If you’re starting a new business, one of the first things you will need to do is to choose a legal structure. The legal structure dictates the ways many aspects of your business run, as well as how you file and pay taxes. There are pros and cons to all structures, so it’s important to weigh the options, considering your business plans and goals for the future.
You will want to opt for a business legal structure that will work for you today and in the future. That being said, it’s often difficult to determine where a business will go over time. You do have the option to change the structure once it’s established but can only do so one time. A common example is a sole proprietor who establishes an LLC, sees the business grow significantly, and switches the business structure to S-corp. One of the biggest deciding factors is how the structure will affect your business and personal taxes. If you plan to keep the business small, then you will be considering entirely different factors than a business owner who wants to own a global empire. Below are some pros and cons from a tax perspective of each legal business structure.
A Sole Proprietorship is actually not a formalized business structure. It is, however, where new entrepreneurs often start their business journey. In a sole proprietorship, there is only one business owner, and he or she is responsible for all forms of debt that the business may incur. The owner is not legally separate from the business, meaning that there are no liability protections for a sole proprietor’s personal assets. Because all income and losses are reported on the business owner’s personal tax return, it’s a straightforward way to start a small business with relatively low revenue and expenses.
Sole proprietors must pay self-employment taxes on their income, including Social Security and Medicare tax. If a sole proprietorship has a loss for the year, they will not owe self-employment taxes, nor will they receive Social Security or Medicare benefit credits for that year. Since the business owner is not an employee, there is no withholding of taxes as you would experience with a traditional employer running payroll. Rather, the sole proprietor must pay quarterly estimated taxes to the IRS. Business owners use Schedule SE (Form 1040) to calculate their taxes due.
A Partnership consists of two or more business partners who share management responsibilities, profits, and debts. The two most common forms are general and limited partnerships. Partnerships can be a very flexible form of business, making it a common choice when multiple individuals wish to formalize their business relationship.
For tax purposes, Partnerships are viewed as an extension of each involved individual. A Partnership is considered a pass-through entity, which means there is no taxation at the business level, but instead at the personal level for each partner. Because Partnerships are quite flexible, ownership can be split in many different ways, depending on the business agreement. Based on the ownership structure, income, gains, losses, deductions, and credits are allocated to each partner. In the eyes of the IRS, each partner is responsible for an equal amount of taxes due, unless the IRS is informed otherwise. With more partners to divide the income between, each partner will have less income to report. As a pass-through entity, the owners get to avoid the double taxation that corporate owners are faced with, making it a highly sought-after advantage. Just as with a sole proprietorship, individuals will have to pay quarterly estimated taxes. Partners will report their portion of business finances on Schedule K-1 (Form 1065).
Limited Liability Company (LLC)
Owners operating a Limited Liability Company (LLC) function very similarly to those of a Partnership. However, an LLC protects the owner’s personal assets from legal liability for business debts. LLCs are often seen as a hybrid between a Partnership and a Corporation, as they have the flexibility and tax advantages of a partnership, but the liability protection of a Corporation. An LLC can have a single owner or multiple partners.
Just as with a Partnership, an LLC is considered a pass-through entity and is not taxed at the corporate level. In some states, LLCs are still required to pay state corporate franchise taxes. It’s best to consult with your CPA to determine your state’s requirements. An attractive, new deduction that LLC members (along with sole proprietors, partnerships, and S corporations) may be able to take advantage of is the Qualified Business Income (QBI) deduction, allowing members to get a 20% deduction from their business net income, in addition to their normal business deductions.
On the other hand, LLC members must pay taxes on distributions, even if they have not yet received a distribution of those profits. LLC members must also pay quarterly estimated self-employment taxes. Depending on the number of members, individuals will either use Schedule SE (Form 1040), or Schedule K-1 (Form 1065) to calculate and report taxes due.
A Corporation, or C-Corp as it’s commonly called, is a separate entity from the founders for both tax and liability purposes. Upon formation, a Corporation must start distributing stock options and have a board of directors. Many times, as a business grows, business owners elect to change their business structure to a corporation from one of the above business structures.
A corporate structure provides some tax benefits to its shareholders. Unlike the above structures, corporate owners are not responsible for self-employed taxes. Owners can be added to the payroll and draw a salary, which means they also have employment taxes withheld from each paycheck. Corporations that are considered a Qualified Small Business may be eligible for the qualified small business stock gain exclusion, which can offer advantages for the investor and the corporation itself.
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A downside to a Corporation is that it is subject to double taxation: the entity itself is taxed on its profits, and then shareholders are taxed on their profits paid through dividends or capital gains. However, unlike an LLC, corporate owners don’t pay taxes on profits until they have been distributed (typically in the form of dividends). It’s worth pointing out that the owner’s salary is deducted as a business expense by the Corporation, so there can still be significant tax benefits to a C-Corp once the business reaches a certain revenue level.
S-Corporations have similarities to partnerships, but with the formality and protection of a Corporation. The main reason for electing to form an S-Corp is due to the fact that the business is not taxed at the corporate level. The profits or losses are passed through to the shareholders, rather than paying both corporate and individual taxes. It is important to be aware that S-Corp owners avoid double taxation at the federal level, but some states do still tax at both levels. It’s best to consult with your CPA to determine how your state treats corporate taxes. Unlike C-Corporations, S-Corporations cannot deduct the cost of benefits, such as health, life, and disability insurance.
Choosing a legal business structure is a big decision and can come with many positive and negative implications. It’s best to discuss your business plans, goals, and ideas with your CPA and/or business advisor before filing any paperwork. Choosing the right structure could cost—or save—you significant money over the lifetime of your business. If you’re considering starting a new business or looking to make a structure change, our team of business CPAs and outsourced CFOs can help guide you through the process. Send us a message to take the first step.