Tax season brings many questions and complexities for small business owners, and one of the biggest questions is related to business taxes vs. personal income taxes. Many small business owners are wondering, “What is the difference between business income taxes and personal income taxes, and how do they affect each other?”
Generally speaking, all small business owners have to pay personal income taxes (taxes paid on the money you make from your business, whether it’s a salary or other income), but most small business owners do not necessarily have to pay business income taxes. Whether or not you have to pay business income taxes depends on what type of formal legal corporate structure you have set up to operate your business as a legal entity. There are a few different options for how to incorporate your business, and these have a direct impact on your tax status.
Here are a few of the most common types of business structures and what they mean for business taxes:
If you run your business as a sole proprietorship, that means that basically, your business has no legal identity separate from yourself – “you” are your business. This means that your business does not owe any business income tax because as far as the IRS is concerned “your business” does not exist as a taxable entity – the IRS just deals with you directly, and you’re expected to report your self-employment income just as if you were an employee. Many small business owners start out as sole proprietors, especially if they operate a professional service business, but there are drawbacks to this arrangement. With a sole proprietorship, all of the money that you make is treated as personal income and you have to pay twice the usual amount of self-employment taxes. Also, there are certain legal liability risks that go with operating your business as a sole proprietorship. For these reasons, it’s almost always a good idea for business owners to take the step of formally setting up a corporate legal entity for their business, such as an LLC.
An LLC, or “limited liability company,” is one of the most common forms of a business entity used by small business owners to incorporate their businesses. By setting up as an LLC, your business gets to have its own name and identity that is separate from your individual self, and there are various financial benefits and legal protections that go with that. For example, you can get a business bank account, a business credit card, build credit in the name of your LLC and more. LLCs do not have to pay business income tax, because the IRS does not view LLCs as being a separate entity for tax purposes – so all of the money that your LLC makes just passes directly through to you and you only have to pay personal income tax.
An S-Corporation is another form of corporate structure that, like the LLC, is considered a “pass through” entity by the IRS – that means the S-Corporation does not have to pay business income taxes, and all of its earnings are directly passed through to the business owner. Many solo entrepreneurs and small business owners have their companies set up as LLCs, and then file taxes as an S-Corporation – it is a bit complicated and you need to talk to an accountant to make sure your business meets the qualifications, but there are often significant tax advantages to using this arrangement instead of paying taxes as a sole proprietor.
A C-Corporation is a different form of corporate entity, and it is the only form of business entity on this list that is required to pay business income taxes. Many C-Corporations are publicly traded companies that issue stock and pay dividends to shareholders. If your business is just a small operation or solo business, you will not need to worry about setting up a C-Corporation. However, if your business is a fast-growing startup and you expect to one day make an initial public offering, setting up your business as a C-Corp is probably the best choice.
Which One is Right for You?
So in general, most small business owners reading this blog article probably do not need to worry about business income tax. But talk to your accountant if you have any questions to make sure you are using a business entity and tax filing status that is most advantageous to help you protect your interests and save money at tax time!
Which corporate entity do you use for your small business – LLC, S-Corp or C-Corp? Leave a comment and let us know!