In general, there are three basic types of business structures: sole proprietorships, partnerships and corporations. The primary difference between each entity designation is the way the business itself is structured and taxed.
What is Sole Proprietorhip? This is the default entity designation for small businesses. Under a sole proprietorship, you and the business are synonymous. This is true whether you’re doing business under your own name or under a fictitious name registered as a “DBA.” In a sole proprietorship, you are the sole owner of the business, and the profits are considered to be your personal income. As such, there are relatively few tax benefits to running a business as a sole proprietorship. There are a few deductions you can take for business expenses, but these will generally not be as advantageous as those offered by other entity selections.
• Very simple to set up, with little or no paperwork required
• Inexpensive to operate from an administrative standpoint
• Low start-up costs
• No liability protection; you must purchase insurance to protect yourself from liability
• Net profits are taxed as income and are subject to both income and self-employment tax
• Higher audit risks than other businesses
As a start-up business, a sole proprietorship makes a lot of sense. Once the business begins to grow and expand, though, it’s wise to change its designation to something else. The reason is simple: Because every penny earned by your sole-proprietorship is considered to be your income, it’s taxed at the same rate as any other income you might receive. You’re also responsible for self-employment taxes. All of this can result in your tax burden being substantially higher than that felt by other types of business owners. It can even be twice as costly, tax-wise, to be a sole proprietor as an employee of another company.
Optimizing your tax strategy can be complex and confusing, and it’s easy to do it wrong without realizing it. This is why it’s so important to do your research and consult with a professional who can help you keep the most money in the bank.
Esther Phahla is a Certified Public Accountant and Certified Tax Coach in Temecula. She also holds a Masters of Science in Taxation. She can be reached at (951) 514-2652 or visit www.estherphahlacpa.com