The Ins and Outs of Choosing a Business Structure
Choosing the right legal structure for your company affects more than just the title on your business card. It also impacts how much you will pay in taxes, as well as your amount of legal liability for debts incurred or business actions taken. In addition, your entity choice might change as the business grows, takes on more risk, and may require more capital and partners. According to the IRS, the most common business structures are sole proprietorships, partnerships, corporations and S corporations. Let’s review each one of these business structures.
The most relevant advantage to a sole proprietorship is its simplicity. For example, a sole proprietor doesn’t need to register the company, or even file with the IRS — though a license or permit may be required, depending on the business and your location.
In essence, the business and its owner are one and the same. That means the sole proprietorship itself isn’t taxed. Instead, all profits and losses flow to the owner’s personal tax return. On the other hand, a sole proprietor is also responsible for all debts, losses and other obligations incurred (including those arising due to legal actions).
A partnership exists when at least two people share ownership of a business. Each partner contributes time, skills and money, and is entitled to a percentage of the profits or losses. Establishing a partnership is often less expensive than incorporating. The partners usually register with the state, execute a partnership agreement and establish a business name.
One drawback of this structure is that the “joint and individual” liability that partners assume for the debts and actions taken by the partnership itself. Each partner is liable for not only his or her own actions, but also those of the other partners.
A C corporation is a legal entity in itself. While C corporations raise funds by selling shares (or pieces of ownership) to investors, the organization itself is responsible for debts it incurs or actions it takes.
The safety offered by a corporate structure is the key attraction to many business owners. However, the truth is that establishing one typically will require more administrative work than that of other business structures. This would include:
- Filing a number of documents with the state, including articles of incorporation,
- Obtaining an employer identification number from the IRS, and
- Publishing annual reports (in many cases).
These requirements often mean higher startup and ongoing costs over the life of the business.
Another potential shortcoming to consider is that C corporations can be taxed multiple times. The organization’s profits are taxed at the corporate level, as well as any dividends paid to shareholders or owners (which are taxes at the individual level). In addition, shareholders who are employees would also pay income tax on their wages.
So the tax picture isn’t always as simple as the phrase “corporations are taxed twice.” C corporation income is taxed at the corporate rate, for which the top rate is currently 35%. In contrast, the highest personal rate is 39.6%. Thus, reviewing the numbers may show that a company and its owners might be able to actually save taxes by structuring as a C corporation.
As its name implies, an S corporation is a specific type of corporation. But, unlike C corporations, S corporations can pass their profits and losses through to owners’ personal tax returns, without being taxed at the corporate level. Owners employed by an S corporation, however, must also receive a “reasonable” or fair market and salaries. They are also required to pay employment taxes on said wages.
Any remaining income from the business can be allocated to the owners as distributions, which are not subject to employment tax. Depending on the owner’s tax bracket, such distributions might not be taxed, or may be taxed at a lower level, than that of a C corporation.
A caveat: the IRS does not look kindly upon S corporation owners who take little in compensation and therefore receive most of their money as distributions, presumably as a way to avoid employment taxes. In certain cases, the agency has even reclassified some distributions as wages.
Finding the Right Structure
Each type of business structure offers specific advantages and shortcomings. So, make sure you consult an accounting professional when choosing, or changing, your company’s entity type.
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