Today, we’re diving into a topic that is super important for anyone starting or running a business. We will explore common business structures and tax differences between Sole Proprietorship, Partnership, Limited Liability Companies, S Corporation and C Corporation.
Choosing your business structure is not just about filling out some paperwork; it can have a huge impact on your business. It affects how you report your income and losses, your tax liabilities, and your ability to protect your personal assets etc… The right business structure can save you a ton of money in taxes and keep you protected.
1. Sole Proprietorship
This is the simplest and most common form of business structure. If you are the only one running your business and do not have any partners, you are considered a sole proprietor. There is no requirement to register your business with your city, county, or state unless you want to use a business name that’s different from your own.
From a legal standpoint, there is no separation between you and your business, meaning you are 100% personally liable for all your business debts and liabilities. For example, if you borrow money from a bank and default on it, the bank can go after your personal assets.
On the tax side, sole proprietors do not need to file extra forms to file a tax return. As a sole proprietor, you report your income and losses on Schedule C of your Form 1040. The disadvantage of a sole proprietorship on the tax side is the self-employment tax, which includes Social Security and Medicare taxes. Sole proprietors have to pay both the employee and employer portions of these taxes, which is 15.3% as of today.
2. Partnership
Partnerships are formed when two or more people go into business together. There are two types of partnerships: general partnerships and limited partnerships. In a general partnership, all partners are liable for the debts of the business. Creditors can go after one or all of the partners to satisfy partnership debts. In a limited partnership, general partners are personally liable for the debts of the business, while limited partners’ liabilities are limited to the extent of their investment in the business. Creditors cannot go after the personal assets of limited partners.
Partnerships are non-tax-paying entities. They do not pay taxes at the entity level but must file an information return with the IRS using Form 1065 to report the total amount passed through to each partner. Income, losses, gains, and deductions of the partnership pass through to the partners, who must report them on their personal tax returns. Also, general partners have to pay self-employment tax, but limited partners do not.
3. Limited Liability Companies (LLCs)
A Limited Liability Company (LLC) is a hybrid between a sole proprietorship or partnership and a corporation. It gives you the liability protection of a corporation, meaning your personal assets are generally protected, and the tax flexibility of a sole proprietorship or partnership.
For tax purposes, LLCs are very flexible. A single-member LLC is treated as a disregarded entity, meaning the business is separate from its owner for legal purposes but not for tax purposes, unless it elects to be treated as a corporation. The business’s income and expenses are reported on the owner’s personal tax return using Schedule C, or Schedule F for farmers. Like a sole proprietor, a single-member LLC has to pay self-employment taxes.
A multi-member LLC is treated as a partnership for tax purposes. The LLC itself doesn’t pay taxes at the business level but must file an information return just like a partnership. Active members of the LLC have to pay self-employment taxes.
LLCs can also elect to be taxed as an S or C corporation by filing Form 2553 for an S corporation or Form 8832 for a C corporation.
4. S Corporation
S corporations are like other corporations from a legal standpoint. The main difference between S corporations and other corporations is their tax treatment for federal tax purposes. An S corporation can elect to be taxed at the individual level, not at the corporate level, to avoid double taxation typically associated with C corporations.
Unlike C corporations, S corporations are pass-through entities. They do not pay federal income tax at the corporate level. Instead, profits and losses are passed through to the shareholders, who must report them on their individual income tax returns.
S corporations are a great option if you want to save on self-employment taxes. Shareholders who work for the company can pay themselves a reasonable salary and take the rest of the profits as distributions. Distributions are not subject to self-employment taxes, thus reducing the overall tax burden for owner-employees.
For example: Let’s say your business makes $100,000 in profit. You can take $50,000 as a salary and pay payroll taxes on that portion, then take the rest of the profit as distributions. You will not pay payroll taxes on the $50,000 you take as a distribution.
The rule of thumb is, if your business makes $40,000 or more in net profit, you should definitely consider an S Corp.
5. C Corporation
A C corporation is an entity separate from its owners; it has its own legal existence. A C corporation is often chosen by businesses that plan to grow significantly, need to raise capital, or want to offer stock options to employees.
From a tax standpoint, a C corporation is a separate tax-paying entity. It files its own return to report its income and losses. The downside of a C corporation is double taxation. The corporation itself must pay taxes on net profits, and you, the shareholder, also pay taxes when you receive dividends.
For example: If your coffee shop makes $100,000 in profit, the corporation must pay taxes on that amount. Then, if you distribute some part of that after-tax profit, you will pay taxes on the dividends.
How Do You Choose the Right Business Structure?
You have to think about your goals, how much control you want, your risk tolerance, and, of course, how you want to handle your taxes.
If you’re just starting a small business and want simplicity, a sole proprietorship or LLC may be the way to go. If you want to attract shareholders, investors, and save on taxes, an S corporation or a C corporation may be what you need.
Remember, tax planning is key. The right form of business organization can save you a ton of money in the long run. So, take your time, consult with a tax professional if you need to, and choose the best form for your business.