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The Wrong Business Entity Can Cost You Thousands in Additional Taxes

  • Posted by Michael Beauchemin on Thu, Oct 04, 2012 @ 03:10 PM

    When setting up a business, you have a choice of what type of business entity you would like to select.  Each business entity has its advantages and disadvantages.  The best business entity for you largely depends on several factors: Your personal tax situation, the income and size of the business, future plans for the business, your residency or US citizenship status.  These are just a few factors that go into determining what business entity is best for you.  Here are the basics on each business entity.

    Sole Proprietorships

    • The simplest structure of all choices.
    • The owner, if he has no employees, will have no payroll, or payroll tax reports to worry about. 
    • The owner cannot take W2 wages.
    • There is no year-end corporate tax return or partnership return to file and business Income is reported on the owner’s personal tax return.
    • The owner will have to pay self-employment taxes on the income earned from the sole proprietorship.
    • The owner will have to track net income carefully and pay estimated quarterly taxes based on the net income of the business for that quarter.  If the owner does not pay any estimated taxes or under pays during the year, there may be a penalty for under payment of income taxes.  The owner may also have to write a large check.   
    • Total Taxes (federal, state, local and self employment taxes) from the business, can total up to 60% of the net income of the business.  The amount of taxes you owe depends on your personal income tax bracket and the state income tax you are liable for.    

    For example

    • Assume you did not pay any taxes during the year and your business generated $50,000 in income.
    • The self-employment taxes would be (13.3%) $7,650;
    • Federal taxes at the 15% tax bracket would be an additional $7,500;
    • Assume you live in a state with a state income tax rate of 7%.  The state tax is an additional $3,500. 

    In this example, on only $50,000 of business income the total for federal, state and self employment taxes is $18,650.  This example assumes a low federal tax bracket and does not include a penalty for underpayment of taxes.    

    Partnerships

    • Commonly used in real estate ventures and other passive income generating activities since passive income is not subject to self employment taxes.
    • A Partnership, like a Sole Proprietorship, if it has no employees, will have no payroll, or payroll tax reports to worry about. 
    • A Partnership return is required and the income earned for each partner is reported on a K1.
    • The income for each partner is based on his or her percentage of the partnership. 
    • Each partner is required to report the income earned from the partnership on his or her personal tax return.
    • If the business is not a passive income generating venture, the income is subject to self employment tax.  the partner pays self employment tax based solely on his or her share of earnings.
    • The federal tax rate for the partner, like a sole proprietor, depends on the personal tax bracket for that individual. 
    • The total amount of taxes that each partner pays can be vastly different.  One partner may be in a federal tax bracket of 15% while another parter may have additional earned income outside the partnership causing him to be in a 35% tax bracket.
    • Like a Sole Proprietorship, each partner will have to track net income carefully, and pay estimated quarterly taxes. If a partner does not pay estimated taxes or under pays, he or she may have to write a sizable check when the return is filed. 
    • Like a Sole Proprietor, a Partner can have a tax liability of 25% to 60% of the net income of the partnership.    

    S Corporation

    • An S corporation is one that passes corporate income, losses, deductions and credits through to shareholders for federal tax purposes.  In other words, the earnings or losses by the S corporation, are passed through and recorded on an owner’s personal tax return.  
    • The owner pays taxes on the earnings based on his or her own personal tax rate.  
    • Unlike a Partnership or Sole proprietorship, an owners of an S Corporation must, by law, take a reasonable and customary salary. 
    • This type of entity allows the owner to take W2 wages and have income tax, as well as social security taxes, and Medicare taxes to be deducted from their wages.  
    • It allows owners to take some compensation out as distributions, which are not subject to social security, Medicare taxes.  
    • A CPA should be consulted to help determine an appropriate salary and reasonable distributions.  
    • Each quarter an owner takes out a distribution, he or she should pay estimated taxes based on the amount of distributions taken and his or her estimated personal tax bracket.
    • The owners of an S Corporation does not have to pay self employment taxes on the income of the business or distributions. 

    C Corporations 

    • The  C Corporation is the only structure where the income earned by the Corporation does not flow through to the owners personal tax return. 
    • The corporation is recognized by the IRS as a separate taxpaying entity. 
    • When people talk about the corporate tax rate, they are referring to the tax rate paid by C Corporations. The tax rate for a C Corporation ranges from 15% to 39%. 
    • One of the biggest downsides of a C Corporation, for business owners, is double taxation.  The Corporation pays taxes on earned income.  When the company distributes its earnings, as dividends to its shareholders, the shareholder must pay taxes on the dividends received.  This results in income being taxed twice, once at the corporate level and again by the shareholder on their personal tax return. 
    • Certain circumstances dictate the selection of a C Corporation.  

    To make things a little simpler we have put together a table that highlights some of the key differences between entities and made that available to you for free. 

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