Determining the right business structure is an important decision for all entrepreneurs. While making this decision, one of the main factors to consider is the overall tax arrangement. If you make the right choice, you could save a significant amount of money on taxes annually.
That’s why you should try to understand what your taxes may look like for each business structure. In this article, let’s try to simplify the tax implications of each business entity.
Which Are the Main Types of Business Structures?
Before we get into the taxation arrangement, let’s list all the main types of business structures that you can choose from.
- Sole Proprietorship
- Limited Liability Company (LLC)
Regardless of the type of business structure you choose, you’ll need to complete legal processes and paperwork. You should take advantage of the professional filing services that GovDocFiling offers to make the process smoother and cost-effective.
But before you do that, make sure you’ve chosen the right business structure that is ideal for saving taxes and fulfilling your operational needs.
Understanding Taxation Arrangements for Different Business Structures
All business structures have their own advantages and disadvantages. However, in this section, we’ll only discuss their tax arrangements.
1. Sole Proprietorship
The biggest advantage of establishing a Sole Proprietorship is that it is easy to navigate taxes. You don’t have to worry about paying separate taxes for your business.
Instead, you are required to report your business’ profits and losses on your personal tax returns. The IRS refers to this system as “pass-through” taxation. That’s because your business profits have to pass through the business to get taxed on your individual tax returns.
In a Sole Proprietorship, you are taxed on all business profits — total business income minus expenses. At the end of the year, you have to pay taxes on your profit even if you don’t take a paycheck or withdraw money from your bank business account.
However, you can deduct all of your business expenses including operating expenses, business-related travel, insurance, and advertising from your tax returns. This business structure also makes it mandatory for you to pay a self-employment tax.
A Corporation is considered a separate legal entity. When it comes to taxation, the processes involved in Corporations are more complex than in Sole Proprietorships.
Corporations have to pay corporate income tax at the state as well as the federal level. In addition to this, any earnings that they distribute to their shareholders as dividends are also taxed on the owners’ personal income tax returns.
In a nutshell, it has a double taxation system. That’s why it isn’t a very appealing option for small businesses.
However, Corporations do give you liability protection if your business is sued. This helps you avoid any personal responsibility and protects you from putting your assets at risk.
Compared to other business structures, forming a Corporation and maintaining it can be a bit cumbersome. All states have some corporate laws that specify all the rules for record-keeping and conducting meetings.
An S-Corporation is like a mixed arrangement of a Sole Proprietorship and a Corporation. Just like a Sole Proprietorship, this business structure provides the simplicity of getting taxes on your individual tax returns.
It is considered a pass-through entity, so there isn’t a double taxation system. However, you are responsible for paying taxes that are related to your profits. In addition to it, it provides liability protection just like a Corporation.
Not all businesses qualify to become an S-Corporation. Most of the eligibility requirements are related to the overall company size. For instance, this business structure can’t have more than 100 shareholders. Additionally, shareholders can’t be Corporations or Partnerships.
4. Limited Liability Company (LLC)
In terms of taxation, a Limited Liability Company offers business owners different choices. LLC members (owners) can decide how they want the IRS to treat their LLC — as a Partnership, Corporation, or as a single-member disregarded entity. The taxation arrangement for an LLC will also depend on how it is structured.
For instance, an LLC that has at least two members is automatically considered a Partnership unless you specifically file papers to treat it as a Corporation.
In single-member LLCs, the income tax of the business is considered to be a part of the owner’s individual tax return. However, single-member LLCs can also choose to be treated like a Corporation.
Despite its multiple advantages and flexibility, forming an LLC may not be the best business structure for everyone. Typically, investors prefer Corporations over LLCs because they offer the option to sell stocks. This, in turn, minimizes their risk and provides a better liability shield.
For two or more people who want to own a business together and want to test it before formalizing it, forming a Partnership is the simplest choice.
From a tax standpoint, Partnerships are considered a pass-through entity. The business’ expenses and income are included as a part of each partners’ personal tax return.
As laid down in the Partnership agreement, each partner’s share of revenue and losses should reflect on their own tax returns. However, the legal process is a bit different than in a Sole Proprietorship.
The Partnership firm is responsible for filing annual information regarding their losses, gains, income, deductions, and other important financial details using Form 1065. Additionally, each partner prepares their separate Schedule K-1 that reports their allocated losses and profits. For each partner, their Schedule K-1 is included in their individual tax return.
Before you finalize a business structure, make sure you do thorough research to understand the tax implications. If you are not sure about making the right choice, reach out to experts for professional advice.
Do you have any questions regarding the taxation arrangement of any business structure? Please feel free to mention them in the comments section.