance, retirement plans and other employee benefits. For example, owners of corporations may be able to deduct the cost of health insurance premiums as a business expense, while sole proprietors may only be able to deduct a portion of these expenses on their personal tax returns.
While 52.4% of small businesses with employees opt for an S-corporation structure, a different formation may be more beneficial for non-employer firms. Understanding the different tax implications can help business owners make informed decisions and set their businesses up for success.