Owning your own business is your life-long dream. You’ve invested many hours in getting it all together and you’re excited about its possibilities.
You know your business – but you’re unfamiliar with different types of business structures.
The most common types of business structures are:
But how do you decide?
The business structure you chose determines how much you owe in taxes, which tax forms need to be completed, how you can raise funds and your personal liability – all vitally important issues for any business owner.
Business Structure – Not a One-Size-Fits-All Decision
It’s certainly not a one-size-fits all decision! Each business structure has its pros and cons, and the IRS has plenty of details on each. I’ll note a few highlights of each below so we can begin a conversation about which one is best for you.
By consulting with you, listening to your needs and understanding your business, I can help you make an informed decision. Together, we can streamline your business processes – so you have more time to do what you’re the expert at! Let’s get started with a brief overview of different business structures…
Sole Proprietorship – Gives You Complete Control
The simplest and one of the most popular business structures is the sole proprietorship. It has no separate existence from its owner.
Sole proprietorships are:
- simple and easy to set up, nominal costs
- can comingle personal and business funds
- profit and loss from the business are taxed on the individual’s personal income taxes
- sole proprietor (yes, that’s you!) remains responsible for all business debt
- creditors can bring lawsuits against the business owner
Pro tip: Consider obtaining an EIN (Employee Identification Number), which is a great way to reduce exposure of your personal SSN (Social Security Number). You can apply for an EIN on the IRS website here.
LLCs – The Best of Both Worlds
With an LLC, you benefit from the perks of both the corporation and partnership business structures, according to the SBA.
LLCs are another popular business structure for many reasons:
- protection of most personal assets in the event of bankruptcy or lawsuits
- business profit and loss passes through to the personal income tax return
- greater flexibility in management versus a traditional corporation
- reduced/simplified paperwork requirements over a regular corp
- members get to decide BOTH how profits and losses are allocated
While LLCs are a very popular business structure, it’s important to know that the pass-through tax treatment can be a double-edged sword. When profits are reported on your personal income tax return, you’ll be responsible for paying the self-employment (SE) tax.
One option is to elect S-Corporation tax status, which is explained briefly below. As a Forbes article points out, if you opt not to be taxed as an S-Corp and those profits do pass through to your personal income tax return, you might wind up owing more than if you were taxed as a corporation.
Some summary points on LLCs to know:
– A Single Member LLC is strictly a legal distinction. Taxes are reported and paid just as a sole-proprietor would.
– A Multi-Member LLC is treated as a partnership and files a Partnership tax return Form 1065.
– S-Election is common – in this setup, the business remains an LLC for legal purposes but an S-Corp for tax purposes.
Partnerships – Basic Business Structure For Two or More Owners
The two most familiar types of partnerships are limited partnerships (LP) and limited liability partnerships (LLP).
- one general partner has unlimited liability, all other partners have limited liability
- general partner pays self-employment taxes in addition to tax on personal profits
- profits pass through to personal income tax returns
Limited Liability Partnerships:
- attractive to medium and/or high-risk business
- corporation and partnership business structure advantages are available
- limited liability to all owners
- protects each partner from debts against the partnership
- profits and losses pass through to personal income tax without corporate taxes
- allowed by state statute in all 50 states
Most states do not restrict ownership, meaning that members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members.
S-Corps Appeal to Small Business Owners
The IRS defines S-corporations as “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” While an S-corp can offer small business owners many tax advantages, it’s also important to consider some important topics associated with this setup.
One key topic surrounding S-corps is reasonable compensation. Even the IRS acknowledges that calculating compensation for employees and shareholders can be tricky. Of course, you’ll want to discuss your unique situation with a tax professional.
Specifically, S-corps must pay reasonable compensation to its shareholder-employees for services provided prior to any non-wage distributions being made. The salary can be less than distributions – as long as it is reasonable. They however should NOT take distributions in excess of basis.
On Form 1120S (US Income Tax Return for an S-Corp), the IRS makes it abundantly clear: “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
The IRS has authority to reclassify other forms of payments to a shareholder-employee as a wage expense. As you may know, those wages are subject to employment taxes.
One of the major reasons S corporations are attractive to business owners is because of the potential SE tax savings: SE taxes (Social Security and Medicare) are paid only on salary – not on the net profit of the business.
This article offers some tax considerations if you’re wondering whether or not an S-Corp is right for your business.
Corporation: An Edge in Raising Capital
A corporation is also known as a C Corp. Corporations exists as separate entities:
- owned by stockholders who share in profits and losses
- can sue and be sued, distinct from its stockholders
- owners pay personal income tax on the profits
- the business must pay corporate income tax on profits
According to the Small Business Administration, corporations have an edge in raising capital by selling stock. So if your business is on the fast track to big growth, a corporation can be the ideal business structure.
S-Corporation – Helps Avoid the SE Tax
According to the IRS, shareholders of S-corps report the pass-through of income and losses on their personal tax returns. This setup avoids ‘double taxation’ of C Corp profits; shareholders are assessed tax at their individual income tax rates.
Perhaps one of the most well-known benefits is that it offers the ability to avoid costly self-employment taxes. With an S-Corp, “owners” are, for tax purposes, considered “employees.” This avoids the self-employment tax consequences a sole proprietor or an LLC that has not elected S-Corp status might face.
According to the IRS, an S Corp can have no more than 100 shareholders, it must be a domestic corporation and can have only one class of stock. Shareholders report income and losses on their personal income tax. You must file for S-Corporation status with the IRS.
Confused By The Differences in Business Structures?
It takes an experienced tax advisor to review your business needs and choose what business structure gives you the most tax benefits – and legal protection.
You’re an expert at your business. That’s solid groundwork:
Don’t ever let your business get ahead of the financial side of your business. Accounting, accounting, accounting. Know your numbers.
-Tilman J. Fertitta, American billionaire businessman
Together, we can ‘know your numbers,’ and you can enjoy the road to success! I know how boring (not to mention stressful) anything related to taxes and accounting can seem to small business owners.
It doesn’t have to be! Whether you’re starting a new business or ready to take your existing business to the next level, I’m here to help. Contact me today to discover how I can support you in your journey.