How Your Business Structure Affects Your U.S. Taxes

Beyond the balance sheet, your company’s business structure impacts how you pay your taxes and how much you owe.

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There’s a lot of new water to navigate when you start a business. You will love some aspects, but others will give you a major headache. I’m guessing that for most, figuring out your business structure, taxes, and other legalities will fall under that second category. After all, no one wants to lay awake at night worrying they’re paying more taxes than they need to. We do enough of that on personal tax returns, let alone through a business.

However, when it comes to business taxes, the key is to know your business’ annual earning and spending. But beyond the balance sheet, your company’s business structure (sole proprietorship, partnership, limited liability company, or corporation) impacts how you pay your taxes and how much you pay.

Note that this reflects U.S. federal taxes and should be considered general information. As a result, it’s not a substitute for the advice of a tax expert who is familiar with your particular situation and which business structures best apply to your business.

 

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Business Structure #1: The Sole Proprietorship

Solo business owners default to a sole proprietorship. This happens when you have a business but never set up an official structure with the state.

How It Affects Taxes

In terms of taxes, a sole proprietorship is not distinct from the owner. You report all your business income and losses on your personal income tax return. Consequently, the business itself doesn’t need to file a tax return.

When it’s time to file your taxes, you will report your business revenues and expenses on Schedule C, attached to your Form 1040. Therefore, you’ll be taxed on all profits for the year, even if you decide to keep money in your business’ 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% (the majority of this goes toward Social Security and has an income ceiling). Check the IRS (Internal Revenue Service) website for the most current tax rate and income ceiling since these numbers can change each year.

A sole proprietorship is an ideal structure 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

Business Structure #2: The General Partnership

When 2 or more people go into business together and don’t select an official business structure with the state, a partnership is their default status.

How It Affects Taxes

A general partnership must file its own 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 income and self-employment taxes on 100% of their share of company profits.

A general partnership is the ideal business structure 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 in a side hustle that isn’t bringing in a significant amount of income yet

Business Structure #3: The LLC (Limited Liability Company)

The biggest downside with sole proprietorships and partnerships is that the owners and businesses are not separate. In terms of liability, 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. Consequently, an LLC has significantly less paperwork and formalities than a corporation.



How It Affects Taxes

By default, 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 used by sole proprietors. 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. So, 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’ profit.

S Corporation Advantages

An LLC can elect S corporation tax treatment with the IRS. An S corporation has pass-through tax treatment like a sole proprietorship, partnership, or LLC. Therefore you will report the 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’ 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.

A limited liability company is the ideal business structure for:

  • Someone who likes the security of separating their personal assets from business liabilities
  • 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
  • A solo entrepreneur/working owner who is concerned about reducing self-employment taxes (needs to elect S corporation status)

Business Structure #4: The Corporation

Like an LLC (Limited Liability Company), a corporation separates the business owner from the business, helping to protect personal assets from company liabilities (removing 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 an LLC, company profits and losses are not passed along to the business owners; the corporation itself pays taxes on its profits.

How It Affects Taxes

In some cases, this tax structure leads to “double taxation.” This means the government taxes a company on its profits, and when the owners take those profits out, they will need to report the distribution on their personal tax return. Certainly, double taxation is costly for some small business owners accustomed to taking profits out of the business.

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However, a corporation can elect S corporation tax treatment to be treated as a pass-through entity. The tax consequences of this action result in profits and losses being passed along to the owners (shareholders).

Should You Elect S Corporation Status?

That said, in which cases does it make sense to keep your business structured as a regular corporation (and not elect S corporation status)? Simply, 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’ profits in a way 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).

This is the ideal business 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 and may be able to take advantage of lower corporate tax rates
  • A business that wants to raise capital by selling stock

There’s No One-Size-Fits-All Business Structure

When choosing a structure, there’s no single correct answer that works for every business. You need to think about your financial situation and future plans to determine the optimal business structure for your needs. As we approach the end of the year, this is an excellent time to get your business structure squared away. Then, you can begin the new tax year fresh with your new entity.

This post was updated in November 2021.

Reviewed for accuracy by Janet Berry-Johnson, CPA.



Nellie Akalp
about the author

Freelance Contributor Nellie Akalp is a passionate entrepreneur, small business expert, professional speaker, author, and mother of four. She is the Founder and CEO of CorpNet.com, an online legal document filing service and recognized Inc.5000 company. At CorpNet, Nellie assists entrepreneurs across all 50 states to start a business, incorporate, form an LLC, and apply for trademarks. She also offers free business compliance tools for any entrepreneur to utilize. Connect with Nellie on LinkedIn.