How Legal Structure Affects Taxable Income

Answers to 2 BIG Questions


I recently conducted a small business seminar for counselors with the City of Philadelphia’s Financial Empowerment Centers (and got so involved with the seminar that I forgot to take photos to share with you!).

These Financial Empowerment Center counselors provide credit, financial and wealth building advice to individuals and small business owners. Some very interesting questions arose during the session, and it occurred to me that other entrepreneurs might benefit from hearing some of this conversation.

Below are two of the most frequently-asked questions that came up during our Q&A session:

Q. How does taxable income flow to the business owner in various legal structures?

A. How the income flows depends on the structure. There are five types of legal structures for small businesses:

Sole ProprietorshipIn a sole proprietorship, the owner’s taxable income is calculated using the following formula:

         Gross Revenue – Total Cost of Goods – Operating Expenses = Taxable Income.

For example: Let’s say you are selling shirts for $40 each, and you sell 5,000. Your gross revenue is $200,000 ($40 x 5,000). Let’s also assume the shirts cost you $10 each (cost of goods). Your total cost of goods is therefore $50,000 ($10 x 5,000). Finally, let’s say your operating expenses (advertising, rent, office supplies, insurance, etc.) total $90,000. The taxable income to the owner is:

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In a sole proprietorship there is no deductible salary for the owner (meaning salary is not an expense that can be deducted from gross revenue). That does not mean the owner cannot pay himself, but it does mean that these payments cannot be claimed as an expense to reduce gross revenue. Why? If an owner of a sole proprietorship was allowed to declare his salary as a deductible expense, he could deduct every dollar of revenue as an expense and not owe any income taxes.

PartnershipThe income in a partnership flows to the owners the same as it does in a sole proprietorship. The difference is how much taxable income flows to each partner. Let’s say the example above is a partnership with two partners: Owner #1 with 60% and Owner #2 with 40%. Owner #1’s taxable income is therefore $36,000 ($60,000 x 60%) and Owner #2’s income is $24,000 ($60,000 x 40%). There are no deductible salaries for the partners.

C-corporationIn a C-corporation the owner pays income taxes on any salary he receives, and the corporation pays taxes on the net profit. In the example above, let’s say the owner earned a salary of $40,000 from the corporation. The owner’s salary would be a deductible expense for the corporation, reducing the corporation’s net income:

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The owner therefore pays an individual income tax on the salary.

S-corporationIn the S corporation the net profit (income) flows to the owner just as it does in a partnership (i.e., in accordance with the percentages owned by each shareholder). The difference is that in an S corporation, the owners’ salaries are deductible. Here’s what would happen in an S corporation if Owner #1 has 60%, Owner #2 has 40%, and each owner earned a salary of $20,000 (for a total of $40,000):                

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LLC (Limited Liability Company) – In an LLC the owner can choose to be taxed as any of the structures listed above: a sole proprietor (single member LLC only), a partnership, an S corporation or a C corporation.

Disclaimer: The above information is provided only as a general description of business legal structures and is not intended as legal, accounting, or tax advice, nor a complete explanation of issues related to business legal structures. You should seek the advice of legal and tax professionals in making personal decisions regarding these matters.

Q. I have worked with several small business owners who report very low or zero profit on their tax returns. What are the implications of this for their businesses?

A. No one likes to pay taxes – and that includes small business owners. However, consistently filing tax returns showing minimal or zero profit may make it difficult to get a loan in the future. Lending institutions view the tax return as a reliable indicator of how your business is performing.

If tax returns show your business is not generating a profit, lenders may be concerned about your business’ ability to repay the loan. Business owners should certainly minimize their business’ tax liability by utilizing all deductions and credits they are entitled to. However, under-reporting income and profit may handicap their borrowing capacity (in addition to being illegal).

I hope this quick overview of business legal structures and their tax implications will help to make the 2015 tax season a bit less confusing for small business owners. April 15th will be here before we know it!

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1 comment

Thx for sharing Mr. EB. These questions apply to business-owners of all stripes. It is great you have passed on this knowledge. If ok, I would like to bring this to the attention of a couple of my clients who may benefit from the exposure.
You will be attributed. Good and practical stuff.

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