As a business owner, you’ve probably wondered if your company’s current structure is the best choice. The same is likely true for those looking to start a business, but aren’t sure which structure to pick.
Regrettably, there is no straightforward answer to this question; it depends on the type of business, its size, and your goals. On the bright side, a business’ structure is not set in stone and can always be changed to meet future needs.
There are four common business structures. For simplicity, we’ll use the IRS’ basic definition for each type:
1) Sole proprietorship. This is the most common business structure, and it accounts for any unincorporated business owned entirely by one individual. That makes it easy to form, and it offers total control. In general, the owner is personally liable for all financial obligations and business debts.
Your net business income or loss is combined with your other income and deductions, and taxed at individual rates on your personal tax return. Sole proprietors do not have taxes withheld from their business income, so you will generally need to make quarterly estimated tax payments if you expect to make a profit.
2) Partnerships. These relationships exist between two or more people. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business. Partnerships are often referred to as pass-through entities since they do not pay any income tax. Each partner reports his share of the partnership’s net profit or loss on his personal tax return. Like sole proprietors, partners generally need to make quarterly estimated tax payments to earn a profit.
3) Corporations. These are more complex business structures. They require complying with additional regulations and tax requirements, and may need more tax preparation services than other structures.
Corporations are formed under state laws and are subject to corporate income tax at the federal and generally at the state levels. Any earnings distributed to shareholders in the form of dividends are also taxed at individual tax rates on personal tax returns.
The corporation is an entity that can be taxed and held legally liable for its actions. This generally protects the owner against personal liability for the corporation’s debts. Unlike other structures, income earned by a corporation is taxed at the corporate level using corporate tax rates.
Regular corporations are called C-Corporations – the Internal Revenue Code’s Subchapter C of Chapter 1 is where you find the corresponding tax rules. If a shareholder is an employee, he pays income tax on his wages, and he and the corporation each pay half of the social security and Medicare taxes. The corporation, however, can deduct its half. A corporate shareholder pays only income tax for any dividends received, which may be subject to a dividends-received deduction.
The Subchapter S-Corporation is a variation of the standard corporation that allows income or losses to be passed through to individual tax returns (i.e., pass-through entity). An S-corporation has the same corporate structure as a standard corporation; the primary difference is the corporation files an election to be treated as a pass-through entity, which exempts it from most federal income taxes.
4) Limited Liability Companies (LLCs). This is a relatively new business structure allowed by state-specific statute. LLCs are popular because owners have limited personal liability for the company’s debts and actions – similar to corporations. Other features are more like a partnership, providing management flexibility and the benefit of pass-through taxation. Since more states do not restrict ownership, members may include individuals, corporations, other LLCs, and foreign entities. However, businesses like banks and insurance companies cannot be LLCs.
Remember: there is no right or wrong answer when determining a business structure. Stay tuned for part II of this blog, where we’ll give a few examples of when one structure may suit your needs better than another.
If you have any questions or would like an in-depth and confidential discussion about your business’ current structure, please contact a member of our Topline team at questions@toplinevaluationgroup.com.