When you start a business, you need to choose a business structure. This choice determines the income tax return form you will file. Common business structures include sole proprietorship, partnership, corporation (C or S) and limited liability company (LLC). Each state may have different rules for ownership, liability, taxes, and filing requirements for each structure.
Your business structure affects your daily operations, taxes, and personal asset risk. You should choose a structure that offers the best balance of legal protections and benefits for you. We recommend you advise with both an attorney and a CPA before registering your company with the state.
Some Common Business Structures
Partnership
Two or more people can easily own a business together in partnerships. Partnerships suit businesses with multiple owners, professional groups like attorneys, or groups testing a business idea before forming a more formal business. With a partnership, the profits and the losses flow to the personal tax returns of the partners. The partners receive from the partnership a K-1 form every year with all the information they need to report their share of the partnership’s activity. Depending on the type of partnership, some partners may be subject to self-employment tax, that’s why it is important to advice with your accountant and determine if this is a suitable option for you.
Sole proprietorship
A sole proprietorship is very simple to set up because basically you do business under your own name. In order to protect your Social Security number, we advise you apply for an EIN to use for your sole proprietorship. In addition, you can also obtain a “doing business as” name. The disadvantage is that you do not have liability protection because you’re personally responsible for the business’s debts and obligations. Another disadvantage is that you are subject to self-employment tax on all your profits. That is why we recommend once your business becomes profitable on a consistent basis to advise with a CPA to see what other options are available to you to save on taxes.
S Corporations
An S corporation requires electing this status by filing IRS Form 2553. It is a pass-through entity that reports its profits on the owners’ personal tax returns. It can only have up to 100 shareholders, and these shareholders must be U.S. citizens or residents. In addition, this tax classification avoids the double taxation of regular C Corporations and can provide savings on the self-employment tax in some situations.
C Corporations
A C Corporation is a separate legal entity from its owners. It can earn profits, pay taxes and be legally liable. Unlike the flow through business structures mentioned above, C Corporations pay tax on their profits. C corporations have the disadvantage that they encounter double taxation:
- once, when the company makes a profit, the C corporation has to pay income tax,
- then, when dividends are paid to the shareholders, the shareholders pay dividend tax on their personal tax returns.
Other disadvantages are that they cost more to form and require more recordkeeping, operational processes, and reporting.
Limited Liability Company
An LLC is like a chameleon. It provides protection from personal liability in most cases and it is very versatile because an LLC can be treated for tax purposes as: a disregarded entity, a partnership, an S corporation or a C corporation.
We advise you to choose wisely. You can change your business structure later, but there might be restrictions and there might be unintended tax consequences associated with the change.
If you are interested in starting a new business, we recommend you to choose our “New Business Formation Consulting” service. We can help you determine what is the best tax classification for your new business and advise you on what is the most tax efficient way to setup your new business entity for federal tax purposes. Click here to schedule an appointment.
This material is for informational purposes only. It does not constitute tax, legal or accounting advice.