Choosing A Business Entity Type For Amazon Sellers
Part of starting your Amazon Seller business is choosing the business entity type that best meets your needs. From a CPA's perspective, forming an entity is all about choosing the type of entity that most easily allows you to put cash into the business and to get cash out of the business with the most favorable tax consequences.
Paying taxes is something you should count on, but you can take advantage of certain entity structures to reduce your tax rates legally. Depending on your specific circumstances, choosing one entity type over another can have significant tax benefits.
There are costs associated with creating a business entity. These are considered organizational costs and like business start-up expenses, a portion of these expenses may be deductible on your first tax return. It’s important to keep good records of these expenses.
I can't possibly cover all of the specific scenarios, but I'll go over some basic strategies here that you may find helpful.
Sole Proprietorship
This is the simplest form of operating a business. There is no legal entity separation between the person and their business. The person is the business.
ADVANTAGES:
Lower organizational costs;
Lower tax prep fees since no separate business tax return is filed. You only a file a Schedule C with your personal tax return;
Business use of home deduction with exemption from exclusive use test. This can be a huge deduction whether you rent or own;
Hire your kids and they will be able to pay no income tax on up to the standard deduction for single filers of income from working in your business. You also get to deduct that as payroll as part of your business expenses. This is huge if you would have otherwise given them the money;
Easily converts to and another entity type if needed;
Qualified Business Income Deduction of up to 20% of your net income.
DISADVANTAGES:
Personal liability. This is the main reason why a lot of people form an LLC, but some states disregard single-member LLCs so you may not even have the liability protection you think you have. If you have employees, certain acts of an employee could create liability for an employer and as a sole proprietor, that means personal liability. Consult an attorney on this, but also consider a good insurance policy for liability protection.
Self-employment tax. You'll pay 15.3% on your business net income. The only way to avoid this is to make less business income because your personal tax deductions won't lower your business income.
Single-Member LLC
A Limited Liability Company with only one owner. Aside from the liability protection that may be offered and lower organization costs, the advantages and disadvantages are the same. That is because for federal income tax purposes single-member LLCs are treated the same as sole proprietorships and file the same tax form.
ADVANTAGES:
May provide liability protection
Lower tax prep fees since no separate business tax return is filed. You only a file a Schedule C with your personal tax return;
Business use of home deduction with exemption from exclusive use test. This can be a huge deduction whether you rent or own;
Hire your kids and they will be able to pay no income tax on up to the standard deduction for single filers of income from working in your business. You also get to deduct that as payroll. This is huge if you would have otherwise given them the money;
Qualified Business Income Deduction of up to 20% of your net income;
Flexibility to add another member or members;
May be a better entity choice than a sole proprietorship if you want to get a business loan at some point.
DISADVANTAGES:
Organizational costs and possibly ongoing costs are higher than a sole proprietorship. In a state like CA, you will have to pay an $800 annual franchise tax fee regardless of whether you make a profit or not;
Self-employment tax. You'll pay 15.3% on your business net income. The only way to avoid this is to make less business income because your personal tax deductions won't lower your business income.
Multi-Member LLC
A Limited Liability Company with multiple members. The IRS doesn't recognize LLCs for taxation purposes, so you will either be taxed as a partnership or a corporation. I'll discuss taxation of corporations after this section so I will focus on LLCs taxed as partnerships for purposes of this section.
ADVANTAGES:
Limited liability for the LLC members;
Income and tax benefits pass through to the partners;
Not subject to double taxation like a C corporation;
Income and expenses can be specially allocated to the partners;
Liabilities provide basis in the partnership;
Qualified Business Income Deduction of up to 20% of your net income.
DISADVANTAGES:
Members pay tax on income whether or not it is distributed. So you cannot reinvest earnings without being taxed;
Members cannot exclude certain tax favored fringe benefits from their income;
Separate tax return must be filed on top of your personal tax return;
Potential self-employment taxes;
Accidental or automatic dissolution possible when a member leaves;
Distributions could be taxed if they exceed basis in the LLC.
S Corporation
A corporation that meets certain criteria that is a pass-through entity. Just like an LLC, the income and tax benefits pass through to the partners. Unlike a C Corporation, the S Corporation pays no tax at the federal level although some states do tax S Corporations.
ADVANTAGES:
Ability to lower self-employment tax by paying a reasonable salary to the owners and taking the rest of income in distributions not subject to self-employment tax;
Limited liability for the shareholders;
Income and tax benefits pass through to the partners;
Not subject to double taxation like a C corporation.
DISADVANTAGES:
Members pay tax on income whether or not it is distributed. So you cannot reinvest earnings without being taxed;
Members cannot exclude certain tax favored fringe benefits from their income;
Separate tax return must be filed on top of your personal tax return;
Distributions could be taxed if they exceed basis in the S Corp;
Income and expense can only be allocated to the owners on the basis of shares held, not specially allocated like an LLC.
C Corporation
A corporation that is not a pass-through entity. The C Corporation pays its own taxes a corporate tax rates.
ADVANTAGES:
Income not distributed to owners can be reinvested and possibly taxed only at lower corporate income tax rates;
Limited liability for the shareholders;
Deduction of tax favored fringe benefits are possible i.e. insurance paid by the corporation for the owners.
DISADVANTAGES:
Does not qualify for the Qualified Business Income Deduction of up to 20% of your net income;
Income distributed is taxed to the owners even though was already taxed to the corporation.
Conclusion
Because there are so many advantages and disadvantages to consider when deciding your entity type, it makes sense to carefully consider your objectives and long-term goals before deciding. If entity formation is a hurdle to getting your business started, you may want to consider starting as a sole proprietorship just to get started since you can easily convert to another entity type later on.
If you would like a consultation specific to your situation, please contact us.
