How Business Structure Affects Your Startup Taxes
We’ve written about what an important decision choosing your startup business structure is, and how it can impact your future fundraising, business growth, and even exit strategy. But it’s also super important for another area of your business: taxes.
If that’s surprising, read on for how your business structure affects the taxes you’ll pay — among other things, how much and what types.
Types of Business Structure
There are several possible ways you can structure your business. You could opt to be a sole proprietorship or a partnership, form a limited liability company (LLC), or a corporation. Sole proprietorships are the most straightforward type of business entity. There is no separation between you as the founder and your business, and you’ll report the business’ profits and losses on your individual tax returns.
When it comes to startups though, the most common business structures we see are C-Corporations and LLCs. Your choice of entity has a number of legal and financial ramifications, in addition to tax ones. But for now, we’ll focus on what it means for your tax liability.
What Taxes You’ll Pay Based on Your Business Structure
If you structure your business as an LLC, you won’t have to pay separate taxes at the business level, but all of your LLC’s members will report their share of the business’ earnings on their individual tax returns. Whether or not your business actually pays out any earnings, any income it generates will count as taxable income for LLC members.
Individual states set their own tax thresholds and requirements for LLCs formed in their states. LLCs incorporated in California must pay an $800 minimum annual tax to California’s Franchise Tax Board. On top of that, those with a gross income of at least $250,000 are subject to an additional income-based fee.
Thanks to the 2017 Tax Cut And Jobs Act, LLCs and certain other types of businesses structured as pass-through entities (the tax liability for earnings or benefit from losses bypasses the business, instead the LLC’s individual members are responsible for taxes) might qualify for a 20% tax deduction on their qualified business income.
C-Corps, specifically Delaware C-Corps, are the most common form of business entity for startups because they allow multiple classes of stock with different voting rights. That makes them highly attractive to investors and for businesses that plan to raise capital down the road.
C-Corps’ main drawback from a tax perspective is double taxation. This happens because they pay income tax at the corporate level and, again at the individual level when shareholders receive dividends. When you sell your shares in a corporation, you’ll also pay federal capital gains taxes — generally ranging from 0-20% — at the federal level. You’ll also pay capital gains taxes at the state level. In some cases, including California, capital gains are taxed at the same rate as ordinary income is.
Double taxation is certainly something to consider, but most startups aren’t at the point where they’re generating profits, paying dividends, or making capital gains distributions. Still finding and working with a startup tax professional now, can help you plan for the future, and even set you up to minimize taxes’ eventual bite.
S-Corps don’t pay income taxes at the corporation level. The individual owners report their share of earnings and losses on their individual tax forms. We don’t see many startups using this structure because the restrictions, including limits on the number of shareholders and the ability to have only one class of stock, among other things, make these less attractive. But one thing to know: both LLCs and C-Corps can choose to be taxed as S-Corps by making an election with the IRS.
Why would this make sense? It can be attractive from a tax perspective, because being treated as an S-Corp for tax purposes can avoid double taxation. Since S-Corp shareholders who are also employees — pay withholding taxes on their wages and salary instead of the higher (15%) self-employment taxes they would pay on their share of an LLC’s business income.
It’s not a slam dunk though; the IRS sets strict rules for making an S-Corp election. It also scrutinizes.
What Else Do You Need to Know About Business Structure?
No matter your business structure, if you have employees, you can expect to pay employer taxes including and unemployment insurance, at the federal and state levels.
With all the complexity, you might be tempted to just kick the can down the road and deal with this another day. But understanding the implications of your business structure is crucial for startup success. Choosing the wrong business entity can be costly and delay or restrict your ability to raise funds. Working with trusted professionals such as your tax advisor and lawyers who have startup expertise, can help you think through all the implications and set you up to navigate them with a minimum of disruption.
About Early Growth
For over 10 years, Early Growth has provided early-stage companies CFO Consulting Services, Accounting for Startups, Taxes, and 409a Valuation. We saw a need in the marketplace for a service that would allow founders to still focus on business while building a healthy financial story. Our Outsourced CFO, Outsourced Accounting, and R&D Credits services have helped many companies grow.