As your small business grows and evolves, the initial structure you chose might no longer be the most tax-efficient option. Moving from a sole proprietorship to a Limited Liability Company (LLC) or even electing S corporation (S Corp) status can have significant tax implications that impact how your business income is taxed and what forms you need to file.
At Lightening the Load, we guide small business owners through every tax consideration. This blog post will clarify how changing your business structure affects your tax preparation, highlighting the differences in tax calculation and potential outcomes.
Understanding Default Tax Classifications
When you start a business, the IRS automatically assigns a default tax classification based on your legal structure:
- Sole Proprietorship: For tax purposes, your business income and expenses are reported directly on your personal tax return (Form 1040, Schedule C). You pay self-employment taxes (Social Security and Medicare) on your entire net taxable income.
- Single-Member LLC: By default, a single-member LLC is taxed as a sole proprietorship. All business taxable income passes through to your personal tax return, and you pay self-employment taxes on the net taxable income.
- Multi-Member LLC: By default, a multi-member LLC is taxed as a partnership. Each owner reports their share of the business’s taxable income or loss on their personal tax return (Form 1040, Schedule K-1), and generally pays self-employment taxes on that share.
- Corporation (C Corp): A C corporation is taxed as a separate entity. The corporation pays income tax on its taxable income. When the corporation distributes earnings to owners, those owners then pay income tax on those distributions (this is often referred to as “double taxation” for tax purposes).
Electing a Different Tax Classification: The Tax Implications
One of the most common reasons businesses consider changing their structure or tax classification is to optimize their tax position.
- LLC Electing S Corporation Status:
- How it Works: An LLC can elect to be taxed as an S corporation by filing Form 2553 with the IRS. This changes how the business is taxed, not its legal structure.
- Tax Impact: As an S corporation, the owners who work in the business must receive a “reasonable salary” (subject to payroll taxes). Any remaining taxable income can be distributed to owners as distributions, which are generally not subject to self-employment taxes. This can lead to potential self-employment tax savings on a portion of the business’s taxable income.
- Filing Requirements: An S corporation must file its own tax return (Form 1120-S) in addition to owners reporting their share of income on their personal tax returns.
- LLC or Partnership Electing C Corporation Status:
- How it Works: An LLC or partnership can elect to be taxed as a C corporation by filing Form 8832 with the IRS.
- Tax Impact: The business itself becomes a separate taxpaying entity, paying corporate income tax on its taxable income. Owners pay income tax on distributions received from the corporation, which can result in a different overall tax outcome compared to pass-through entities.
- Filing Requirements: The business files Form 1120, U.S. Corporation Income Tax Return.
Common Tax Surprises When Changing Structures
Changing your business’s tax classification is not always straightforward and can lead to unexpected tax outcomes if not managed properly:
- Payroll Tax Obligations: If you elect S corporation status, you’ll need to set up payroll and comply with payroll tax requirements for owner-employees.
- Reasonable Salary Rules: For S corporations, the IRS requires owner-employees to take a “reasonable salary.” If the salary is too low, the IRS can reclassify distributions as wages, triggering additional payroll taxes.
- Increased Compliance: More complex structures often come with increased tax compliance requirements, including more detailed record-keeping and additional forms.
- State-Specific Rules: Some states may not recognize federal S corporation status or may impose different tax rules on certain entity types.
Navigating Your Business Structure Changes
Changing your business’s tax classification is a significant decision with direct tax implications. It requires careful consideration of your business’s taxable income, expenses, and long-term goals.
At Lightening the Load, we are your steadfast partners, accompanying you through every tax season and helping you navigate complex tax matters. Let us help your business understand what changing your business structure means for your taxes.
Let us lighten your load.
