Starting a new business will be one of the most stressful but exciting times of your life. There are many questions to consider, for example, how will you get funding? How many employees will you need? How will you market your product or service? One definite during this time of many unknowns is that properly structuring your business can save you thousands of dollars in taxes as well as possible legal headaches down the road.
When starting your new business, one of the first decisions you will have to make is how to structure your new venture. You can simply report all your income under your own social security number as a sole proprietor on Schedule C of your income tax return. Alternatively, you can begin by creating an LLC and choose your method of taxation. It is important to discuss the pros and cons of the various tax structures with your accountant.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a simple business structure that allows you to reduce your liability. If someone was injured due to a faulty product or procedure and was seeking damages, your personal assets are not at risk. If you do not commingle personal and business funds, your liability is limited to the assets within your business.
Another important aspect of creating an LLC is the flexibility in tax structure. While your company is in its infancy, you can simply remain as a sole proprietor (you only report your income and expenses on your Schedule C) while still maintaining your limited liability status. This will keep down your reporting costs, cut out the need for payroll for shareholders, and allow you to streamline the tax reporting process.
As your business grows and your income level increases, you may want to consider having your business taxed as an S corporation. An S corporation allows you to report your income and expenses on a separate business tax return (an 1120S). This may allow you to have an additional layer of anonymity.
Although you are required to pay any active shareholders a “reasonable” salary, your net income is not subject to the self-employment taxes (the employer and employee portions of social security and Medicare taxes). For example, if you have $50,000 of net income as a sole proprietor, you will be required to pay $7,650 in self-employment taxes. However, say you report as an S corporation and pay yourself a reasonable salary of $30,000. You would only have to pay the 15.3% self-employment taxes on your salary ($4,590). As you can see, you would save over $3,000 in taxes just from this simple example!
As an LLC owner, you can also decide to tax your business as a C corporation. From a tax perspective, C corporations are very undesirable due to the concept of double taxation. Corporate profits are taxed at a rate of approximately 35% while dividends paid to shareholders are taxed at their own personal tax rates. Although the C corporation has a more complicated tax structure, it allows more flexibility when admitting shareholders.
Starting a new business in this entrepreneurial climate can be very stressful and rewarding. There are many factors to consider when opening your business and one of the most important items is determining the proper legal and tax structure for your business. As you can see, status as an LLC and proper tax structure can possibly save you thousands of dollars in taxes as well as legal headaches. You should consult with your trusted tax advisor to discuss your unique tax situation and determine the best methods for you.