It'll affect your taxes and your liability
How to Decide What Business Form Your Side Gig Should Take
by Kate Zhang
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Are you a small business owner or have a side hustle but are not sure which form of entity your business should be in to save on taxes?
If so, then this article is for you. The type of entity you choose for your small business can have a big impact on your tax bill. In this post, I will talk about the tax implications of a sole proprietorship, corporation, and LLC.
Sole proprietorship is the default form for your business if you don't file for a formal structure.
There's no distinction between the business and you, the owner. All the business income and expenses are considered to be your income and your expenses. Your business income and expenses are reported on your Form 1040 Schedule C (Profit or Loss from Business).
You need to pay self-employment tax on all your business net earnings, if you have net earnings from self-employment of $400 or more. Self-employment tax rate for 2016 is 15.3% on the first $118,500 of net income and then 2.9% on the net income that is in excess of $118,500. This is reported on Form 1040 Schedule SE (Self-Employment Tax).
Depending on your tax bracket and amount of self-employment taxes, you might end up paying more in taxes as a sole proprietor than an owner of a corporation. In this case, creating a C corporation, S corporation, or LLC that's taxed like an S corp or a C corp could help lower your tax bill.
Additionally, sole proprietorship does not offer legal protection over your personal assets against debt and liability of your business.
A corporation offers protection over your personal assets.
However, to form a corporation, certain legal formalities must be observed and you need to comply with various regulatory reporting requirements. Compliance with these formalities often comes with significant legal costs.
A corporation can be taxed as an S corporation or a C corporation.
A corporation can elect to be taxed as an "S corporation."
For an S corporation, both income and losses are going to be passed along to you and reported on your own personal income tax returns, though you also need to file Form 1120S (U.S. Income Tax Return for an S Corporation) annually for the S corporation for information reporting purposes.
In an S corporation, only the wage you pay yourself is subject to self-employment tax. This creates substantial savings in self-employment tax if you actively work in the business because in a sole proprietorship, all your business's net earnings are subject to the self-employment tax.
For example, if your share of the S corporation income is $100,000 and you pay yourself a wage of $50,000, you will owe the 15.3% self-employment tax on the $50,000 but not on the remaining $50,000. However, the wage you pay yourself can't be artificially low and needs to be reasonable.
Unlike a sole proprietorship or an S corporation, a C corporation is taxed as a separate business entity from the business owner. This means that as an owner of a C Corporation, you'll need to file a personal tax return and business tax return for your C corporation, Form 1120 (U.S. Corporation Income Tax Return), each year.
Double taxation - If your business is structured as a C corporation, first, the business will be taxed on its profits. Then, if you decide to take some of those profits home, you'll have to pay taxes on those distributions on your personal tax return.
So there can be two levels of tax on the same income. This double taxation issue can lead to higher taxes if you want to take home the company profits.
Losses - Additionally, because a C corporation is considered to be a separate entity, losses from your C corporation can only be used to offset the corporation's income, while in an S corporation or a sole proprietorship, you can use the company losses to offset your personal income.
So if your business is losing money, it is better to consider an S corporation or a sole proprietorship than a C corporation.
Income splitting - However, a C corporation can be very tax efficient due to the so called income splitting.
A C corporation is taxed separately and has its own graduated rates. For the first $50,000 taxable income, the C corporation's tax rate is 15% compared to your individual tax rate.
The wage you pay yourself increases your personal taxable income and reduces the C corporation's income taxed at corporate tax rates. Similarly, if you pay yourself less wage and leave the profits in the C corporation, your personal taxable income will decrease while the C corporation's taxable income will increase.
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Let's say your company makes $100,000 in profit this year and your individual tax rate is 25%. Instead of paying yourself $100,000 and getting hit with a $25,000 tax bill, you can pay yourself only $50,000 which is taxed at $12,500 and leave $50,000 in your C corporation which is only taxed at 15% for $7,500. You save $5,000 in tax by income splitting.
Additionally, because when you receive wage from the company rather than taking the profit home, the wage can be used to reduce the C corporation's income and it is only taxed once as your personal taxable income. This way, you can avoid double taxation.
Deductions - Another benefit of a C corporation is that it can deduct certain benefits like medical, life insurance, education, child care, and retirement plans from its business income without limitation, while owners of S corporations are limited in the amount they can.
If a retirement plan or saving on your medical insurance is important to you, you might want to consider a C corporation instead.
Limited Liability Company (LLC)
The LLC is a hybrid between a sole proprietorship and corporation. By default, a single-member LLC is taxed similar to the sole proprietorship, but you can choose to be taxed as a C corporation or an S corporation.
It's great for small businesses because it offers the personal liability protection of a corporation with a minimum of paperwork and formalities, and you have the flexibility of choosing how your business should be taxed.
Choosing the right entity for your business can create substantial tax savings. Do you have a small business or a side hustle? What entity form did you choose for your small business? How are you doing on taxes for your small business?
Kate is a tax lawyer. Since entering the workforce, Kate has been enjoying a six-digit increase in her net worth every year from aggressive saving, sensible investment strategy, and efficient tax planning. In her free time, Kate shares tax saving and money tips on her blog TaxOptimizedInvestment.com to help people save on taxes and reach financial independence.
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