Save on Taxes and Protect Your Assets: When to Consider Changing Your Business Entity

As a business owner, it's essential to understand how your legal structure affects your taxes and liability. Let's break it down in simple terms.

Business Entity Types

If you're a sole proprietor, your business's property and liability are not legally separate from your personal assets. This means that your business income is considered personal income, and you must file taxes using Schedule C (IRS Form 1040). If your business is growing, you may want to consider changing your legal structure to protect your personal assets. For instance, if you bring on a partner, you may want to become a limited liability company (LLC) or a C Corporation. 

Partnerships are similar to sole proprietorships, and business taxes are passed through to partners. Limited partnerships (LPs) have limited partners who invest money or property but are not held personally liable for the company's operations. If you're in a partnership, you may also want to consider changing your legal structure to protect your personal assets and reduce your taxes.

If you're already an LLC, you can choose to be taxed as an S Corp or a C Corp, as well as a partnership. S Corp election can help you save on employment taxes, while C Corp election can help you attract private equity money or venture capital. However, it's important to note that becoming a C Corp comes with increased corporate compliance requirements and double taxation.

As a C Corporation, your business is a separate legal entity from its owners, and you must file separate tax returns. There is a flat tax rate of 21% on corporate income. If you're a C Corp, you may also want to consider converting to an LLC to avoid double taxation. 

When to Change

If you're thinking about electing S Corp status with the IRS, keep in mind that there are potential tax implications you should be aware of. For example, if your S Corp inherited assets from a C Corp and sells them within five years, you and your shareholders may be subject to built-in gains tax on the asset sale. Additionally, if more than 25% of your S Corp's gross income comes from passive income sources like rent, interest, or stock sale funds, you may also be subject to tax.

If you're currently a C Corp and looking to avoid double taxation while still maintaining liability protection, you may consider converting your business to an LLC. To do this, your C Corp should follow the conversion plan laid out in your bylaws. If there's no conversion plan, your business must follow the rules dictated by the state, which usually requires a majority of shareholders' approval. Converting to an LLC can be a complex process, so it's important to consult with an accountant or attorney before making any decisions.

Remember, understanding the tax implications of your legal structure is essential to protect your personal assets and reduce your taxes. If your business is growing or your ownership structure is changing, it's important to have a conversation with me and your attorney to determine the best legal structure for your business.