How You Structure Your Business to the IRS Can Affect More Than Your Tax Bill. Here's What You Need to Know. From startup to going public, the business formation structure you choose affects your company in many ways, including how you file your taxes and how much you owe the IRS.
By Nellie Akalp Edited by Kara McIntyre
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The business formation structure you chose at startup may no longer be the best one for your business. As you grow, your company's legal entity can affect your tax bill, personal assets and ability to attract investors, raise money and expand your business.
Those are many variables, so let's explore your options.
Related: Which Business Structure Is Right for You?
Sole proprietorships
Most startups in the U.S. start — and stay — as sole proprietorships. Of 33 million U.S. small businesses, the Internal Revenue Service (IRS) says 28.3 million are nonfarm sole proprietorships.
Sole proprietorships are the simplest form of legal business entity. The setup process is easy. While sole proprietorships without employees don't need an Employer Identification Number (EIN), it's recommended since many banks won't let you open a business account without one.
There is a downside, however. There is no legal separation between a sole proprietor and the business. So, you are personally liable for any debts, obligations and lawsuits against your company. If your company is sued, your personal assets (property, bank accounts, etc.) can be at risk.
For tax purposes, sole proprietors report their profits and losses on their individual tax returns (IRS Forms 1040) and attach a Schedule C Profit or Loss From Business, showing income, expenses and allowable tax deductions. In addition to income taxes, sole proprietors pay self-employment taxes of 12.4% for social security and 2.9% for Medicare. Taxes are due April 15.
Partnerships
Many entrepreneurs start businesses with family or friends or look for partners when their businesses grow. Like sole proprietorships, there is no legal separation between the partners and the company, so the partners' personal assets are at risk if something goes wrong.
Unless specified differently in the partnership agreement, all partners are equally responsible for paying taxes. Partnerships use IRS Form 1065, Schedule K, to list partners and the business's revenues and expenses. Plus, all partners must pay self-employment and estimated taxes. Partnership tax returns are due March 15.
Related: 5 Tips for Structuring Your New Business Like a Pro
LLCs offer liability protection
As their businesses grow, many entrepreneurs become uncomfortable with their personal assets being at risk and explore incorporating their companies.
There are two ways to incorporate: forming a Limited Liability Company (LLC) or a C Corporation. Both structures are considered separate legal entities and protect business owners from the company's liabilities, shielding their personal assets.
Owners of LLCs are called members. Single-member LLCs are taxed like sole proprietorships using tax form 1040 and Schedule C. Multi-member LLCs are taxed like partnerships and use partnership forms 1065 and Schedule K and K-1. LLC members must still pay self-employment taxes. You can also opt for an S Corp election (see below).
You must file Articles of Organization with your state to form an LLC. And while not required, it's recommended that you create an operating agreement. An operating agreement defines the roles and responsibilities of a multi-member LLC.
LLCs are becoming increasingly popular due to their relatively simple management structure, fewer compliance requirements and flexible tax treatment. They're essentially a "have your cake and eat it too" option. For instance, multi-member LLCs can allocate percentages of the company's profits and losses to the members as they see fit.
LLCs have fewer and less complex compliance responsibilities than C Corps. They don't have to elect officers or a board of directors. There are some ongoing compliance requirements — check with your state to learn more.
The biggest disadvantage of owning an LLC is that you can't issue company stock, making it more challenging to raise money.
C Corps offer robust liability protection
As your business grows, you may want stronger liability protection and opt to form a C Corporation. While C Corps are more complex to form and operate, they provide the most robust liability protection for the company's shareholders. C Corps must file Articles of Incorporation in the state where you operate.
A C Corp is a separate business entity and files a tax return on its profits and losses using IRS Form 1120. But the owners/shareholders are considered corporation employees, receive W-2s and are taxed as individual taxpayers, often called "double taxation."
However, C Corps can deduct employee-related costs, like wages, health care, retirement plans, operational expenses and fringe benefits like company cars. Ultimately, the current C Corp flat tax rate of 21% may be lower than what sole proprietorships and partnerships pay,
In C Corps, the company and its employees each contribute 6.2% of the employee's wages to Social Security and 1.45% to Medicare. Plus, employers contribute to their state-run unemployment insurance funds (SUI).
It's easier to raise money and attract investors since C Corps can offer unlimited numbers of shares and multiple classes of stock.
C Corps typically have higher registration costs and more compliance requirements, including adopting bylaws, submitting annual reports, holding shareholder and board of director meetings and more.
Related: The 5 Biggest Tax Differences Between an LLC and Corporation
The S Corp tax election
LLCs and C Corps can elect to be taxed as S Corporations, allowing them to divide profits into wages and dividends. While dividend distributions aren't subject to employment taxes, shareholders must be paid reasonable compensation as defined by the IRS. Electing to be taxed as an S Corp can lower your overall tax bill while maintaining liability protection. S Corps use IRS Form 1120-S, and tax returns are due on March 15. To elect S Corp status, you must file IRS Form 2553 no later than March 15 of the tax year the election is to take effect.
However, only American citizens and residents can be S Corp shareholders, and only 100 shares can be issued, so check with your accountant before choosing this path.
Get advice
It's crucial to weigh the advantages and disadvantages of the different business structures. For many entrepreneurs, the liability protection and possible tax savings outweigh the added costs and complexity of incorporation.
With so much at stake, it's recommended that you consult with your accountant or attorney to help determine which structure is best for your business today and for future growth.
