When you first started your business, you probably chose the simplest structure: a sole proprietorship or a partnership. But as your company grows and profits increase, that initial choice could be costing you a significant amount in taxes.

 

The tax savings from changing your business structure can be a game-changer. Re-evaluating your business entity is a smart, strategic move that can reduce your tax liability, protect your personal assets, and set you up for future growth.

 

The Tax Tiers: From Simple to Strategic

 

Let's look at the most common business structures and their tax implications for business owners.

 

  • Sole Proprietorship and Partnership (Default LLCs): These are known as "pass-through" entities. This means the business itself isn't taxed. Instead, all profits and losses "pass through" directly to your personal tax return. This sounds simple, but it has a major drawback: you pay income tax and self-employment tax (Social Security and Medicare) on all of your business's net income. For a highly profitable business, this can be a huge tax burden.
  • S Corporation: This is where the tax savings truly begin. An S corporation is a special tax election that an LLC or a C corporation can make. It's still a pass-through entity, but with a critical difference: you are treated as both an owner and an employee. This allows you to pay yourself a "reasonable salary" (which is subject to payroll taxes) and then take the rest of your profits as a "distribution" (which is not subject to self-employment tax). This can lead to substantial tax savings once your business becomes consistently profitable.
  • C Corporation: This structure is a separate legal entity from its owners. A C corporation pays its own corporate income tax on its profits. Then, when the company pays out dividends to shareholders (you), those dividends are taxed again on your personal return. This is known as "double taxation." While it may seem like a poor choice for a small business, a C corp can be the right choice if you're looking to raise significant capital from outside investors, as it can issue different classes of stock. It may also be beneficial if you want to reinvest profits heavily back into the business, as the corporate tax rate may be lower than your personal tax rate.

 

When to Make a Change

 

Changing your business structure isn't just about tax savings. It's a strategic decision for your business's future. Here are a few signs it's time to consider a change:

 

  1. Your Profits Are Growing: If your business is consistently earning a healthy profit (generally over $40,000 to $50,000 per year) and you're paying a lot in self-employment taxes, it's a prime time to consider an S corp election.
  2. You Need Liability Protection: A sole proprietorship offers no legal separation between you and your business. By converting to an LLC or a corporation, you create a legal shield that protects your personal assets—like your home and savings—from business debts and lawsuits.
  3. You're Bringing in Partners or Investors: As you grow, you may want to formalize your business with new partners or bring in outside investors. A new business structure, like a partnership or a corporation, can provide clear ownership rules and make your business more attractive to capital.
  4. You're Hiring Employees: A more formal structure provides the framework for payroll, benefits, and legal compliance as you build your team.

 

How to Make the Change

 

Changing your business structure isn't as simple as filling out one form. It requires careful planning and a clear understanding of the legal and tax implications.

 

  • Research Your State’s Requirements: Each state has its own specific filing rules and fees for forming an LLC or a corporation.
  • File with the IRS: If you're electing S corporation status, you'll need to file Form 2553 with the IRS.
  • Update All Business Records: This includes bank accounts, contracts, licenses, and EINs.

 

The most critical step is to talk to a CPA or a business attorney. They can help you analyze your business, project your tax savings, and guide you through the conversion process to ensure everything is done correctly.

 

Your business structure is not a one-time decision. By proactively re-evaluating it as your company grows, you can unlock significant tax savings and create a more secure foundation for your business's success.