Talk to any financial advisor and you’ll hear a similar message: the key reason to consider incorporating your small business is to separate your personal and business finances, shielding your personal assets from any liability of your business. And while these words couldn’t be truer, tax concerns usually top the list for the small business owner.

Each business entity (LLC, C Corporation, S Corporation) has its own tax consequences, so you want to choose the structure that best meets your financial and business needs. To jump-start your selection process, I’ve assembled some of the key factors to consider in selecting the right business structure for your particular business and its impact on your taxes.

Introduction to the Corporation

Owners of unincorporated businesses (this includes sole proprietorships, partnerships, and LLCs) must pay income taxes on any net profit of the business, regardless of how much they actually withdraw. This means that even if you keep all profits in your business checking account in anticipation of some big expenses next year, you’ll still need to report these profits as income on your personal income tax returns.

By contrast, owners of a corporation don’t report their share of corporate profits on their personal tax returns. They pay taxes (on their personal income statement) only on profits that actually receive as salary, bonuses, or dividends. The corporation itself pays taxes (at a corporate tax rate) on any profits left in the company at the year end ⎯ these are known as retained earnings.

The C Corporation is preferable for some companies; these are typically businesses that plan to raise capital by issuing stock or attracting investors through VC funding. However, for most small businesses, the C Corporation is simply the wrong fit, and the main reason boils down to two words…“Double Taxation”.

The Problems of “Double Taxation”

Owners of a C Corporation end up paying double taxes on their businesses’ earnings. How does this happen? First, the corporation itself files corporate tax returns on the federal and state level, and pays taxes on its profits. Then the earnings can be distributed to shareholders in the form of dividends. These dividends are taxed at individual tax rates on their personal federal and state income tax returns. As a result, owners effectively pay taxes on the same earnings twice ⎯ once at the corporate level and then as individuals on their personal income tax returns.

The S Corporation and It’s “Pass-through” Tax Treatment

To avoid this double taxation, businesses can elect for S Corporation Status by filing Form 2553 with the IRS (and take note…the filing deadline for existing companies is March 15 if they wish to receive the benefit for their current tax year). This means that corporate profits and losses are “passed-through” and reported on the personal income tax returns of the shareholders. That’s why the S Corp is known as a “pass-through entity”.

Let’s take a look at an example to illustrate the benefit. Let’s say your business earns $100,000. And to keep things simple, we’ll assume the tax rates for individuals and corporations are 28% each. In a regular C Corporation, the business pays $28,000 in income tax, and $72,000 is distributed to you. You would then owe 28% personal income tax on the $72,000 dividend, which is $20,160. This means that overall you’ve paid $48,160 in taxes for the year.

Now let’s say you created an S Corporation for this same business. As an S Corp, the corporation pays no income tax. The $100,000 is distributed to you, and you pay $28,000 in tax. It’s pretty easy to see the benefit between $28,000 vs. $48,160 tax payments for the year. Bear in mind: this was an over-simplified example.

Pass through losses with an S Corporation

With the S Corporation, you can also pass losses on to your personal income statement as well. So, if your business is just starting out and is not yet profitable, you’ll be able pass through this loss to offset other sources of income on your personal tax statement. This can greatly reduce your personal tax liability as you ramp up your business.

The S Corporation and Its Limitations

An S Corporation is great for small business owners who can qualify: The IRS places limits on the number of owners and who can be an owner in an S Corporation.   In addition, the S Corporation only allows for one type of stock. And this can have significant implications.

Let’s say you and a friend open a jewelry business, and you each own 50% of the business. Your friend is more of the investor, while you are the designer and in charge of the day to day operations. Your business takes off and is more profitable than you ever imagined. You’ve been working night and day to fulfill the orders, while your partner has been focused on her full-time job. As a result, you both agree that you should take 60% of the profits and your friend 40%. However, the S Corporation does not offer the flexibility for this type of arrangement. With one type of stock, each owner/shareholder must share in the income in direct proportion to their ownership. Since you and your partner each own 50%, you will be allocated 50% of the corporation’s income (at least for the purpose of computing personal income tax statements), regardless of any other agreements you might make.

If you do not meet the qualifications for the S Corporation, you may want to consider the Limited Liability Company (LLC). In an LLC, the owner’s personal assets are shielded from business liabilities just as they would be in a Corporation.  In addition, the IRS views the LLC as a “disregarded entity”. Thus, an LLC does not file separate taxes; company profits and losses flow through to the owners and are subject to each owner’s individual tax rates. The LLC is great for a business that wants liability protection, but seeks minimal formality.  It’s also the perfect structure for a business with foreign owners since anyone (C Corp, S Corp, another LLC, a trust, or an estate) can be an owner of an LLC.

Business Structure and Audits

Believe it or not, your choice of business structure can also affect your chances of being audited by the IRS. A sole proprietor reporting business income on a Schedule C is more likely to be audited by the IRS than an S Corporation. The reason for the increased attention is the IRS’ conclusion that sole proprietors are far more likely to make mistakes and under-report taxable income than corporations.

As you consider these examples, bear in mind that every business has a unique financial situation and it’s always wise to consult with a tax advisor on your own situation. Your choice of business type will ultimately depend on all the particular aspects of your business. But regardless of your ultimate selection, taking a serious look at your legal structure is essential and is one of the easiest ways to save on your income taxes for years to come.

Good luck!

Nellie:) xo

This original content by Nellie Akalp was written and published on