Business Structures & Tax Classifications
When you start a business, one of your first steps should be to choose a legal business structure for your business. The type of business structure you choose influences how much of the business’s liabilities you are personally exposed to, the type of fees and recordkeeping duties are associated with maintaining the business structure, your ability to raise money, and type/amount of taxes you will be liable for.
One common misconception that some people have about business structures is how exactly they relate to the IRS tax classifications. How your business is treated for tax purposes (what tax return you should file and what type of taxes you will pay) has a lot to due with your legal business structure, but it’s not always crystal clear. Did I lose you? No worries, here is an example:
For every business structure out there (sole proprietorship, LLC, partnership, corporation) the IRS has a default way of treating you for tax purposes. In some cases, however, some businesses can elect to be treated as a more beneficial classification. This means that with proper research and guidance, you can choose a business structure that satisfies your legal structure needs, as well as your tax needs. The best of both worlds!
Below are a few of the most common business structures, what are the different options for tax purposes, and the all-around pros and cons of each:
Sole proprietorship
The sole proprietorship is the most basic business structures out there. If you were to come up with a business idea, and simply started offering your products or services without registering your business with the state, you would be considered a sole proprietor. For legal purposes, your business and you are one and the same.
The benefits of this structure come from its simplicity. There is no initial registration process, and no annual fees to maintain a separate legal entity. This may be a good choice for low-risk businesses, and for ideas that are being tested out before creating a more formal business.
On the other side of the coin, if the business and you are one and the same, it means that you may be personally liable for the debts and obligations of the business - which is the biggest drawback of sole proprietorships. Also, obtaining funding for your business might be more difficult because you can’t sell part of a sole proprietorship to a potential investor in the form of stock. You will depend on personal loans to fund your business.
For tax purposes, sole proprietorships don’t have any options to be treated differently. The business revenue and expenses would be reported on Schedule C, which is part of the owner’s personal tax return (Form 1040). A drawback of the sole proprietorship tax classification is that you will have to pay self-employment tax on all the profits of the business. Self-employment tax is made up of Social Security taxes of 12.4% and Medicare Tax of 2.9%. A benefit of sole proprietorships is that since there is no separate tax return filed for the business, so you will save on tax preparation fees.
Limited Liability Company (LLC)
If you are looking to form your business as an LLC, you will need to decide in what state you want to open your LLC and follow those instructions. In most cases, you will need to file Articles of Organization, which require a name for your business, an address, name and information of the owner(s), and to pay a fee.
With an LLC, your business is considered a separate legal entity, with their own assets and liabilities, which means that your personal assets are protected (for the most part) in the case the LLC faces bankruptcy or lawsuits. LLCs can also benefit from lower taxes than those imposed on businesses formed as corporations.
For tax purposes, LLCs have a few different options. The default classification for LLCs depends on the number of “members” the LLC has. If there is only one member, it will be be treated a sole proprietorship. If there are two or more members, the classification will default to partnership (file Form 1065). However, LLCs can elect to be treated as corporation by filing Form 8832, or elect to be treated as an S-Corp by filing Form 2553. By making the S-Corp election, you might pay less in taxes by avoiding some part of the self-employment tax that is imposed on all self-employment earnings of a sole proprietorship.
Many LLC owners opt to make the S-Corp election because it offers potential tax savings and limited liability benefits that sole proprietorship does not.
Corporation
In order to create a corporation, you will need to follow the instructions of your specific state and file Articles of Incorporation. Corporations offer the most limited liability of any other business organization, and one of its biggest benefits is the ability to sell its own stock in order to raise money. However, a big drawback is double taxation. Corporations are taxed on their profits. Then, when the profits are distributed to shareholders as dividends, shareholders pay personal taxes on those same profits. This double taxation drawback makes the S-Corp election attractive for small business owners. By filing Form 2553, Corporations can be treated as S-Corps for tax purposes and avoid double taxation while still having the limited liability benefits that the corporation business structure offers.
Takeaways
When it comes to choosing a legal business structure and a tax classification for your business, there are a few different things to consider. Among them are:
· The amount of limited liability that is right for you
· The number of owners or members the business has
· Needs for raising capital
· Capacity for paperwork and fees to maintain a separate legal entity
Additionally, it is crucial to know the IRS default tax classifications, and to explore the options to elect for a more favorable treatment. In any case, the answers will depend on the specific circumstances of the business and its owners.
If you have any specific questions or business struggles that we can help you with, please visit our website and follow us on social media for additional resources.