When it comes to business taxes, there is no one way to do things. Businesses have options and can choose from various tax classifications that impact how you file, what you file, and how much you owe.
So, how do you know which tax classification is right for your business?
What Is a Tax Classification?
Before we discuss tax classification, we must clear up a common misconception. Business classification is not the same as tax classification. It can be easy to confuse the two because they share many of the same category names.
Business classification refers to your company structure and how it was set up. It defines ownership, liability, and how you report income. A business may be set up as a:
- Sole Proprietorship
- Partnership
- LLC (Limited Liability Corporation)
- S Corporation (S-Corp)
- C Corporation (C-Corp)
Tax classification refers to how your business is taxed by the IRS. It dictates tax rates, filing requirements, and legal obligations. A business may be taxed as a:
- Sole Proprietorship
- Partnership
- S Corporation (S-Corp)
- C Corporation (C-Corp)
Business classification does not always correlate with tax classification.
While a default tax classification is assigned to a business based on its structure, a business can elect a different tax classification. Electing a different tax classification can provide benefits to a company, so it’s good to know your options and select the best tax classification for your unique business and goals.
Related: Want to Avoid a Surprise Tax Bill? Do This Right Now.
Tax Classification Options for Small Businesses
Many small businesses are structured as LLCs (limited liability corporations), so you may be surprised that an LLC is not listed as a tax classification.
An LLC is not a tax classification; it is a business classification that can have various tax classifications. By default, a single-member LLC is taxed as a sole proprietor and a multi-member LLC is taxed as a partnership, but an LLC can elect an S-Corp or C-Corp tax classification.
Structuring a business as an LLC benefits individual and partner owners as it provides legal liability protection. Individuals and partners can set up an LLC for their business to legally keep their personal interests separate from the business.
Let’s consider the differences between each tax classification and how you can determine which one is right for your business.
Sole Proprietorship
A sole proprietor tax classification is assigned to individuals who are the sole owners of their business and have not elected to have a special tax classification. They report all business income on their personal tax return and pay both income tax and self-employment taxes.
Pros
- The most simple tax classification
- Easy and inexpensive to set up
- Minimal compliance and paperwork (no need to elect tax classification)
Cons
- Owner must pay self-employment taxes on all profits
- More difficult to raise capital or secure investors
- A sole proprietor not set up as a single-member LLC is liable for business liabilities
Might Be Right For You If
- You’re the only owner of the business
- You want a simple, low-cost setup with minimal paperwork
- You’re not planning to raise investment capital
- You’re making less than $120,000/year
Related: Freelancing and Taxes: The Tax Guide for Side Hustles
Partnership
A partnership is similar to a sole proprietorship but instead, has multiple owners. Each owner reports their portion of business income on their personal tax return and pays both income tax and self-employment taxes.
Pros
- Easy and inexpensive to set up
- Minimal compliance and paperwork (no need to elect tax classification)
- Good for businesses with a few partners
Cons
- Owner must pay self-employment taxes on all profits
- More difficult to raise capital or secure investors
- Requires a separate tax return
- Owners in a partnership not set up as a multi-member LLC are liable for business liabilities
Might Be Right For You If
- You have a business with partners
- You want a simple, low-cost setup with minimal paperwork
- You’re not planning to raise investment capital
S Corporation (S-Corp)
S Corporation tax classification is assigned to businesses structured as S-Corps as well as businesses who elect S-Corp tax status. C-Corps and single-owner and multi-owner LLCs can elect S-Corp tax status. To elect S-Corp tax status, a business must file tax form 2553 with the IRS. It must be filed. There are deadlines for this filing and the IRS has to approve the election.
Owners of businesses with S-Corp tax classification do not report 100% of business income on their tax return. Instead, they receive a salary and distributions that are then taxed as income tax (without self-employment taxes). Business owners receive a K-1 with their portion of the corporation’s net income that they will have to report on their tax return and pay taxes on.
Pros
- Owner/owners minimize self-employment taxes
- Business income is not taxed at the corporate level
Cons
- Must pay payroll taxes
- May need to justify salary versus distributions to the IRS
- Limited to 100 shareholders (Shareholders must be US individuals or certain trusts, and partnerships or corporations cannot own shares in an S-Corp.)
- Limited to one class of stock
Might Be Right for You If
- You’re a sole proprietor making over $120,000 (and could benefit from reducing self-employment taxes)
- You’re comfortable paying owner/owners a reasonable salary and taking distribution
- You can handle (or outsource) payroll and more formal recordkeeping
C Corporation (C-Corp)
C Corporation tax classification is assigned to businesses structured as C-Corps as well as businesses who elect C-Corp tax status. Single-owner and multi-owner LLCs can elect C-Corp tax status. C-Corps are subject to double-taxation. The business profit is taxed, and owners also pay taxes on the dividends they received from the corporation.
Pros
- No limit on the number of shareholders
- No limit to the number of different classes of stock
- Easier to raise capital and secure investments
- Expanded tax deductions
Cons
- Business must pay corporate income tax on profits, and owner/owners must pay taxes on dividends
- More rules and costs than pass-through entity tax classifications
- More complex compliance and IRS scrutiny
Might Be Right for You If
- You plan to reinvest profits back into the business
- You want to attract venture capital or issue multiple classes of stock
- You’re scaling and need a structure that supports growth and employee benefits
Related: What Type of Accounting Does My Business Need?
Get Personalized Tax Advice
Choosing the best tax classification can save you money and prevent issues with the IRS, so make sure you get it right.
Research can help you narrow down your options, but the best advice will always come from a professional. A professional tax accountant can help you look at the unique details of your business (your goals, profit, business structure, etc.), to help you pick the best tax status for your situation.
If you need help making a tax plan for your business, CFO2U is here to guide you.
We love small businesses and helping them get what they need to survive, thrive, and grow. Schedule a call with our team to see how our tax services and outsourced CFO solutions can help you take better control over your business’s financial frameworks. Schedule your call today.
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