For many small business owners, entrepreneurship is adventurous, rewarding, and at times utterly confusing. From the outset, few people who wish to start a business spend much thought on their entity type or the tax structure of their enterprise. That's understandable—while many entrepreneurs thrive when coming up with ideas and putting them into action, thinking about tax structures isn't always as exciting.
This article is written by our friends at Gusto.
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When new business owners are eager to get things off the ground, a sole proprietorship makes sense, especially if they are starting a relatively simple business where they'll be working for themselves and won't be hiring any employees in the near future.
As a business grows, however, there are many reasons why a sole proprietorship may not continue to be the right entity form. If this sounds like you, you're in luck. This post covers a good solution for a new structure: the small (but mighty) S corporation, commonly known as the S corp.
Before we dive in, we'll point you to some useful resources on business entities and revisit tax structure just so you're familiar with them.
Let's start with entity types. There are five main entity types:
Your entity choice (or type of business) has a direct impact on how you're taxed, what degree of liability you're exposed to, who your owners can be, and more. Each entity type has its pros and cons, so you'll want to think carefully about your options.
How an entity is taxed is one of the chief drivers of decisions on entity types. S corporations, for example, are often considered a smart choice because of the tax benefits they offer.
Self-employed individuals such as sole proprietors generally must pay self-employment tax as well as income tax at their individual tax rate, just like before they started the business. They report their income and expenses on their personal tax returns, rather than on a separate business tax return like a corporation would.
S corporations don't pay corporate income taxes. Instead, they are treated as pass-through entities, which means earnings from the business will "pass through" to be included on the owner(s)' personal income tax returns.
Subchapter S Corporations, aka S corps, operate under a special designation of the tax code. The S corporation provides its owners with limited liability and flow-through tax status, allowing them to avoid double taxation (more on that below).
It's important to remember that S corporation status is a tax status that a business "elects" by filing IRS Form 2553. That means the owners must first create a corporation or limited liability company and then choose to be taxed as an S corp by submitting the form to the Internal Revenue Service.
There are a few key indications that should cause a sole proprietor to consider S corp status. If at least two of the following points are of high interest to you, an S corp will probably be the way to go.
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If your business is operating as a sole proprietorship, and you're a U.S. citizen or equivalent, converting to an S corporation is relatively simple.
Step 1: Establish a single-member limited liability company (LLC) (assuming that you haven't already done so). This LLC will be your legal entity structure. Forming an LLC is also relatively simple, but keep in mind that every state will have its own set of rules. In general, there are three steps to creating an LLC:
An attorney can help you with these items, but if your business will be pretty basic, completing them shouldn't be too difficult.
Step 2: File IRS Form 2553 Election by a Small Business Corporation to convert your single-member LLC to an S corp. There are four sections to a Form 2553, but most small businesses really only need to worry about one of them:
Filling out the required information in Part I will suffice for most businesses, but we'll cover the other parts quickly, just in case:
There are a few tax advantages to converting to an S corporation.
Here's a simple example to help illustrate the tax savings
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*Assumes FUTA wage base and rate for: $7,000 and 6% respectively.
**Includes SE tax of 15.3% and the SE tax deduction of 50%.
Whether your sole proprietorship is relatively new or well established, in many cases, converting it to an S corp has too many benefits to ignore.
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