The early days of establishing a new business are full of excitement and to-do lists. There are many tasks that have to be taken care of to get a new business off the ground, but one of the first decisions – and sometimes most impactful- you will make is about the structure of your business. If you’re unsure which structure is best for your business or what the options mean for how you manage tax accounting, liabilities, and more, we’re breaking it all down for you below. As always, be sure to consult your tax accountant and legal counsel for tailored advice.
Business Structure Basics
There are four common business structures in the United States: sole proprietorship, partnership, LLC, and corporation. Which one you choose will depend on a variety of factors, but most importantly it will come down to what level of liability protection and tax implications you want for your business.
A sole proprietorship is the most common business structure and is perfect for small businesses and startups. It’s relatively simple and inexpensive to set up and you are in complete control of the business. The downside is that you, the owner, are personally liable for all debts and obligations of the business.
A partnership is similar to a sole proprietorship in that there are only a few people involved and there is no legal distinction between the business and its owners. However, in a partnership, each person is equally liable for the business’s debts.
Limited Liability Company
A limited liability company (LLC) is a business structure that combines elements of both sole proprietorships and partnerships. LLCs have the benefit of limited liability, meaning that the owners are not personally liable for business debts. LLCs also have more flexibility than corporations in how they can be taxed.
A corporation is a legal entity that is separate from its owners. This means that the owners, or shareholders, are not personally liable for business debts. Corporations can be either for-profit or nonprofit. For-profit corporations are taxed differently than LLCs and sole proprietorships, but there are also tax benefits associated with operating as a corporation.
The Right Business Structure for You
There is no one-size-fits-all answer when it comes to choosing the right business structure. The best way to decide is to consult with your tax accountant and legal counsel to discuss the specific needs of your business.
Once you have chosen a business structure, you will need to obtain the necessary licenses and permits from the state in which you are operating. You will also need to register your business with the IRS and obtain a tax identification number.
Changing Your Business Structure
Once you have chosen a business structure, you are not stuck with it forever. In fact, many businesses start out as sole proprietorships or partnerships and then convert to LLCs or corporations as they grow. The process of changing business structures can be complex, so again, it’s best to consult with your tax accountant and legal counsel to see if this is the right move for your business.
Basic Tax Filing Tips
Now that you have a basic understanding of the different business structures, let’s take a look at some general tax filing tips for each one.
If you are a sole proprietor, you will need to file a Schedule C with your personal tax return as well as the standard Form 1040 for personal income tax. Because there is no legal separation between the business and a sole proprietor, all business income and expenses are reported on the personal tax return.
Partnerships file an annual information return to report the income, deductions, gains, and losses from its operations, but, unlike a sole proprietorship, a partnership does not pay income tax.
Instead, it “passes through” profits or losses to its partners. Each partner reports their share of the partnership’s income or loss on their personal tax return. Because partners are not employees, they should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) each partner.
Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”) for tax purposes.
An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it files Form 8832 and affirmatively elects to be treated as a corporation.
A corporation is an entity that is taxed separately from its owners. The income of a C corporation is subject to corporate income tax and then the shareholders are also subject to personal income tax on the dividends they receive from the corporation.
This double taxation can be avoided by electing to be treated as an S corporation. An S corporation is a special type of corporation that is taxed only once at the shareholder level.
To elect S corporation status, the corporation must file Form 2553 with the IRS.
Not sure what to do? Consult with an expert.
SME CPAs team of experienced tax and accounting professionals can help answer questions about these structures and how each option can impact your personal and business tax liability. Looking for more hands-on advice about managing day-to-day finances in your growing business? Check out our full suite of tax planning, accounting, and CFO services.
Get in touch today.