How much you earn matters more now than ever...
From self-employment tax to the new net investment income tax small business owners are being taxed more heavily now then ever before. Depending on how much you earn the importance of how you structure your business can have a tremendous impact on your tax bill at the end of the year. There are no catch-alls and what works for your situation may not fit the categories below, but this is a general guide to who can benefit from forming entities for their business ventures.
Losing money or recently formed businesses?
Businesses that have been recently formed or are not yet making a profit are best structured as the default sole-proprietorships (filing Schedule C) or formed as partnerships. If you are losing money you can more easily deduct the losses without an entity and not deal with accounting issues down the line. Keep in mind that if you lose money for three years or more in a row you are inviting trouble as your business may fall under the hobby rules that disallow losses. And there is truth behind this- if you really are trying to make a profit at a business enterprise you likely will not keep running the business and losing money for more than three years. This is where partnerships come into play. They are a separate entity that is easy to form and easy to dissolve, making them good vehicles for businesses that may not pan out and will be closed in a couple years before the hobby loss rules apply, and the losses are ordinary losses that can be used to offset other earned income.
Businesses earning less than $25,000?
Businesses that earn very little money are best to still remain structured as the default sole-proprietorships. Yes, this goes against much of what you have heard at investment workshops and from other advisors. The reason for this is twofold. One, with a business earning modest income every dollar counts and the expense of forming an entity and filing returns for it each year in most cases outweigh the benefits the entity can provide. Second, recordkeeping is simpler for filing a Schedule C and allocation between personal and business expenses is simpler when all is reported on the individual return. Also you may take standard mileage rather than actual expenses, a big benefit for many small business owners.
Businesses with income in the range of $25,000-100,000?
This covers the vast majority of small business owners. In this range the self-employment social security and medicare tax of 15.3% is the biggest concern. Forming a subchapter S corp can be of big tax benefit in this range as this allows taxpayers to separate out the business income from paying out dividends and allows taxpayers to pay a wage to themselves for their work contribution to the business and only the portion paid as wages is taxed for social security and medicare.