Some of the decision factors include how profitable your business is, and how much of those profits you want distributed to you versus re-investing the profits back into the business.
Generally speaking, profitable businesses should be C-corporations (regular corporations that file on Form 1120). The lowest tax bracket for a C-Corp is the 15% bracket that goes from zero to $50,000. It may be possible to manage your small business finances so that your corporation will never pay more than 15% in taxes.
For other forms of business (partnership, S-Corp, LLC partnerships, Schedule C), tax is not levied at the corporate level, instead all profits are fully distributed to the shareholders, and reported & taxed on each shareholder's 1040. On a profitable business, this will increase each shareholder's taxable income, and possibly move them to a higher tax bracket.
If the business is losing money, losses are retained by a C-Corporation and offset next year's income. In other forms of business, the loss is passed-through to the shareholder, where the loss reduces the shareholder's total income. Losses on a pass-through entity provide a significant tax break in the year the loss occurs. Losses in a regular C-Corporation provide a significant tax break in the future by reducing future income. Generally speaking, business owners prefer to operate an unprofitable business as an S-Corp, partnership, LLC, or sole proprietor, and prefer to operate profitable businesses as a regular C-Corp, LLC, or partnership.
S-Corporations can be owned by a single person, and so the IRS expects S-Corps to pay areasonable salary to the managing shareholder in addition to a profit distribution. Naturally, I am inclined to pay myself more as profits and less as salary in order to minimize the payroll taxes (Social Security and Medicare taxes) that are due on salary. The IRS is aware of this situation and is on the lookout for it. The IRS expects S-Corps to pay reasonable compensation for the services of the officers. "Reasonable compensation" can be interpreted in different ways. But it means what you would expect to be paid if you were hired by someone else. The fastest way to an IRS audit as an S-Corp is to report zero officer compensation.
Partnerships and Limited Liability Companies are taxed at the shareholder level, much like an S-Corp. The IRS, however, has not demanded that partnerships pay a reasonable salary to managing shareholders. General partners in a partnership are considered self-employed, and their share of profits are subject to the self-employment tax. Limited partners, however, pay self-employment tax only on "guaranteed payments" for services rendered to the partnership. Every partnership must have at least one General Partner. LLCs, however, can be composed of shareholders who designate all management responsibility to salaried employees. Thus on an LLC, shareholders would not be subject to self-employment tax unless they receive a "guaranteed payment" for services rendered to the LLC. (See IRS Publication 541, Partnerships, Partner's Income or Loss.)
Schedule C sole proprietors are taxed on their 1040. The entire business profit is considered self-employment income, and is reported on a Schedule C. As a Schedule C business, you do not pay yourself a salary. Only salaries and payroll taxes paid for other employees are allowable business expenses.
C-Corporations are taxed separately from their shareholders. Any salary paid to yourself is deductible as a business expense to the C-Corporation. Also, if the C-Corp distributes dividends to the shareholders, the dividends are taxed at a special "qualified dividends" tax rate of 15%. Dividends from a corporation are taxed twice, once at the corporate level and again at the shareholder level. Since the corporation has already paid tax on its earnings, this distribution qualifies as a "qualified dividend" at the lower 15% tax rate. On my 1040, I pay only 15% tax on these dividends.
C-Corporations are the only business that can split profits between retained earnings and dividends. S-Corps and Partnerships must report all profits as a distribution, even if the business has retained some of the cash for next year's operating expenses. The ability to choose when and how much you are taxed by controlling when and how much money is distributed is a crucial tax advantage for C-Corporations. This means that there is more flexibility with a C-Corporation to pick your tax rate than there is with the other options. However, S-Corps, partnerships, and Schedule C businesses are easier to set up and operate.
