Determining which type of business is right for your situation can be difficult. There are many things to consider when making this decision. Taxes should be an integral part of this choice. The type of business that works for you will depend a great deal on your size and structure.
The right legal entity will involve manageable administrative burdens for a business your size and meet your organizational needs as well. In addition, determining the right legal entity could save you a significant amount of money at tax time.
This article provides an overview of how taxes work for each business entity. Although this article is not exhaustive, it is a good starting point to consider what your taxes may look like for each business type. Small businesses may not need the complicated structures that you would find in a corporation, but medium and larger businesses could benefit significantly from creating a more complex business type to reap the tax benefits.
Before you choose your business structure, you should sit down and develop a business plan. Having this plan will help you determine what type of services or products your company will offer and how it will offer them. This information will be important to find out which structure works best for your situation.
There are six basic types of business structures. Each one has advantages and disadvantages. These structures include the following.
Each of these business types will generally be responsible for payment of income taxes, employment taxes, and any applicable excise taxes. Sole proprietorships, LLCs, and partnerships may also need to pay self-employment taxes. The focus of this article is on income taxes.
The major advantage of a sole proprietorship from a tax standpoint is that it is simple. There are no separate taxes for your business, and you report all of your business income and losses on your personal income tax return. You should make estimated tax payments on a quarterly basis, and be sure to track how every dollar is received and how every cent is spent.
Keep in mind that as a sole proprietorship, you will be taxed on all of your revenue. This is regardless of whether or not you actually withdraw the money from your business bank account or take a paycheck. You are taxed as if the money is in your personal account and you can spend it freely, even if this is not the case.
As a sole proprietorship, you can still take all of the expenses for your business as a deduction on your Schedule C. These costs may include some of the following:
As a sole proprietor, you will also be required to pay self-employment taxes. These are contributions to Social Security and Medicare that regular employees normally have taken out of their paycheck (sometimes referred to as “payroll taxes”).
A corporation is a separate legal entity, which means that it files its own tax return. It is completely separate from your individual tax return, and it has a different tax rate system. You, as the owner, are not taxed on the profits from the corporation directly. Instead, you are only taxed on the amounts that the corporation actually pays you in the form of dividends or a salary. That means that the corporation gets taxed, and then you get taxed on your income from the corporation. This double taxation sometimes makes corporations an unappealing business structure for small businesses.
Corporations have many advantages that are not tax related. For example, corporations provide liability protection in the event the corporation or business gets sued. This helps corporate owners avoid personal responsibility and does not put their own assets at risk.
However, corporations also have some drawbacks. One of the major problems is all of the reporting and document maintenance requirements. Corporations must create and file articles of incorporation in most states when they form. Some states also require corporate bylaws as well. Further, many states require that corporations provide annual reports and keep records for a certain amount of time. Each filing is often associated with a fee as well. All of these administrative burdens can make a corporate structure not feasible for some small businesses.
An S corporation is a unique combination of a corporation and a sole proprietorship. It offers many of the non-tax-related benefits of a corporation, including liability protection. It also provides a simplicity of being taxed on your own personal tax return. There is no double taxation in an S corporation because it is considered a pass-through entity.
Like a sole proprietorship, however, you are responsible for all of the income taxes related to profits. This applies even if those profits are still sitting in a corporate bank account.
Only certain businesses are qualified to be S corporations. Most of the requirements deal with the size of the company. For example, you can have no more than 100 shareholders, and eligible shareholders include individuals, trusts, or estates. Shareholders in an S corporation cannot be partnerships or corporations.
Limited liability companies are unique in that they can decide how the IRS should treat them from a tax standpoint. LLCs can be treated as a corporation, partnership, or part of the LLC owner’s individual tax return. How the LLC is structured will often dictate this information.
For example, an LLC with at least two members is considered a partnership unless it elects to be treated as a corporation by filing Form 8832. An LLC that only has one member, on the other hand, is treated as a “disregarded entity” and income taxes are part of the owner’s personal tax return. However, even one-member LLCs can also elect to be treated as a corporation.
In its simplest form, a partnership will be treated from a tax standpoint as if it is a sole proprietorship for more than one person. That is, the business’s income and expenses will be included on each partner’s individual tax return. Each partner’s proportionate amount of losses and revenues, as laid out in the general partnership agreement, should be reflected on their own personal tax return. However, the process for doing this is slightly different than a sole proprietorship.
The partnership will file annual information regarding its income, deductions, losses, gains, etc., but this information does not relate to a separate tax rate. Instead, this information is transferred to a Schedule K-1 that each partner will use on their personal income tax return. Schedule K-1 is essentially used in place of a Schedule C for a sole proprietorship. It is not as detailed a Schedule C because it does not include an itemization of expenses. Cost information is included in the partnership annual reporting, Form 1065.
General partnerships do not have the added protection of limited liability like an LLC or corporation. However, Limited Liability Partnership (LLP) structures are available. LLPs are also pass-through entities like a general partnership, but they are appealing because of the extra layer of asset protection.
Cooperatives are infrequent business structures, but they sometimes work well for companies that want to have members or user-owners. Farming operations and grocery stores are perhaps the most well-known cooperatives in the United States.
Cooperatives are technically corporations from a tax perspective, but, like S corporations and partnerships, they have a “pass-through” designation. Although they are considered a separate legal entity, they do not pay federal income taxes as an independent entity. Taxing methods for cooperatives may vary at the state level, so it is important to check your local laws for more information regarding specific cooperative taxes.
You should put a great deal of thought into which business structure will work best for your venture. Taxes should be one of the things you think about, but you may also want to consider:
The type of product or service that your business produces will also have a bearing on the kind of structure you should choose.
Thankfully, you can change your structure later if you decide that the structure you have chosen is not the right one for you. However, this process may be difficult, time-consuming, and expensive, so take the time now to think about which structure will work best so you can avoid those costs in the future. You should also keep in mind that as your business grows, you can “upgrade” your structure to accommodate for your growth.
LegalNature provides a variety of legal forms that can help with formation and maintenance of your business, whether you are a sole proprietorship or a large corporation. These self-help tools allow you to cut down on costs, regardless of your structure. Expenses related to these legal documents are also a tax deductible business expense for every type of business. Click here to view our variety of legal documents available.