The best business structure type for a small startup depends on your risk tolerance, capital needs and growth goals:
Selecting a business structure can be one of the more complex decisions you will make when starting a new business. The structure not only determines your tax liability in the short term but can also have lasting effects that you may not notice until you reach retirement age.
Let’s dive into the fundamentals of business structures to help you choose the best path forward.
A business structure is a legal recognition of how your company is organized. It defines the relationship between the business owners, the business entity itself and the government. Your chosen structure decides who is legally responsible for business debts, how the business can raise capital and how profits are taxed.
When looking at the different types of business structures, you’ll see that they generally fall into categories defined by how the law views their liability and taxation. The primary business structure types include sole proprietorships, partnerships and corporations. In addition, a limited liability company provides the flexibility to be taxed as any of these structures.
A sole proprietorship is the simplest business tax structure. It consists of a single owner who does not file a separate tax return for their business. Business income is simply recorded on a Schedule C (Form 1040) or, if they are a farmer, a Schedule F, and included as a part of their personal tax return. The business owner is responsible for paying income tax and a 15.3% self-employment tax. The self-employment tax is equal to the amount an employer would typically withhold and match for FICA, Medicare and Social Security.
A partnership is a lot like a sole proprietorship but consists of two or more business partners. A partnership files an annual information return to report income, deductions, gains and losses, but does not pay income tax as a business. Instead, it operates as a pass-through entity.
The partnership issues a Schedule K-1 to each of its partners. This form reports each partner’s share of the business earnings, losses, deductions and credits. Each partner is then responsible for reporting this on their personal tax returns and paying income and self-employment tax.
There are two types of corporations, a C corporation and an S corporation, and each is taxed differently, although neither structure pays self-employment tax.
C corporations are typically capital-intensive businesses. Publicly traded corporations are required by law to be structured as C corporations.
The C-corp is a separate legal entity that pays a flat tax, which is typically 21% on all its profits but is also subject to what is sometimes referred to as the “double tax.” After the profits are taxed at the flat rate, any dividends that are paid out to stock shareholders will be taxed again upon distribution.
This is called a flow-through entity and does not have its own tax rate structure. Income from an S-corp is taxed based on each shareholder’s personal return according to their ownership percentage.
For example, if a two-person S-corp made $100,000, each equal shareholder would be taxed a progressive rate on their $50,000 return as opposed to a 21% flat tax on the company’s collective $100,000 income. There are situations, if each shareholders’ returns are high enough, that the progressive tax rate could be higher than the flat tax rate of a C-corp, but you also need to consider the “double tax” that is in effect when deciding between the two.
Many businesses may choose to form a corporation to avoid the self-employment tax but regret it later on when they reach retirement age and find out they are not eligible to receive as much money from Social Security.
A limited liability company (LLC) is a business structure allowed by state statute with regulations varying from state to state. The LLC business structure provides the most flexibility for a new business. By default, an LLC is taxed as a partnership, but it can also be taxed as an S-corp or, for a single-member LLC (also known as a “disregarded entity”), as a sole proprietorship.
When evaluating LLC vs. S-corp, it helps to understand that an LLC is a legal structure, while an S-corp is a tax status. By default, the IRS taxes a multi-member LLC as a partnership and a single-member LLC as a sole proprietorship. However, when weighing S-corp vs. LLC strategies, an LLC can actually ask the IRS to tax it as an S-corp to save on self-employment taxes.
For example, if a newly formed business like a feed store is expecting initial losses during their startup period, they might consider operating their business as a partnership, thus allowing a full tax deduction for the losses incurred.
With other business structures, such as a corporation, losses can be suspended and carried forward to offset future income and reduce tax liability going forward. So, if the feed store gets to year 3 or so and decides that they want to get that benefit later on, they can do that by electing to be taxed as an S corporation, keeping the same EIN number and name.
The best business structure for a small startup depends entirely on your risk tolerance, capital needs and growth goals. Here’s a quick breakdown:
Because every business is different, always consult with your attorney, CPA and business banker. It is extremely important to involve them from day 1 because there are dramatic differences in how each business structure affects the operation and financial status of your business.
The CPA will help you decide which business structure you should choose. Your attorney would then be involved in advising you and the CPA on the legal ramifications of that business choice. A community banker will help you align your new structure with the right business checking accounts and lines of credit. They can also help you with small business loans or small business financing as your company grows.
To learn more about the tax implications of each business structure, visit the official business section on the IRS website.
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