In the United States, most businesses are pass-through entities [source: Tax Foundation]. And when it comes to income tax, "passing through" the profits is a huge benefit. In the case of the sole proprietorship or partnership, however, it has a significant downside: self-employment taxes.
Social Security and Medicare contributions, collectively known as employment taxes, are calculated based on a person's income. When you work for a company as an employee, your income is the wages you take home, and you and the company split the cost of your employment taxes [source: IRS]. When you work for yourself, your income is your business's entire net profit, and no one is splitting anything [sources: IRS, Dratch].
Self-employment taxes can be a huge drain. For this reason, many self-employed small-business owners choose the S corporation structure. In essence, S corporations combine the income-tax benefit of passing through profits with the employment-tax benefit of being employed by someone else.
In corporations, both C and S types, owners also can be employees. The business pays them wages just like any other employees. And as employees, those business owners pay employment taxes only on their wages, not on their companies' entire profits [source: Piper].
This can mean significant savings. Self-employment tax is 15.3 percent for the 2015 tax year [source: IRS]. If a sole proprietor's business profits total $75,000 for 2015, he pays 15.3 percent of $75,000, or $11,475, for Social Security and Medicare.
If an S corporation brings in $75,000, and out of that $75,000 the owner pays herself a salary of $40,000, she pays 15.3 percent of $40,000, or $6,120. That's a savings of $5,355.
Of course, this may not work out to an overall savings of $5,355. Since tax filing is a lot more complex for an S corporation, the owner will be spending more time on tax paperwork, and time is money.
Ultimately, which structure is most beneficial depends on the specifics of the company and the corresponding minutiae of the U.S. tax code. But, in short: If you're mostly looking for tax simplicity, a sole proprietorship or partnership is a good bet. If you're mostly looking for tax savings and have fewer than 100 owners, an S corporation might be the right fit.
If you've got 1,000 owners, simplicity is probably not in the cards, and the S corporation isn't an option. C corporation it is.
Author's Note: How does your business structure affect your business taxes?
When I went into business for myself, I chose to structure as an S corporation, and this did save me considerable cash. I was paying self-employment taxes on 20 percent of my profits instead of 100 percent. However, it's worth noting that after a few years, I learned I wasn't paying myself enough. Apparently, the IRS isn't stupid, and the organization expects S corporation owners to pay themselves a reasonable salary. I learned that audits of S corporations were increasing in recent years due to owners paying themselves a pittance and therefore getting away with paying almost nothing into Medicare and Social Security. So now, I pay myself a salary that's 50 percent of my profits. But hey, it's still a savings.
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