Taxes are confusing, especially for small business owners. You likely picture popular large businesses and brands when you think about a corporation. However, you may never consider how these companies are taxed. Believe it or not, how a company is classified will affect its taxes. There’s a common misconception about the type of entity and taxation methods for those entities. For example, someone might say they are taxed as an LLC, which isn’t possible because that’s the type of business they own, not the tax class they are in. Essentially, many people mix up entities and tax classes, making the process of taxes even more confusing.
Legal Entities
Legal entities are what the business is. Choosing a legal entity can protect your personal assets from your business liabilities, such as your home. For example, if you’re ever sued, you won’t lose the house with the mortgage just paid off as long as you have the proper business entity and have filed with your state. Corporations and Limited Liability Companies (LLCs) are the most popular types of entities. Ultimately, legal entities are what a business refers to when they’re talking about the business they own.
In most cases, they own either a corporation or an LLC. What makes a business a corporation versus an LLC depends on how the business operates, but both options offer protections and obligations. Typically LLCs are easier to deal with, so many new businesses are LLCs instead of corporations.
Tax Classes
Tax classes refer to how a business is taxed. There are four different types of taxation methods for LLCs, including disregarded entity, partnership, S corporation, and C corporation. Corporations can only choose from S corporations or C corporations.
Disregarded Entities: Disregarded entities are for single-member LLCs, such as freelancers and self-employed artists, because there is one owner. In the case of disregarded entities, the IRS disregards the LLC entity for tax purposes. Instead, the income and expenses of the owner are recorded on their personal Schedule C tax document. In this case, the entity only exists for legal purposes, such as lawsuits and getting insurance, and is no different than a sole proprietorship when it comes to taxation.
Partnership: Partnership taxation is also only for LLCs, but Partnership LLCs have more than one owner or member. In this case, the income is reported on the patterns’ tax returns to avoid double taxation.
S Corporations: S corporations are similar to partnerships because the income is reported on the partners’ tax returns. However, S corporations have the advantage of allowing one owner to report and not both. However, there are some disadvantages, including limitations on stock classes.
C Corporations: C corporations are taxed twice since the net income and loss are not reported on shareholder tax returns. C corporations are ideal for larger companies because small companies don’t want to be double taxed.
Deciding on Entities
Now that you understand entities and tax classes are not the same, you can decide which entity to form and how it will be taxed. There’s no right way to form an entity, but you should have an understanding of how your business will operate. Here’s what to consider when deciding which type of entity to form and how it should be taxed:
State: Small businesses should form entities where they live and work. If you have a complex entity with multiple shareholders around the nation, it could become more complex. First, however, you should determine if the entity should be formed in a tax-friendly state or the home state where the business is headquartered.
Entity: You’ll need to choose between an LLC or Corporation. While there are other options, these are the most common and the easiest to understand. Your state law may dictate which option is best for you.
Taxation: The choice of taxation is often linked to the type of entity because LLCs have more flexible taxation options available.
Structure: Once you have your designed entity and tax class, you’ll need to structure the entity. LLCs can be flexible, especially if there’s only a single member. If you have a corporation, you’ll need to consider voting, officers, and other terms that will be relayed in the operating agreements.
LLCs taxed as disregarded entities, or sole proprietorships, are the least complex and also have the lowest cost of setting up since only one person is dealing with the business. The LLC structure is typically the best for most sized businesses based on the tax benefits and how simple it is to set one up.
Which is Best for Your Business?
It’s up to you and your accountant to decide which entity and tax class are right for your business, but there are some general guidelines to follow. For example, if your business is simple or small and not expected to earn much more than the owner needs to live, the best option is to form an LLC taxed as a sole proprietorship or disregarded entity. Additionally, if you’re starting a business with co-owners and employees, you might choose an LLC taxed as a partnership to start until you experience more growth. Then, once your business grows, you can change your entity to an S or C corporation to provide the flexibility of a partnership and avoid federal tax on profits.
You should only become a C corporation if your business is experiencing unprecedented growth, such as a popular new start-up, and you’re looking for funding or an exit. C corporations are not ideal for small businesses or freelancers because they’re unnecessarily complex.
Final Thoughts
Entities and tax classes are not the same, but the entity you choose can affect your tax class. For example, if you’re an LLC, you’ll have four options of how you’re taxed, but only one of those options will be right for your business. Choosing the right entity can help you figure out the best way to make your business more profitable so you can earn more money while reducing unnecessary risk and making the setup more complex.
Hopefully, this article has taught you everything you need to know about forming an entity and how it affects your taxes. However, if you’re not sure which entity to choose, you can always reach out to a tax advisor who can help you understand the different types of taxation methods based on your business structure.