Do S corporations need to pay employment tax?

It is a common misconception that S corporation owners do not have to pay any employment taxes. This is because S corporations distribute earnings as a flow-through entity that are taxed in the current year and are not subject to self-employment tax. In fact, the IRS has ruled that the managing owner of an S corporation must pay themselves a salary that represents reasonable compensation for services rendered. The business must withhold payroll taxes just like any other paycheck received from an employer. It is only the remaining profits after salary expense that can be passed through as a distribution not subject to payroll taxes.

Should I create a C-Corporation?

The main reason on entrepreneur would want to become a Corporation is to raise capital because you want to issue multiple classes of stocks such as options and warrants to attract investors or you intend to sell your corporation in five years. Other secondary reasons to become a Corporation are because you have a foreign owner or you would like to take advantage of certain fringe benefits. The primary disadvantage to becoming a C Corporation is that there is a second level of tax on C corporation profits.

Should I create a limited liability company (LLC)?

There are two main reasons to become a limited liability company the first one is to protect your assets and the second is to legitimatize your business. Similar to a Corporation, the main advantage of an LLC is that it creates a legal structure around your business that makes it difficult for someone to sue you and obtain your personal assets as a result of a liability from the business. In fact, an LLC can offer better asset protection then a Corporation because it is easier to maintain the formalities of an LLC and if someone is successful in a lawsuit against you they can only obtain future profits interests, they cannot obtain shares in your stock as in a Corporation. LLCs also make an ideal structure to contain real estate investments.

The second reason to establish an LLC is to enhance the perception of legitimacy to your customers or to the public. Often times, a sole proprietorship does not convey to the public that a legitimate business venture is being undertaken. In fact many people believe that if you aren’t a Corporation or an LLC then you’re not legally a business. Although this is not true perception can be more important than reality for the small business that is trying to gain a foothold in their market.

It is important to note, that an LLC does not change your tax status. That is, an LLC can be a sole proprietor, a corporation, or a partnership. This is why they call the LLC a wrapper. Because it just wraps and protects business entity that’s inside the LLC, it does not change the tax status of of the business. Once you are in an LLC you can pick and choose however you would like to be taxed; a sole proprietorship a Corporation or even an S Corporation can all be LLC’s.

Should I create a partnership?

A partnership is similar to a sole proprietorship, except you are running the business jointly with somebody else. What is misunderstood about partnerships is how easy it is to become one. As soon as you shake hands and decide to make profits together, you become a partnership. In fact, your children’s lemonade stand is a partnership that should file a partnership tax return. The partners to a partnership will also pay self employment tax on their share of the income generated by the partnership.

What is great about a partnership is that it is a very flexible entity. Oftentimes, when two or more people get together to start a business, it is unclear as to who will make the greatest contributions, do the most work, or bring in most of the business. In fact, it is common that the performance of a partner is not quite what was expected which leads to problems in the business. The partner you thought was wonderful becomes something very similar to a messy roommate. Partnerships can be structured so that even under a 50-50 profit split arrangements, a disproportionate distributions can be taken from the partnership to compensate partners for their contributions that are inconsistent with the original 50-50 agreements. These disproportionate distributions are impossible under an S Corporation arrangement which is quite common structure for new entrepreneurs to use. S corporations and C corporations must make profit distributions according to the number of shares owned by each owner.

How important is it for the new entrepreneur to pick the right entity structure for tax purposes?

The first thing to understand about this decision is that even if you’ve done nothing, by the mere fact that you are engaged in a business you are already a sole proprietorship. In tax this is known as your default classification. The reason that this is important is that from a tax perspective your classification is already determined and you do not need to worry about getting the entity structure rights before you start your business.

A sole proprietorship is filed on your schedule C of your form 1040. It tracks your revenue and expenses from your business and arrives at a profit. This profit is taxed at self-employment tax rates of 13.3% in 2012. This self-employment tax is in addition to your income tax. These taxes replace the employment tax deductions that are taken out of your paycheck. Employment taxes include Social Security and unemployment taxes. Self-employment taxes become a problem after profits are being generated in your business and changing your structure to optimize taxes become important after you are making at least $50,000 in profit in your sole proprietorship. As long as profits are low, the sole proprietorship offers an easy, flexible, low-cost, structure for your business.