The 5 Types of Business Structures and Their Tax Implications
Why is it important to choose the right structure for your business?
Deciding how to structure your business is one of the most important decisions you can make as you start your new venture. The entity type that you choose won’t have a big impact on the day-to-day operations of your business, but it will be very important in defining ownership, managing business taxes, limiting personal liability, and enabling you to raise capital in the future. There is no single best entity type, as they each have their own benefits and drawbacks that we will discuss below. You will want to choose the structure that best fits the needs of your business.
Sole Proprietorships
Sole proprietorships are the most common type of business structure, as this is the default for anybody who owns an unincorporated business by themself. The main benefit of running your business as a sole proprietorship is its simplicity, you simply start your business and report all profits and losses on Schedule C of your personal tax return.
Pros:
No cost or difficulty to start, you are a sole proprietor by default.
There are no ongoing registration or legal requirements to maintain or dissolve a sole proprietorship.
Cons:
May not be the most tax-efficient structure for larger businesses as you will pay self-employment tax on all of your earnings.
Since there is no separate legal entity, you have personal liability for anything that goes wrong with the business.
You may have difficulty raising capital from investors or getting business loans from a bank with no separate legal entity.
When should you be a Sole Proprietor?
Sole proprietorships are best suited for businesses with low risk and low profits. Generally, this will be new businesses that are just getting up and running. As you expand and either add more owners or increase the size of your business, you can then transition into one of the other entity types when appropriate.
Partnerships
Partnerships are the default structure for any business that has 2 or more owners. As such, they have many of the same benefits and drawbacks as sole proprietorships. Just like sole proprietorships, partnerships are pass-through entities. This means that the business itself does not pay taxes, rather the profits are passed through to the owners who then pay the taxes on their individual tax returns.
Pros:
No cost or difficulty to start, you are a partnership by default if you start a business with multiple owners.
There are no ongoing registration or legal requirements to maintain or dissolve a partnership.
Cons:
May not be the most tax-efficient structure for larger businesses as you will pay self-employment tax on all of your earnings.
Similar to sole proprietorships, you and your partners have personal liability for anything that goes wrong with the business.
May have difficulty raising capital from banks or investors with no separate legal entity.
When should you be a Partnership?
Similar to sole proprietorships, this structure makes a lot of sense for new businesses but in this case with multiple owners instead of one owner. You are a partnership by default when starting a business with multiple owners which makes things simple as you get up and running. However, as you grow it may make sense to transition to one of the other entity types to either limit your liability, minimize your tax bill, or enable you to raise capital from investors.
Limited Liability Companies
From my experience running Gaines Tax Solutions, many people have heard about LLCs but most people don’t fully understand what their purpose is and when it makes sense to use one. The most important thing to know is that forming an LLC actually does not change the way that you are taxed, which is one of the most common misconceptions that I hear. A single-member LLC is taxed in the same way that a sole proprietorship is and a multi-member LLC is taxed in the same way that a general partnership is. So if that is the case, why jump through the extra hoops to create an LLC? As the name suggests, a limited liability company is a separate legal entity from the owner or owners and therefore limits your liability. This is important because if something goes wrong with your business such as getting targeted with a lawsuit or defaulting on business loans, your personal assets such as your house, car, and personal savings accounts are protected from creditors. The main choice here is whether that legal protection is worth the extra expense of annual LLC fees and more complicated tax compliance.
Pros:
Owners are shielded from personal liability for the acts of the LLC and the other owners. Creditors cannot pursue the personal assets of the owners to satisfy business debts.
Having a separate legal entity may enable you to obtain business loans more easily.
Cons:
You must take the time to create the LLC or pay someone to create the entity for you.
You must pay the annual LLC fee to your state. This can range all the way from $0 in some states all the way up to a minimum of $800 per year in California.
Reporting requirements are increased as compared to sole proprietorships and general partnerships.
When should you be a Limited Liability Company?
Individuals or businesses seeking limited liability protection and flexibility in managing their company should consider forming an LLC. It is an ideal option for small to medium-sized businesses, startups, and entrepreneurs looking to separate personal assets from business liabilities.
S Corporations
As businesses grow and become more profitable it ends up making sense in many cases to transition to an S-Corporation. The main benefit of an S-Corp is that it can minimize your tax burden significantly. With all of the previous structures we have discussed, you pay self-employment tax at a rate of 15.3% in addition to federal and state income tax on all of your profits. With an S-Corp, you must pay yourself and any other owners a reasonable salary and pay self-employment tax on this amount. However, any profits that the business generates beyond this amount avoid that 15.3% self-employment tax.
Pros:
S-Corporations have the potential to significantly decrease your tax bill, especially for more profitable businesses.
Owners are shielded from personal liability for the acts of the S-Corp or other owners, similar to an LLC or C-Corp.
Cons:
The formation process is more complex than other entity types, you must first form an LLC or a corporation and then make an S-Corp election.
There are many specific rules for S-Corps regarding reasonable compensation, who is allowed to own stock, how many shareholders you can have, and when you can make the election.
There are some additional costs to consider such as paying for a payroll provider, paying federal and state unemployment tax on your salary, and increased tax prep costs. However, for more profitable businesses the tax savings can more than offset these additional expenses.
When should you be an S-Corporation?
This structure makes a lot of sense for growing or established companies that are more profitable. For these businesses, the tax savings that are realized by doing an S-Corp election and limiting their self-employment tax burden more than offset the extra cost and complexity.
C Corporations
C-Corporations are unique from all of the other entity types in the respect that they are not pass-through entities. Rather, the C Corporation pays its own tax at a rate of 21%, and then the profits are taxed again when they are distributed to shareholders in the form of dividends. This double taxation makes C-Corps less tax efficient than many other structures, so what would be the reason to pick this over something like an S-Corp? The main benefit of a C-Corp is for very large companies that need to raise capital from investors all over the world. S-Corps are limited to 100 owners, can only be owned by US citizens, and can only have one class of stock. Conversely, C-Corps have no limitations on the number of shareholders and where the shareholders are from. They are also able to have multiple classes of stock.
Pros
C-Corps are the best option in most cases for publicly traded companies that need to raise capital from a large number of investors.
Owners are shielded from personal liability for the acts of the corporation, similar to an LLC or S-Corp.
Cons
There is double taxation, profits are taxed first at the 21% corporate rate and then taxed again as dividend income to the owners when profits are distributed.
There is increased complexity as the law requires more formality in how the corporation is managed, such as compulsory shareholder and director meetings. Corporations also tend to generally have stricter record-keeping requirements.
When should you be a C-Corporation?
This structure makes the most sense for very large companies that are publicly traded and need to raise capital from a large number of investors. The double taxation aspect limits the appeal of this structure for any businesses that do not need the flexibility in ownership that a C-Corporation provides.
This article was written and reviewed by Chad Gaines, CPA
