Whether you’re running an established business or just starting out, one of the most important decisions you’ll face is choosing the right business structure. The decision involves several factors, with tax considerations being a primary concern. This case study explores the tax implications of two common business structures: a sole proprietorship and an LLC taxed as an S Corporation.
Case Study Overview:
Let’s consider the example of “Bullet Express,” a small acting business owned by Letty Speed, an aspiring actor. Letty is exploring her options for structuring her business: she could operate as a sole proprietorship, form an LLC, or elect to form an S Corporation. In this case study, we will focus on how Letty’s tax situation differs under two common options: the sole proprietorship and the LLC taxed as an S Corporation.
Sole Proprietorship
Business Structure:
A sole proprietorship is the simplest and most common structure for solo business owners. In this scenario, Letty decides to start her acting business as a sole proprietor, meaning there is no separate legal entity. She and her business are one and the same.
Tax Considerations:
As a sole proprietor, Letty reports her business income and expenses on Schedule C of her personal income tax return (Form 1040). The profits from her business are directly reported on her personal tax return, where she will be taxed at her individual tax rate.
Example:
LLC Taxed as an S Corporation (S Corp)
Business Structure:
Letty opts to form an LLC and elects S Corporation status. This structure allows her to potentially reduce her self-employment taxes by paying herself a reasonable salary and taking the remaining profits as distributions, which are not subject to self-employment tax.
Tax Considerations:
As an S Corporation, Letty must pay herself a reasonable salary for her work. This salary is subject to payroll taxes (Social Security and Medicare), but any additional profit distributed to Letty is considered a distribution, which is not subject to self-employment taxes. This structure can lead to significant tax savings for profitable businesses.
Example:
By structuring her income this way, Letty avoids self-employment tax on the $30,000 profit distribution, leading to substantial tax savings.
Conclusion:
Each business structure comes with distinct advantages and challenges, especially when considering tax implications. Here’s a summary of Letty’s findings:
For Letty, the optimal choice depends on her business goals. If she expects her business to grow and become more profitable, the LLC taxed as an S Corporation may be the most tax-efficient choice. However, if simplicity is her priority and her business remains small, she might prefer the ease of a sole proprietorship or LLC with pass-through taxation.
