Forming a new business is such a fun adventure! It can be hard determining which kind of structure to select. We have broken down the most popular options to help you better understand what is available. As always, we are here to help answer any questions you may have!
Why does it matter what your business structure is? Because your form of business determines which income tax return form you have to file. The most common forms of businesses are sole proprietorship, partnership, corporation, S corporation and a limited liability company (LLC). Let’s go into detail about each structure and how they are used.
A sole proprietorship is the simplest and most common structure people use to start a business. It is a business owned and managed by a single individual. They can have multiple people operating the business but MUST have one owner. Sole proprietorships have several advantages over other business entities because they are easy to form and the owners have sole control of the business profits. Make sure to keep in mind that the owner is personally liable for all business losses and liabilities.
Sole proprietorships are relatively easy to form, easy to maintain, and easy to dissolve with minimal licenses to obtain or separate forms to follow.
Note: If you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation. Also, you are not allowed to take payroll. Instead you pay yourself through what is called a draw (a fancy word meaning you write yourself a check or transfer money from the business bank account to your personal).
A partnership is a formal agreement that has two or more people managing a business together. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business. Partnerships are required to file an annual information return to report the income, deductions, gains, losses, etc., from its operations. However, it does not pay income tax. This type of business “passes through” profits or losses to its partners. Each partner is expected to report their share of the partnership’s income or loss on their personal tax return.
Please keep in mind that partners are not employees and should not be issued a W-2 form. The partnership must furnish copies of Schedule K-1 (Form 1065) to each partner.
Under US federal income tax law, a C Corporation or C Corp refers to any corporation that is taxed separately from its owner. This structure is much more traditional than that of an S Corp.
C Corporations are taxed twice—the business pays taxes at the corporate level, and shareholders pay taxes on income received. There are no limits on how many shareholders own this type of company.
The profit of a corporation is taxed to the corporation, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.
C Corps have limited liability which applies to directors, officers, shareholders, and employees. They can exist perpetually—even if the owner leaves the company. Because this kind of company can use unlimited stock sales, there is unlimited potential for growth.
S corporations elect to pass corporate income, losses, deductions, and credits through to their shareholders instead of through the business for federal tax purposes. They assess tax at their individual income tax rates which allows them to avoid the double taxation on corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level. The term “S corporation” means a “small business corporation”.
To qualify for S corporation status, the corporation must be a domestic corporation, have no more than 100 shareholders, have only one class of stock, and have only allowable shareholders (which may be individuals, certain trusts, and estates and can not be partnerships, corporations or non-resident alien shareholders). S Corporations may not be an ineligible corporation like certain financial institutions, insurance companies, and domestic international sales corporations.
Also keep in mind that owners can only get common stock which comes with voting rights.
Limited Liability Company (LLC)
A Limited Liability Company or LLC is regulated on the state level. The owners of an LLC are called “members”. Members are not personally liable for the company’s debts or liabilities—this is especially important because if an LLC files for bankruptcy, the members do not have to use personal money to pay the company’s debts. If the LLC faces a lawsuit, the members do not risk losing their home to cover a settlement.
The best way to describe an LLC is to call it a hybrid entity that combines the characteristics of a corporation with those of a partnership or sole proprietorship.
An LLC’s owner/member may include individuals, corporations, and/or other LLCs and foreign entities. There is no maximum or minimum number of members—most states permit single member LLCs (only having one owner).
There are a few types of businesses that cannot be an LLC. This includes banks and insurance companies. Make sure to check your state’s requirements and the federal tax regulations for further information. There are also special rules for foreign LLCs.
An LLC resembles a sole proprietorship or partnership in its requirements to the IRS. The owners of the LLC list business profits and losses on their personal tax returns—the LLC does not pay income taxes itself. The LLC can also choose to tax itself as a corporation and must follow corporation tax law and filing requirements.
If you need help deciding which structure to choose, Bechtel CPA can help! Just reach out to us by clicking here. We also highly advise seeking legal counsel before choosing a business structure that fits your needs.