Beyond the balance sheet, your business structure impacts how you pay your taxes and how much you owe. Understand these 4 common types of business ownership and their tax implications.
No one wants to lay awake at night worrying they’re paying more taxes for their business than they need to. (We do enough of that on personal tax returns!)
For federal income tax purposes, the key is to know your business’s annual earnings and spending. But beyond the balance sheet, your company’s business structure impacts how you pay your taxes and how much you pay.
In plain terms, your business ownership structure is how your business is represented to legal and tax authorities. The most common types of business ownership are sole proprietorship, partnership, limited liability company, or corporation.
Note that the information provided here relates to U.S. federal taxes only and should be considered general information on U.S. business ownership structures. It’s not a substitute for the advice of a tax expert who is familiar with your particular situation and business.
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By default, business entities with one owner are classified as sole proprietorships. So, if you have a business but never established an official business ownership structure with the state, your business is considered a sole proprietorship.
How It Affects Taxes
For federal tax purposes, a sole proprietorship is not distinct from its owner. As a sole proprietor, you report all your business income and losses on your personal income tax return. The business itself doesn’t need to file a tax return.
When you file your taxes, you will report your business revenues and expenses on Schedule C, attached to your Form 1040. You’ll be taxed on all profits for the year, even if you decide to keep money in your business’s bank account to save for future expenses.
If you’ve never filed taxes as a sole proprietor before, be prepared to pay self-employment taxes. As a self-employed individual, you are solely responsible for your Social Security and Medicare contributions.
The current self-employment tax rate is 15.3%. Most of this goes toward Social Security and has an income ceiling. Check the IRS website for the current tax rate and income ceiling since these numbers can change each year.
Who Should Form a Sole Proprietorship?
A sole proprietorship is an ideal business ownership for:
- Someone who wants to keep things as simple as possible
- Someone who isn’t too concerned about liability and separating themselves from the business
- A solo entrepreneur who is not making a significant amount of profit each year
- Someone who is just starting out and deciding if entrepreneurship is the right course
When 2 or more people go into business together and don’t select an official business ownership structure with the state, a general partnership is their default status.
In a general partnership, partners have unlimited liability and are personally liable for business debt. Alternatively, limited partnerships (LPs) and limited liability partnerships (LLPs) provide some level of liability protection for partners.
How It Affects Taxes
A partnership must file its own income tax return: Form 1065. But a partnership doesn’t pay income taxes directly. As a pass-through entity, the partnership’s profits and losses pass through to the partners.
Once the partnership files a tax return, each partner receives a Schedule K-1 reporting their share of income and deductions, and they use that schedule to prepare their individual tax return.
Like sole proprietors, partners in a partnership pay self-employment and income tax on 100% of their share of company profits.
Who Should Form a Partnership?
A general partnership is the ideal business ownership type for:
- 2 people going into business together who want to keep things simple
- Business partners who aren’t concerned about legal liability or keeping themselves separate from the business
- Partners operating a side hustle that isn’t bringing in a significant amount of income yet
LLC (Limited Liability Company)
The biggest downside with sole proprietorships and partnerships is that the owners and businesses are not separate entities. That means, if someone sues a sole proprietorship or partnership, they are suing the owner or owners personally, and their personal assets are on the hook.
A limited liability company or LLC puts some separation between you and your business by removing personal liability. As a result, if you’re sued or can’t pay business debts, your personal assets may be protected.
What’s nice about an LLC is that it offers complete or limited personal liability protection and keeps administrative requirements to a minimum. An LLC has significantly less paperwork and formalities than a corporation.
How It Affects Taxes
For federal tax purposes, an LLC is considered a pass-through entity, similar to a sole proprietorship or partnership.
The tax forms filed by an LLC depend on whether the LLC has one owner (member) or more than one member.
Single-member LLCs (SMLLCs) report revenues and expenses on Schedule C, the same form sole proprietors use. Multi-member LLCs file Form 1065, the same tax form used by partnerships, and each member receives a Schedule K-1 reporting their share of business income and deductions.
The owners (members) must pay taxes on their share of the profits. And that’s true whether or not the money stays in the business.
Let’s say you’re the sole owner of an LLC. The company makes $80,000 in profit for the year, but you want to keep $40,000 in your business bank account to prepare for a big expense next year. With an LLC structure, you have to pay taxes on the entire $80,000 on your personal tax return.
If you’re actively working in the business (e.g., you have a graphic design business and you personally do graphic design or account management work), then you will need to pay self-employment taxes on the business’s profit.
Who Should Form an LLC?
A limited liability company is the ideal business ownership structure for:
- Someone who likes the security of separating their personal and business assets
- Someone who prefers minimal formalities and paperwork
- Entrepreneurs who anticipate a loss in the 1st year or 2 and want to report this loss on their personal tax return
Like an LLC, a corporation is a legal structure that separates the business owner from the business, helping to remove personal liability. A corporation is a separate legal entity: It can sue and be sued, it has its own credit history and rating, and it’s responsible for paying its own corporate income tax.
However, unlike in an LLC, in a corporation, company profits and losses are not passed along to the business owners. The corporation is a separate taxpaying entity and pays taxes on its profits.
How It Affects Taxes
In some cases, a corporation is subject to “double taxation.” This means the government taxes a company on its profits, and when the owners take those profits out, they will also need to report the distribution on their personal tax returns.
Double taxation is costly for some small business owners accustomed to taking profits out of the business. However, a corporation can elect S corporation status to be treated as a pass-through entity, where profits and losses are passed along to the owners (shareholders).
Should You Elect S Corporation Status?
Both LLCs and corporations can elect S corporation tax treatment with the IRS. An S corporation has pass-through tax treatment like a sole proprietorship, partnership, or LLC. So while the S Corp files its own tax return, you pay taxes on any business profits on your personal tax return.
But there’s one key difference: With an S corporation, you have the flexibility to separate the business’s income into 2 buckets: Your salary and distributions. Only your salary is subject to FICA tax for Social Security and Medicare—the distributions are not. This allows you to take a chunk of money that’s not subject to FICA or self-employment tax.
However, be cautious with this strategy. It’s an IRS requirement to pay yourself a reasonable salary for the job. (And they will check!) You can’t get away with a $10,000 annual salary and $50,000 in distributions.
So when does it make sense to keep your business structured as a C corporation (the default type of corporation) and not elect S corporation status? Simply put: If you want to keep some money inside the business.
C corporation owners are taxed only on the actual amount they receive as distributions. By working with a tax adviser, you can allocate your business’s profits to take advantage of lower income tax brackets. You won’t be taxed personally if the money remains in the business, and the corporate tax rate may be lower than your individual rate.
Who Should Form a Corporation?
A corporation is the ideal business ownership structure for:
- Someone who likes the security of separating their personal assets from business liabilities
- Someone who doesn’t mind added corporate formalities and paperwork
- Entrepreneurs who want the flexibility of keeping money inside the business to take advantage of lower corporate tax rates
- A business that wants to raise capital by selling stock
- An LLC owner looking to reduce self-employment taxes
There’s No One-Size-Fits-All Business Entity
When considering types of business ownership, there’s no single correct answer for every business. You’ll want to consider the tax implications and the amount of personal liability you are comfortable with.
Furthermore, the federal government has different regulations for each type of business entity. Business owners need to consider these regulations when choosing a legal business structure.
Ultimately, think about your long-term goals, the amount of control you want to have, and your financial resources before selecting a business ownership structure.
This post was updated in March 2023.