Your company’s business structure is how it is organized – it answers questions like who is in charge, how are profits distributed, and who is responsible for business debt. The most common business structures are:
- Sole proprietorships have one owner. The IRS taxes the sole proprietors on all profits as personal income. The owner is personally liable for any business debts.
- Partnerships are similar with sole proprietorships but can have an unlimited number of owners. Partnerships are flow through entities. This means the owners report their share of profits as personal income on their tax returns.
- C corporations have unlimited shareholders who each own part of the company. C Corporations distribute profits to owners as dividends. Owners are not personally liable for business debts.
- S corporations are flow through entities that can have up to 100 owners. Owners are taxed on their share of profits. Owners are not personally liable for business debts.
In addition to affecting how a business operates and who is responsible for business debts, the business structure impacts how much a company and/or its owners pay in taxes. The U.S. tax code is complex and includes four main tax categories:
- Income tax – paid on profits
- Employment tax – employee Social Security and Medicare contributions
- Self-employment tax – Social Security and Medicare contributions for self-employed individuals
- Excise tax – special taxes for specific goods and services like tobacco, alcohol, etc.
The state(s) in which the company operates might also impose taxes, such as: sales tax, franchise tax, state income tax, property tax on the business personal assets, real estate tax. The business structure impacts some of these taxes.
That is why it is important to choose the most beneficial business structure from the beginning. Unfavorable business structures can be very costly.
Net earnings (i.e., net income or profit) is the gross business income minus business expenses. Regardless of the business, it begins with gross income (the income received from customers) and allowable expenses are deducted to arrive at net income. How you calculate this figure dependents upon business structure.
Net earnings are used to calculate business income taxes. Again, the calculation process differs slightly for different business structures. It is best to seek a professional to help with net earnings calculations for the proper calculation and maximum legal deductions.
Employ a Family Member
One of the best ways for small business owners to reduce taxes is hiring a family member. For example, suppose you hire your child, as a small business owner. In that case, you will pay a lower marginal rate or eliminate the tax on the income paid to your child. Certain business structures are not required to pay Social Security and Medicare taxes on a child’s wages, if child is under 18 years old. They can also avoid Federal Unemployment Tax Act (FUTA) tax.
Retirement plans can be a very good tool to reduce taxes, as well as saving for retirement. As a small business owner, you should look at options such as SEP IRA, solo 401(k), SIMPLE plan, or even more complex plans, depending on the business structure, what other employees the business has, the cash flow and plans for the future.
As with any tax situation, consulting your trusted accounting professional is always best. They are up to date on the latest tax laws, information, and allowable deductions. By being aware of ways your small business can reduce taxes, you can bring these topics up with your accountant, discuss the best options for you, and be prepared long before tax time rolls around.