First of all, when starting up your own business it is important that you determine the structure of your business. There are 3 types of business structures to consider.
- Sole proprietorship
- Corporation
- Partnership
For income tax purposes, these structures have different tax implications. Which is why it’s important to discuss with a tax expert a strategy for success. When deciding which structure is best, one should consider the advantages and disadvantages of each business structure.
Sole Proprietorship
Advantages
- Easy and inexpensive to register.
- No corporate tax payments.
- Minimal accounting and legal fees to form and operate a sole proprietorship.
Disadvantages
- Unlimited liability (if you have business debt, collectors can make claims against personal assets to pay them off).
- Higher income taxes at your personal rate when the business is profitable.
- More difficult to raise capital from investors.
Corporation
Advantages
- Limited liability and asset protection (if you have business debt, collectors can only make claims up to your investment in the company.
- Corporate tax rates are only 13.00% for small business. This amount is going to decrease to 12.62% in 2017.
- Tax planning is much more effective when you are incorporated and profitable, since you only pay personal taxes on what you draw from the company.
- Income splitting and dividends (a corporation can choose the most tax effective strategy for paying owners or family members involved in the business).
- When it’s time to sell the business, you are selling an independent entity and may be eligible for a one-time capital-gains tax exemption of $800,000. A sole proprietor may not claim this exemption.
Disadvantages
- Higher accounting and legal fees to maintain and startup the company. Typical legal fees range from $1,000-$1,500 to have a lawyer incorporate your business.
- Double taxation. You must file an annual corporate tax return in addition to your personal tax return.
- As a sole proprietor, you can use business losses against other types of income, as a corporation the losses may only be used in the corporation, however, these losses can be carried forward or back to reduce income tax of other years.
- When you want to close a corporation, there is more paperwork involved to dissolve the company.
Partnership
Advantages
- Easy to establish and low startup costs.
- Inexpensive to maintain.
- Ability to pool resources and share financial obligations.
- The partnership doesn’t file its own taxes. Each individual partner files their own tax return.
Disadvantages
- Liability of the partners in unlimited.
- Disagreements among partners.
- Partners are taxed at personal tax rates which are much higher than a corporation when the business is profitable.
Plan Sooner Rather Than Later
It’s very important to decide the structure of your business when you are first getting started. Once the business accumulates assets and liabilities, there is much more complex accounting work to be done when switching from a sole proprietor to incorporated. Also, tax planning strategies cannot be put into place retroactively. Therefore, it’s very important the right business structure is selected from the get-go.
Owners or prospective owners of small businesses should work with their accountant and lawyer to determine what business structure is right for them.
Do you need help filing your tax return? Contact Argento CPA today!