Various factors are worth considering when deciding on the best business structure. However, income tax is arguably one of the most important factors as it directly affects profitability, operations, and, thus, the viability of the business in question. The business structure you finally choose will have serious, long-lasting legal, and tax implications. This article highlights the tax implications of various incorporated and unincorporated business structures, stating the pros and cons of each.
Sole Proprietorship/Partnerships
Tax preparation for Sole traders is perhaps the easiest amongst the various business structures. Since the owner and the business are mostly a single entity, the business is not taxed separately; the business’ income is the owner’s income. This means that the owner’s total profit minus tax-deductible business expenses (net profit) is taxed at individual tax rates. It’s the owner’s responsibility to withhold and pay all income taxes, including estimated and self-employment taxes. The only major disadvantage is superannuation; the owner can only claim a tax deduction for super contributions as a self-employed person. The final consideration of capital gains tax is not a significant issue for a sole trader.
Furthermore, owners pay taxes on profits using their tax file number (TFN), and the tax rates applicable to sole proprietorships are the lowest of the different business structures. Fulfilling tax reporting requirements and calculating annual tax returns is made much simpler by maintaining separate personal and business accounts. The same tax benefits also apply to partnerships.
Limited Liability Companies
Since an LLC combines the benefits of both the partnership and corporation forms of business, for tax purposes, income from the LLC is taxed at individual tax rates (approximately 30% flat rate). Income from corporations is taxed twice (first at the corporate entity level and secondly upon distribution of shares), but the ‘limited liability’ aspect of LLCs enables tax savings for its members. LLCs with multiple partners hold the default tax-status of a partnership; each member (partner) of the LLC reports their distributive share of the LLC’s income/loss which is then reported on their individual income tax return. Furthermore, members of an LLC are considered self-employed and are required to pay the self-employment tax contributions towards Medicare and Social Security; the LLC’s entire net income is subject to this tax. Furthermore, an LLC has the option to choose whether it wants to be taxed as a sole proprietorship, partnership or corporation (including S and C corporations).
‘S’ Corporations
This special type of corporation is created through an IRS tax election. It is legally considered to be a separate entity from its owners, thus limiting the financial liability for which the owners (shareholders) are responsible. Businesses with this structure can avoid double taxation (the combination of corporate taxation and shareholder tax). However, S Corporations offer restricted liability protection as they do not necessarily shield you from all litigations, the tort actions of an employee, for instance. Furthermore, S corps are not taxed equally in every state. S corps offer major tax savings for you and your business; only the wages of a shareholder who is also an employee is subject to employment tax. The remainder of the income is taxed at a lower rate (if at all) and is to be paid as a ‘distribution’.
‘C’ Corporations
C corporations are traditional corporations that are subject to double taxation, and their profits are taxed at the corporate tax rate. Their profits are taxed when earned (at approximately 34%) and once again when distributed to shareholders as dividends (approximately 20%). Other than the opportunity for shareholder-employees to avail tax-free fringe benefits, C corporations also provide the ability to accumulate earnings at a lower tax-cost for future expansion. This enables the corporation to deduct all medical payments to a fixed amount, while shareholders-employees can enjoy this benefit on a tax-free basis. Whereas the double taxation aspect and the inability of shareholders to deduct corporate losses are major drawbacks, the ability to reinvest profits back into the company at a lower corporate tax rate is a major advantage. It is for this reason that most people prefer to form an S corporation instead.
Unincorporated Businesses
An unincorporated business/association is an organization such as a sports club or voluntary group, established through a mutual agreement between a group of people who share a common profit-oriented interest. Unincorporated businesses do not need to be registered and do not require any setup costs. Technically, since it’s not a legal structure, it isn’t recognized by the law; individual members are personally responsible for business debts and any contractual obligations. However, certain unincorporated organizations such as associations, some members’ clubs, and societies may be liable for corporation tax. Other unincorporated businesses may also be liable for tax payment, including certain occupations of sole proprietorships, partnerships, LLCs, fiduciaries, estates, trusts, and associations.