The decision to launch a new business venture involves a great deal more than choosing what products and services to sell or where to set up operations. Choosing the right business structure—the legal framework through which your business operates—can have a serious effect on your profit potential and tax obligations in the coming years.
Below is an explanation of some of the most prevalent structures for small businesses, along with the tax benefits and liabilities that go along with each one. Read up on the various options, and decide which one will best meet your needs in the years to come.
A sole proprietorship is a business that is owned and operated by one individual. It’s often regarded as the most basic type of business structure.
Compared to other business structures, sole proprietorships are relatively easy to set up. Also, since sole proprietorships have just one owner, filing taxes is relatively simple. Instead of filing on behalf of the business, the proprietor pays taxes based only on his or her income.
While launching a sole proprietorship offers a number of benefits, this structure is not without its drawbacks. First, owners must pay their own self-employment taxes, including contributions to Social Security and Medicare. Additionally, sole proprietors are forbidden from selling interest in the business. As a result, sole proprietors are responsible for the full tax burden from Day 1. The proprietor is also fully liable for any lawsuits brought against the business, and judgments against the proprietor can be satisfied with his or her personal assets.
Despite these drawbacks, it’s worth noting that sole proprietorships are taxed at a lower rate than most other business types.
Corporations refer to businesses that are taxed individually from their owners. Legally regarded as separate entities, corporations afford business owners a number of benefits, including reduced legal liability and greater credibility among banks and lenders. Most corporations fall into one of two categories—C corporations and S corporations—each with their own perks and drawbacks.
For instance, C corporations can deduct a wider range of business expenses than other structures come tax time. But income collected by a C corporation is subject to double taxation, in which case a business is taxed once for annual earnings and a second time when dividends are distributed to shareholders. To avoid these costs, many business owners opt to start S corporations instead.
Unlike C corporations, S corporations pay individual taxes at the shareholder level instead of corporate tax rates. To be eligible for this status, businesses must have fewer than 100 shareholders and a single class of stock. It’s important to note that certain types of businesses, including financial and insurance firms, don’t qualify for S corporation status.
If you’re considering a corporation for your business structure, the Small Business Administration provides an excellent primer on each type.
Limited Liability Company
A limited liability company (LLC) is a business structure that is formed in accordance with state law and provides its owners with legal protection from business debts and more options regarding managerial structure. While S corporations limit the number of potential owners, LLCs are free to distribute shares to as many parties as they desire.
Additionally, LLCs offer a number of tax benefits over other types of business structures. Because they operate under pass-through taxation, LLCs aren’t subject to double taxation. Instead, LLC owners make quarterly IRS payments on their personal tax forms. LLC owners must also submit Form 1065 each year for informational purposes.
An LLC structure, however, isn’t without drawbacks. For one thing, transferring rights can be complicated, as all members of the LLC must typically agree on ownership changes. Additionally, some states subject LLCs—but not corporations—to property taxes. Finally, LLC owners are obligated to pay their own self-employment taxes. While the corporation pays half the Social Security and Medicare taxes for owners who work as employees, LLC owners are responsible for the full self-employment tax.
Partnerships refer to businesses owned and operated by two or more people. Business owners can opt to form various types of partnerships, each with their own benefits and drawbacks. Most partnerships are known as general partnerships (GP), and there are other variants, such as limited partnerships (LP) or limited liability partnerships (LLP).
While GPs enjoy pass-through taxation, meaning that income is taxed through the partners instead of being subject to corporate tax rates, business owners in a GP risk personal liability if the company can’t pay its debts. On the other hand, limited partnerships protect silent partners from personal liability but restrict them from participating in the company’s daily operations.
In some cases, entrepreneurs may choose to form a limited liability partnership. Restricted to certain professional fields (i.e. law, medicine, finance, etc.), LLPs prevent partners’ personal assets from being used to fulfill business debts. However, it’s important to note that owners may still be liable for malpractice.
If you’re considering forming a partnership, do your research to determine which variety best meets your industry-specific needs. Furthermore, should you decide to form a partnership, be sure to write a partnership agreement, which can help stop intra-partnership conflicts before they start.
While most owners form businesses with the intention of earning a personal profit, some businesses are run exclusively for the benefit of the general public. In contrast to conventional businesses, nonprofit organizations (NPOs) devote profits exclusively to accomplishing objectives that benefit the general public instead of distributing them among shareholders or other owners. For this reason, nonprofit organizations are granted tax-exempt status by the IRS.
Not every business will qualify was a nonprofit group. To register as an NPO, you must submit your application and user fee within 15 months of formation. Additionally, nonprofits must reveal their financial and operating information to the general public so contributors know their money is being used as intended. You should also ensure that your business doesn’t receive income from other activities not related to its exempt status in order to qualify as a nonprofit.
While nonprofits enjoy a number of benefits come tax time, businesses that demonstrate fraudulent behavior may be subject to harsh IRS penalties. In recent years, the IRS has increased audit rates for all business structures, including nonprofits, so business owners should perform their due diligence to avoid issues.
The fact is that the type of business you choose to start can have a profound impact on your tax responsibilities moving forward. Before launching a new company, take the time to consider how profitable you expect to be in the coming years, and determine whether you want to circulate those profits or invest them back into the company.
Do your research regarding the various types of business structures so there won’t be any surprises come tax time. To avoid penalties and other losses, startup owners should take steps to ensure they can adhere to all the IRS requirements for self-employed persons and small businesses.