Just as every human has a skeleton, every small business has a structure. The 5 most popular ways to structure your business are partnership, sole proprietorship, corporation, S corporation, or a limited liability company (LLC). And there are various benefits associated with each format, particularly when it comes to your tax situation.
“Of all the decisions you make when starting a business, probably the most important one relating to taxes is the type of legal structure you select for your company,” explains a business guide from Entrepreneur. “Not only will this decision have an impact on how much you pay in taxes, but it will affect the amount of paperwork your business is required to do, the personal liability you face, and your ability to raise money.”
Let’s examine the tax benefits and drawbacks of each small business structure, as well as some of the details associated with the setup process.
As the name implies, this structure is ideal for businesses that are owned and operated by multiple people. There are a couple of different types of partnerships. With general partnerships, all of the partners help manage the company and share responsibility for its financial obligations. In limited partnerships, some partners assume full responsibilities, while others are merely investors who don’t have any personal liability.
Partnerships are desirable because they’re so easy to form and the process is inexpensive. If you want to ensure everyone has equal standing in the business and shares in the profits, a general partnership is best. Just be aware that it also means all partners will share liability.
If your business is a partnership, you’ll get to leverage the benefits of “pass through” laws. Essentially, your business won’t pay taxes on its income. Instead, the profits and losses pass through to the partners. This arrangement makes tax season much more streamlined and enjoyable, as the taxes are handled on the personal level.
If you thought partnerships were easy to form, they can’t hold a candle to sole proprietorships. This structure benefits from the fact that it only involves a single owner. Thus, there are no agreements to work out with other partners, and all the infrastructure is boiled down to its simplest element. It’s no wonder they’re the most popular business format available.
In sole proprietorships, the owner of the business is entitled to all profits from the business. At the same time, the owner shoulders all responsibility for any debts and losses. Liability looms large in a sole proprietorship, and your assets can be put at risk.
Like “pass through” partnerships, sole proprietorships are taxed on the personal level. Because the government views your business and you as the same legal entity, any money you owe on taxes will need to be paid with your own money. Luckily, sole proprietorships have the lowest tax rates of any of the business structures referenced in this guide.
If personal liability isn’t something you want to deal with, consider structuring your small business as a corporation, where the business becomes a legal entity apart from the owners. Because the debt of corporations isn’t directly tied to the owners, your assets will remain safely in your possession regardless of what happens with your business.
The tradeoff here is that creating a corporation is more complex and costly than other business structures. You should also know that you’ll sometimes need to pay taxes twice. First, you’ll pay corporate income tax for both state and federal, then you’ll need to pay taxes on the personal level for any earnings given to shareholders as dividends.
All in all, the corporate structure has unique advantages that may justify the added sophistication, paperwork, and expense. It’s just important that you understand these factors from the onset so that you can plan accordingly.
Many entrepreneurs consider S corporations to be a more user-friendly version of a corporation. You get the same liability shield offered by a regular corporation, but you’ll only need to pay taxes once because the profits and losses can be passed through to your personal tax return. Another benefit is that you can add up to 100 shareholders, allowing you to attract more investors.
However, S corporations are still more complicated than some other business structures. Depending on your situation, the time and costs involved can be a downside. Once your business has been set up, you’ll need to hold director meetings, shareholders meetings, keep minutes, and make it so shareholders can vote on major decisions.
Your tax process with an S corporation will be similar to that of a sole proprietorship or partnership. Every shareholder will be taxed at the time dividends are paid, with all remaining income going to the owner. The money will be taxed at a lower rate at this point, which is a unique benefit of this business structure.
Limited Liability Company (LLC)
Another popular business structure is the LLC, which combines many of the benefits of corporations and partnerships. You’ll get protection from liability, and all the earnings and losses will be passed through to your personal tax return.
While LLCs have a lot in common with S corporations, there are some key differences. For example, there is no limit to how many shareholders your business can have. And every member of an LLC gets to have a stake in decisions.
If the benefits of an LLC are attractive, you should look into using this structure for your business. It certainly simplifies the tax process when you can pass through the profits and losses. Just be aware that self-employment tax will enter the picture, potentially increasing the amount of money you’ll need to pay the government.
Just as every business has its strengths and weaknesses, business structures run the gamut. If you have questions about what would work best for your business, talk to a mentor or other business expert. Your ultimate goal should be to find the structure that fits your business, rather than trying to fit your business to a structure.