Choosing a Business Structure

One of the first decisions you need to make when starting a business and thinking about taxes is the decision on what business entity structure makes sense for your particular situation.

The main types of legal structures are:

Sole Proprietor

Operating as a sole proprietor is the easiest form of business because it is owned and controlled by one person – YOU. There are no official forms to file, no legal requirements to follow, except perhaps for local business licenses, vendor permits, and the like depending on your industry or profession.

You will often be operating under your personal Social Security number unless you hire employees.  If you hire employees, you will be required to obtain an EIN (employer identification number). You are fully responsible for your actions and all actions of employees.

If you operate as a sole proprietor, your personal assets are not protected from creditors. All income and expenses are reported on Schedule C and incorporated into your individual 1040 tax return. Taxes are paid on the total income of the company, plus any other income sources you may have, not on the business as a separate entity. You have to pay your own self-employment tax, which equates to twice the amount of Social Security and Medicare tax you would pay as an employee. As a sole proprietor, you cannot deduct any premiums paid for life insurance.

Partnerships

Two or more individuals can join forces and create a partnership. Partnerships are governed by the laws of each state, so there can be variations between jurisdictions when it comes to establishment, rights, responsibilities, and obligations of partners, and reporting requirements.

In general, almost every state recognizes two types of partnerships: a General Partnership, where all partners equally share in profits, risks, and responsibilities; or a Limited Partnership, where there are two classes of partners, General Partners and Limited Partners. General Partners are responsible for their own actions and the actions of employees and actively manage the business. Limited Partners generally do not have an active role in managing the business and have limited responsibilities. Personal assets of General Partners may be open to attachment from creditors, but Limited Partners generally are not.

Partnerships need to establish an Employer Identification Number (EIN) to report their taxes, even if the partners are the only “employees.” Partnerships report their income and all business expense deductions for tax purposes on Form 1065 and each partner receives a K-1. Each partner then reports their proportionate share of the partnership’s bottom line on his or her individual tax returns. If a partner has additional business expenses deductions he or she took on an individual basis, they can claim them on their individual tax return.

Corporations

Corporations are the most formally organized business structures and are required to operate under an EIN, not an individual Social Security Number. They are incorporated by one or more individuals who own shares in the organization.

Again, state laws govern many aspects of corporations. Different states have different rules and regulations. You can choose to incorporate your business in a state other than where you live if you want. Many corporations used to incorporate in the State of Delaware because its laws provided the most benefits and protections for the business owners and limited shareholder rights. More and more states are moving more toward the Delaware models, but it doesn’t hurt to check out the differences between states when you are first starting out.

Shares in the corporation may be distributed to and owned by outside interests. Corporations are run by a board of directors and must follow numerous corporate formalities. If you choose to incorporate, make sure you understand the requirements for documenting decisions, voting rights, and maintaining corporate minute books. Shareholders are not personally responsible for actions of employees and personal assets are widely protected.

Types of Corporations:

Corporations can be C-Corporations (traditional corporation structure) or an S-Corporation, depending on how the organization wishes to be taxed.

A C-Corp is taxed on its business earnings and files its own tax return (Form 1120). All deductions are taken at the business level. The corporate tax rate is less than the individual tax rate, so, depending on how money from the corporation is dispersed or held for future uses, this type of structure can be appealing in many instances. Each shareholder is then taxed on his or her dividends, or income paid out to them by the company, at their individual tax rate. This is often called double taxation. The owners of the corporation have to pay tax on their company’s earnings, and then pay tax again on the earnings that they remove from the company. Shareholders may not deduct any losses of the corporation on an individual level. Health insurance premiums are deductible to the corporation, as are group life insurance premiums for employee benefits up to $50,000. A C-Corp has no limitation on the number of shareholders.

An S-Corp, on the other hand, does not pay taxes on its earnings. Similar to partnership, each shareholder will report his or her proportionate share of income, deductions, loss, and credits on his or her individual tax return. An S-Corp cannot have more than 100 shareholders and no shareholder can be another business entity or foreign. If you plan to be an S-Corp, you must have unanimous consent of all shareholders and you must make the election by filing Form 2553 with the IRS within 75 days of incorporating your business.

If you start out as an S-Corp, you can elect to change to a C-Corp. However, you cannot start out as a C-Corp and then easily change to an S-Corp after the initial 75 days have passed. It can be done, but you’ll need a good business law attorney to do it right.

Limited Liability Company:

Limited Liability Companies (LLC) often represent the best of all worlds. They are organized by one or more individuals who are known as members. LLCs have the advantage of protecting personal assets similar to a corporation, but having few formalities to follow.

An LLC can choose how they want to be taxed. Most choose to be taxed like an S-Corp or Partnership, but some may choose to be taxed like a C-Corp. An LLC must file Form 8832, the Entity Classification Form and “check the box” to let the IRS know what tax treatment is desired. If a form is not filed, the IRS will decide for itself how it will consider your tax: If you are a LLC with a sole member, you will be expected to file like a sole proprietor; if you are an LLC with two members, you will be considered a partnership or S-Corp; if you have multiple members, the IRS will consider you a corporation for tax purposes.

An LLC can choose an effective date for tax entity classification. The date can be anywhere between 75 days prior to filing the form with the IRS, up to twelve months after filing for recognition with your state. LLCs must have an EIN for tax purposes.

If the LLC is taxed like a sole proprietorship, all business income and deductions are accounted for on Schedule C of the member’s 1040 return.

If the LLC wants to be taxed like a partnership, the LLC’s income and deductions are reported on a K-1. Taxes are then paid by the individual members on their personal tax returns for their proportionate share of the business income or loss. Each member must pay his or her own self-employment tax for Social Security and Medicare purposes.

If the LLC wants to be taxed like a C-Corp, the LLC will be taxed as a separate entity and the members will only be taxed on their earnings.

Your choice of business entity will have tax implications. There are advantages and disadvantages to each type so some thought needs to be taken in selecting the right entity. Some structures require more reporting and documentation of decisions than others. Some have more limitations. Some provide more liability protection for the owners. Some structures make more sense in some types of businesses or industries, and do not lend themselves well to others. Your best course of action is to research the different types and discuss your options with your accountant, business consultant, and a business attorney to make sure you make the right choice for your situation.