I have three important questions for you:
- Do you know the different types of business structures?
- Do you know the way in which such business structures are taxed?
- Do you know that every business structure determines your business profit?
These questions imply how your business is doing which is also tantamount to what your business is doing. Rich business people spend their time to deciding or choosing the most important and effective business structure.
Let’s begin now to deepen the idea about the importance of business structures to various businesses. There are tax implications on business structures . I have written down here a short primer you can use to run your enterprise. There are recommended methodologies and then we’ll go deeper to the details on how each is taxed. It’s important to note that your profits will be subjected to tax laws and they depend on how you operate your business. In short, your business structure determines the taxes and, after all, it helps gauge how much of a profit it will bring in to your business.
A business structure reflects how your business is organized for both tax and other legal purposes. The focus of this article is to explain initially the significant points of having decisions (both on the context of WHAT and HOW). A structure is the main determinant of the success of your business and how to maintain the profit flow.
What are the different types of business structures? These are:
- Sole Proprietorship (Self Employed)
- Single Member Limited Liability Company (LLC)
- Husband and wife (Self Employed)
- Multiple Member Limited Liability Company (LLC)
- General Partnership
- Limited Partnership
- “C” Corporation
- “S” Corporation
Each business structure decides the number of things you, as a business owner, will use as an indicator to paying your incurred taxes through the IRS and your respective state. A number of wealthy clients I professionally represent spend enough amount of time in deciding their business structure before doing a new business. The very purpose of having a certain structure is to determine the taxes.
Sole Proprietorship (the so-called self-employed)
If you’re a self-employed, your profit is at the greatest risk when it comes to taxes. The taxation process can be done in many different ways which can have an effect towards limiting the amount of profits you can enjoy from your business.
There are three levels or phases of tax for your business being self-employed. The first one is the Self-Employment Taxes that are directly incurred on the profit itself. This tax is the Social Security Tax (FICA and Medicare) at the usual rate of 15.3%. This figure is applied to the maximum profit of $118,700. Another 3.9% on every dollar will be levied thereafter without any limit on the particular amounts that are taxable.
The profits on Line 12 of your Form 1040 minus the deductions (itemized or standard) as well as the exemption credits (you including your dependents) will be computed to determine the taxable income. Further, the tax at your maximum tax rate between 15% and 39.6% that depends on the amount of taxable income will be computed, too. Eventually, you can have the annual tax being computed.
You have to also add 3.9% as Obama Tax on some particular amounts. This will be over the threshold levels of your earned income. You’ll be paying 15.3% plus 39.6% including another 3.9% as federal tax. The total will be 58.8% NOT including the important state taxes. In the case of California, the state tax is up to 11%.
Single Member Limited Liability Company (LLC)
It is important to note that a Single Member LLC is not included in the collection of federal taxes. So if you belong to this type, you will be taxed like a self-employed Sole proprietorship (Self Employed). The only issue here is in some states of the country, for example California, you will be taxed according to “Gross Receipts” as an LLC entity. Your tax is not according to the Net Profits. If you’re going to review the tax impact to your business, about 60% will be going to the tax you’re going to pay.
Husband and Wife (Self-Employed)
In the case of husband and wife being self-employed, the federal tax laws always require that both couples have to file a “partnership.” This is for the purpose of determining the tax returns. The only exemption is when they make a special tax election through Marital Joint Venture (MJV) in line to the taxation of both spouses. In this case, an MJV has to file 1 Schedule C for the business versus a partnership with Form 1065 Return being filed. As a result, both spouses are taxed being self-employed based on their equally divided profit share. The limitation is up to 118,700 then 15.3% Self-Employed Tax is levied.
Multiple Member Limited Liability Company (MMLLC)
MMLLC is taxed under the partnership tax rules and policies, unless the LLC prefers to be categorized as a corporation. There will be 15.3% tax to be collected (as a Self-employed) for the first 118,700 as profit by an individual business partner. Any LLC entity in this case can be elected to be considered as a corporation; then, the taxation is taken as “C” corporation. But there’s an option to elect as an “S” corporation. The other issues in relation to MMLLC are related to the partnership tax rules itself. The tax rulings between and among the business partners can become higher in terms of tax impacts, generally speaking.
With respect to General Partnership, two or more members can join together to come up with the so-called “Partnership Agreement.” This is to conduct business while the capital is shared by individual members. The profits as well as the losses are also determined for each member to have a share. To reiterate, the payments to the individual members from the earnings will be subject to taxation like they belong to the “self-employed” category. In this case, there is a higher level of tax impact.
The business losses in other considerable cases that are in accordance to the capital account of each member are limited and taken as the basis of profit shares. Let’s say you contribute the amount of 10,000 as your capital or investment and own 50% of the partnership and the the loss is about 60,000, you’re only subjected to a deduction of 10,000 of your half of 60,000 in loss. The remaining amount lost is withheld and will be carried over going to the following year.
In this situation, there is no Self-Employed Tax because you’re not sharing any activity in the business itself. But, any possible business loss is subjected to the Passive Activity Loss (PAL) Rules and Policies. Therefore, there is a certain restriction on the amount you can claim as a profit share.
Every corporation starts as a typical “C.” This is a regular corporation. The shareholders are taxed twice. The first one is the corporate tax rate which is computed according to the tiered levels of profits. The maximum rate is 39%. The second one is during the payment of the dividends or profit share and will be computed through Personal Form 1040 Return. As a result, there are two taxable rates as a shareholder.
An “S” corporation refers to the Sub-Chapter S of the Internal Revenue Code. The result is that the profit is going to pass through the corporation category but without any tax being a corporation.The tax is at the personal tax return level for each of the shareholders.
The only issue here is when you, as a shareholder, are doing activities for the business. In this case, the tax laws require the corporation to pay you a wage with corresponding taxable computations based on W2. Then, there is an obligation to include FICA, Medicare, FUTA, and SUTA. Furthermore, the salaries must be lawful and logical, which means they are not unreasonably high or low. The shareholders must also apply the partnership tax laws in deciding the level of tax owed by the shareholder.
Summary of the Impacts of Tax Policies
Wealthy business people always understand the importance of business structures in relation to their taxes. Before launching your business, you need to understand this idea. Answer the contextualized questions WHAT to do to establish a great business and HOW to achieve your business goals. You will reap financial success sooner or later.
With respect to tax impacts, you need to formulate combinations of effective and proven structures first before conducting or operating your business. An example of this is when a certain partnership can have party members, also known as partners, who are Single Member LLC. That structure can be categorized as a corporation. You need to design approaches according to the structure.
For more than 30 years in my profession as an Enrolled Agent in developing business organization and plans, I always put emphasis on the importance of a business plan together with a chosen structure. I always assure my clients that proper taxes are going to be determined.
Now, my final advice is, after you decide the focus of your business, go to the next phase which is the HOW. It reflects many things like how your business will run and how your taxes are computed. By this way, your financial success is only a step ahead of you.