The Abc's of Small Business Taxes: Why is Choice of Entity so Important?

The typical sole proprietor trying to find legal tax reduction strategies is faced with a daunting task. Our tax code is so complex, how can you even begin to unravel all the convoluted rules and regulations?

Just how complicated is the tax code? Consider this: Back in 1913, when federal income taxes first began, the entire tax code occupied a mere half-inch thick book. The first federal income tax return was a simple two-page form with four pages of instructions.

Now what do we have? -- a literal monster. Today the tax code takes two four-inch thick volumes to print, along with well over a million lines of "regulations" that officially explain and interpret what the code means. Then when you add all the relevant tax-related court decisions that apply the code -- well, now we're talking about 25 feet of library shelves.

With all these tax rules, what's the small business owner to do? Here's the first thing you must realize: Given the same amount of profit, not all businesses pay the same amount of taxes.

Think about that for a moment. It's probably something that you've always wondered about, maybe were even a bit suspicious about. Well, if you always thought that some people pay less tax than you (even though they make the same amount of income), you are correct.

Why is that? Is it fair? Is it "right"? Is it legal? Yes, it is legal for one business owner to pay less tax than another business owner, even though both have the same income. Any why does this happen? I'm going to answer this question by telling you about the easiest (and perhaps the most overlooked) tax-reduction strategy on the books. Many small business owners are paying too much tax, simply because they own the "wrong" type of business. I'm not talking about "type" in the sense of whether you own a carpet cleaning business vs. a pet store. I don't mean what kind of industry your business is. I don't mean whether you are a manufacturer, a wholesaler, a retailer, or a service business. I'm talking about whether your business is a sole proprietorship, a partnership, a C corporation, an S corporation, or a limited liability company (LLC).

There are several "types" of business ownership, from a legal entity standpoint. And you have got to get this right, or you will pay literally thousands of dollars more in taxes than you should. The simple fact is, there are significant differences in the amount of taxes that each of these business "types" usually pay.

Sole proprietors are especially vulnerable to overpaying their taxes because they are sole proprietors. So if you are a sole proprietor, I must ask you this question: Have you ever done an analysis of the tax consequences of operating your business as a partnership, a corporation (both C and S), or a LLC? This is known as a choice of entity analysis, and this analysis is a great place to start on the journey of small business tax reduction. It could be the best thing you ever do for yourself and your business.