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Business Structure: Tax Implications

This post marks part three of our blog series debunking the business structure selection process. Today, we look at the tax implications of the structure you select. Perhaps less of an influence on your decision-making process and more an effect of the choice you’ve made, keep these items in mind this tax season and beyond. 

In a sole proprietorship situation, your business and personal taxes will not be separate because your sole proprietorship income is your income. Think of it as one income with one return. The business will not need to file its own return. This does allow you to receive the lowest tax rates of any of the business structures. Filing will involve a Schedule C (to report profits and losses) and the Form 1040 usually involved in your personal return. All profits will be taxed in the year they are earned. First-timers should prepare themselves to pay self-employment taxes. This means you are solely responsible for your social security and Medicare contributions. partner

Similarly, in a partnership arrangement, the partners will need to pay taxes on their share of profits from the business, even if that money is staying in the business. Like a sole proprietorship, an LLC is a pass-through entity. In this situation, Schedule K-1 of Form 1065 will be critical to filing.  Again, self-employment taxes will come into play on your personal return.

On the federal level, taxation of Limited Liability Companies will treat the business as either a corporation, partnership or disregarded entity. If there are two or more owners, the LLC will be taxed like a partnership: with pass-through taxation, and taxes paid on the personal tax returns of its owners rather than at a business level. If the LLC has only one member, it will be treated as an entity separate from its owner. In either case, if the LLC files Form 8832 it will affirmatively elect to be treated as a corporation. However, LLCs also have variable state tax implications based on your individual state.

Although a cooperative operates as a corporation, its operations pass-through income to its members. As we’ve seen in previous examples, this means the individual members will pay taxes on their cooperative gains when they file their personal returns. Certain cooperatives do obtain tax-exempt status. Based on these variables, tax forms for cooperatives may require 1099-PATR or 3491 Consume Cooperative Exemption Application. team

Electing to structure your business as a corporation will make it a separate legal entity from its owners. These entities will file taxes with a Form 1120 or 1120S. The primary difference between the two main types: S-Corps and C-Corps, is the tax implications.

S-Corps receive some tax savings compared to their C-Corp counterpart. Owners treat taxes on income as they would for a partnership or sole proprietorship. Shareholders are taxed on the dividends they are paid. Any remaining income is paid to owners as a distribution and thus taxed at a lower rate. Businesses might not elect to be a S-Corp because they have too many shareholders (there’s a 100 shareholder limit) or because they want to keep money in the business, a benefit to the C-Corp structure.

Corporate taxes are often lower than personal taxes, but C-Corps can incur double taxation. First, the corporation is taxed when it makes a profit. Second, these same funds are taxed when dividends are paid to shareholders or when owners draw a salary. Then again, owners will not be taxed personally if the money remains in the business.  

 

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Business Structures: Ownership and Liability Differences

The most common differences in business structures are ownership, liability and tax considerations. When it comes to liability, it’s important to consider where you, as an owner, could personally afford liability risks. Protecting personal assets is a key reason people incorporate their business, and while some structures are easier to form than others, it can be difficult to change your entity’s structure down the line, so avoid restricting your business’s ability to grow in your selection.

Sole Proprietorship: Sole proprietorships are simplest to form, and if you don’t register your business as another entity, you’ll automatically be considered a sole proprietorship. Owned by one individual, this structure comes with the greatest personal liability. As the business grows, your personal liability will increase. Therefore, this structure is best for lower risk businesses. Also consider that it is difficult to obtain outside funding for sole proprietorships.

Partnerships: Partnerships are owned by two or more people. The partners will share in any profits, losses and decision-making responsibilities. These entities require an operating agreement that outlines the roles of its owners and the percentage of profits they each receive. Consider that you will be held liable for both decisions you make, and those made by other owners. Funding for these entities will generally come from the personal accounts of its owners, their personal credit or by taking on more partners.board room

Limited Liability Company (LLC): Forming an LLC protects you from personal liability if you don’t act in a manner that is in any way illegal, unethical or irresponsible when carrying out business activities. Personal assets and company assets are deemed separate under this entity. This structure is great for medium-high risk businesses and owners with a lot of personal assets they want to protect.

Corporation: Incorporating your business makes it a separate entity from its owners. That entity can be sued, own and sell property, and sell ownership rights in the form of stocks. No individual owner has sole or primary control. Instead, most corporations have a Board of Directors to answer to. More specifics apply depending on the type of corporation…

C Corp: C-corps are ideal for medium-high risk businesses, businesses that need to raise outside funds and businesses that intend to go public or eventually be sold. As you can see, forecasting where you would like to see your business go or grow into, is important to many of these considerations.

S Corp: S-Corps are intended for smaller corporations. There can be no more than 100 owners, and all must be United States citizens.

B Corp: B-Corps differ from other types of corporation in purpose, accountability and transparency. In some states, B-Corps are required to submit annual benefit reports to demonstrate that they are indeed contributing to the public good.

Closed Corporations: Closed corporations are similar to B-Corporations. However, these generally smaller companies are usually barred from public trading.high rise

For a more simplified depiction of this breakdown, reference the following table:

Business structure Ownership Liability Taxes
Sole proprietorship One person Unlimited personal liability Personal tax only
Partnerships Two or more people Unlimited personal liability unless structured as a limited partnership Self-employment tax (except for limited partners)

Personal tax

Limited liability company (LLC) One or more people Owners are not personally liable Self-employment tax

Personal tax or corporate tax

Corporation – C corp One or more people Owners are not personally liable Corporate tax
Corporation – S corp One or more people, but no more than 100, and all must be U.S. citizens Owners are not personally liable Personal tax
Corporation – B corp One or more people Owners are not personally liable Corporate tax
Corporation – Nonprofit One or more people Owners are not personally liable Tax-exempt, but corporate profits can’t be distributed

 

Later this week, we’ll delve into the tax differences and implications of each of these business structures.

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