How you legally structure your business affects your tax status and your liability. It has a significant impact on how investors, banks, and credit unions perceive your worth.
The organization structure you select is especially crucial with the passage of the Tax Cuts and Jobs Act of 2017. In addition to making significant cuts to corporate tax rates, the Tax Cuts and Jobs Act altered how many small businesses structured as 'pass-through' entities will pay their taxes.
For these companies, income that passes through to their individual federal tax return from the pass-through entity will be taxed at individual tax rates less a deduction of up to 20% to bring the rate lower. However, there are qualifying rules for this treatment, so make sure to become familiar with those.
Changing from one structure to another after you have been in business for a while is possible, but there is paperwork and legal tasks to perform. These functions may include transferring licenses and permits, dissolving the entity, registering with local and state agencies, and notifying the IRS, banks, credit unions, and vendors. Plus, you might need to hire an accountant and lawyer to ensure the change is properly executed.
There are four main types of business structures: sole proprietorship, partnership, limited liability or LLC and corporation.
Many businesses start as a sole proprietorship. It gives the owner complete control over operations. This may include home-based businesses and one-person consultancies, small shops, and service-based firms.
With a sole proprietorship, you need to keep your records and pay the IRS with self-employment taxes. To reduce the burden of once-a-year tax payment, you can spread it out in four equal payments throughout the year, using estimated tax as your basis.
This structure does have limitations. You are afforded no safety net for liability, debt, and financial obligations, so your personal assets are at risk.
However, it has tax advantages. You can use your business losses to offset other income since everything is reported on your personal tax return.
There can be two or more people in the partnership, each with an equal share of both the net profits and the net losses.
Each partner reports their income on their personal IRS tax form and pays self-employment taxes. If the partnership gets sued, each partner is personally liable for debt and obligations, as well as the actions of each of the other partners.
LLCS AND S CORPS
Both LLCs and S Corps are hybrids of the corporation form of organizational structuring.
A corporation is the most complex of all the types. Its most significant advantage is that any liabilities and obligations are borne by the corporation, not the individual owner. Corporations are taxed as separate legal entities at specific corporate tax rates. Individual states regulate corporations.
Limited liability corporations offer some protection in liability cases, as the name implies, just like a corporate structure does. With an LLC, even if you are the sole person in the business, you are viewed as a member of the company. Some LLCs are partnerships.
With an LLC, both earnings and losses are passed through to the person who owns the business, who then includes them on their personal tax return. With the passage of the Tax Cuts and Jobs Act of 2017, the rate you pay will be dependent on how your income is earned and the type of business you operate.
Subchapter S corporations, usually called S corps, can pass both losses and income on to their shareholders. This gives them a legal avenue to avoid paying federal income taxes, eliminating the chance of double taxation of the profits of the corporation.
It is wise to ask an accountant or lawyer for input as to which structure will work best for your business and the future you envision for it. As your business grows and its needs change, your business structure can most likely be altered to meet these changes.
Revised November 2022