When starting a business, what you pay in taxes is one of the most important considerations. This is especially true in California, where state taxes are among the highest in the country. Choosing the right entity structure can help minimize your tax liability, but this is not a “one size fits all” proposition.
There are tax advantages and disadvantages to each entity structure, and the right entity for you will depend on the type, size, and other specifics about your business. Here is a closer look at the tax implications for the various business entities:
A sole proprietorship is the easiest way to go into business for yourself, and this a popular choice among freelancers and independent contractors. There is no additional paperwork to file and no entity that needs to be set up to go into business is a sole proprietor, and as far as the IRS is concerned, all of the assets, liabilities, and income of the business are considered to belong directly to the business owner. This also means that a sole proprietor would not have to pay the additional taxes and fees California charges for other entity structures (more on this later).
The top income tax rate for a sole proprietor is 29.6% if they qualify for a “pass through” deduction. If the sole proprietor exceeds the income threshold for the “pass through” deduction, they may be better off setting up a formal entity. One of the biggest drawbacks for sole proprietors is having to pay self-employment taxes in addition to regular income taxes. Essentially, this means you are paying double what an employee would pay for Social Security and Medicare.
A general partnership is similar to a sole proprietorship, except that the business is owned by two or more individuals. Again, there is no additional paperwork to file and no entity to set up, and all business income is passed through to the owners and taxed at their individual rate. And as with a sole proprietorship, owners of a general partnership do not have to pay additional California corporate taxes and fees, but the owners do have to pay self-employment taxes.
An S corporation and is an entity that is often set up by small to medium-sized businesses largely for tax purposes. Like a sole proprietorship or general partnership, an S corporation is a “pass through” entity where net income flows directly to the business owners and is taxed as personal income. One of the primary tax advantages of an S corporation is the ability for owners to receive dividends, which are taxed at a different rate and not subject to self-employment taxes. However, in California, an S corporation must pay a franchise tax of 1.5% of net income, and their minimum franchise tax is $800 annually, even if there is no net income at all.
A C corporation is a traditional corporate structure typically used by larger businesses and for startups who plan to go public in the future. One of the biggest tax advantages for a C corporation is the new 21% federal corporate income tax rate that went into effect in 2018. The primary drawback is the potential for “double taxation”, in other words, net income from the business can be taxed at both the corporate and personal levels. In California, the state corporate tax rate is 8.84% or an alternative minimum tax (AMT) rate of 6.65% if there is no net taxable income.
Limited Liability Company (LLC)
An LLC is one of the most flexible entities from a tax standpoint. LLC owners (known as “members”) can choose to be taxed as a sole proprietor, partnership, S corporation, or C corporation. An LLC is a “pass through” entity, and members report profits and losses on their personal federal income tax returns. However, California charges LLCs with a minimum $800 tax, along with a franchise tax that is calculated using a complicated formula that is based on gross income.
Speak with an Experienced San Diego Business Lawyer
Determining the best business structure to save on taxes can be complicated, and this will always depend on the specific circumstances and needs of your business. The best place to start is to speak with a seasoned business attorney to discuss your options.
At Garmo and Garmo, LLP we provide comprehensive guidance on business entity formation and all other types of business legal matters in San Diego and throughout Southern California. Call our office today at 619-441-2500 or send us a message through our online contact form to schedule a free consultation with one of our attorneys.