Structuring Your Business: A quick look at the tax implications of various business formations
There’s a lot to consider when starting your own business, and how to structure your business should be at the top of your list. Tax implications—advantages and disadvantages—vary with each type of business structure, making the right choice an important step toward the success of your business.
While it’s always best to consult with tax and legal professionals, here’s a general and basic overview of the tax implications associated with the most common types of business structures.
For those who own a business by themselves, sole proprietorship may be the most straightforward and simplest type of business structure. According to the Utah Department of Commerce, sole proprietorship is the most common type of business structure, the least expensive to form and the simplest in terms of legalities.
In this type of scenario the owner, not the business, is responsible for all taxes, and taxes are filed on personal tax returns. The owner is also responsible for the company’s liabilities, debt and any legal claim filed against it. According to Lynn G. Hillstead, CPA/ABV, CVA with Squire & Co., many businesses start as a sole proprietorship and then move into a different business structure as the business grows, more capital is needed or a different type of asset protection is desired.
As opposed to sole proprietorship businesses, corporations are independent from owners. As such, their tax filings are often more complex, but liability lies with the business itself, which frees the owner’s personal assets from risk. According to the Utah Department of Commerce, the majority of large businesses are classified as corporations.
While there are more facets to consider, the main thing to know about C Corporations is that they are subject to what many refer to as double taxation.
“Corporate profits are double taxable; once at the corporate level and again at the shareholder level, but only when those profits are distributed in the form of dividends or upon liquidation of the corporation,” Hillstead says. If you’re wondering why anyone would choose this type of business structure, publicly traded corporations must be structured and filed as C Corporations.
Like a C corporation, an S Corporation is a separate legal entity, but in this structure corporate profits and losses are passed onto shareholders thus avoiding double taxation.
“This means that the corporation, generally, does not pay income tax, but its shareholders are responsible to pay the income tax on the shareholder’s pro rate share of the profits,” Hillstead says. According to the IRS’s descriptions of business structures, S Corporations must be domestic, can include individuals, certain trusts and estates, must not be partnerships, and can have no more than 100 shareholders.
Limited Liability Corporation
An LLC is also a pass-through entity where tax responsibilities are passed on to the members of the LLC. States differ on LLC regulations, but according to the IRS most states do not have restrictions on ownership, meaning members can be individuals, corporations and even foreign entities, and there is no limit on the number of members that can be a part of an LLC. As its name suggests, what sets LLCs apart is that members are not liable for the debts of the corporation.
A partnership is similar to a LLC in that “partners are responsible to pay the income tax on the partner’s pro-rata share of taxable income, as reported on form K-1,” Hillstead says. This allows the company to avoid double taxation. As with S Corporations and LLCs, “distributions of previously taxed income or capital contributed are generally tax-free and taxable income may be subject to employment taxes, as well as income taxes.”
According to Hillstead, LLCs and Partnerships are both taxed under Subchapter K of the Internal Revenue Code, and the way in which they differ the most is the amount of liability protection. Unlike members of an LLC, partners are personally liable for the debt and liabilities of the company.
While taking tax ramifications into consideration is vital step in starting your business, Hillstead recommends that issues such as “legal protection, complexity and formalities to be observed” also be taken into consideration, which is why it’s always best to consult with legal and tax professionals as you make your business entity choice.