There are so many exciting things that come with starting a business. While it can seem overwhelming at first, there’s a lot of joy to be had in bringing your hard work to life. As I wrote about previously, one of the first steps in getting a business off of the ground is to obtain an Employer Identification Number from the Internal Revenue Service (IRS). Related to that, one of the first important business decisions you’ll make is deciding which form of business to establish. The business structure chosen has important tax considerations for both the business and its owners.
The most common forms of business are the sole proprietorship, partnership, limited liability company, C corporation, S Corporation, and nonprofit corporation.
A sole proprietorship is an *unincorporated business owned by one person. It is the simplest and easiest type of business to form. An individual is automatically considered a sole proprietor if they engage in business activities, but do not register as any type of business. With sole proprietorships, the business and owner are inseparable. This means that business assets and liabilities are not separate from the owner’s personal assets and liabilities.
For example, my friend Michael started a new business on his own called “Mike’s Pet Shop.” He financed the business himself and has no other partners. He did not register with his state for any other type of business. This business is considered a sole proprietorship and Michael is entirely responsible for the assets and liabilities associated with that business.
Financing sole proprietorships can be difficult. Due to the risk of unlimited liability, and the ease with which sole proprietorships can be started, banks are often hesitant to lend to sole proprietorships. Also, sole proprietorships cannot issue stock, since in the United States stock can only be issued by corporations or limited liability companies.
The applicable tax forms for a sole proprietorship can be found here.
A partnership is an arrangement in which two or more individuals share the profits and liabilities of a business. Partnerships are the simplest business structure for two or more people. There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
Limited Partnerships (LP): Limited partnerships have one general partner with unlimited liability, and all the other partners have limited liability. Generally the partners with limited liability tend to have less control over the company. These terms should be documented in the partnership agreement.
Partnership profits are passed through each of the partners’ personal tax returns. The general partner, the partner with unlimited liability, must also pay self-employment taxes.
Limited Liability Partnerships (LP): Limited liability partnerships (LLP) are similar to limited partnerships, except every owner has limited liability. An LLP protects each partner from debts against the partnership. The applicable tax forms for a partnership can be found here.
Like a corporation, a limited liability company or “LLC,” is a separate and distinct legal entity. It can have the benefits of both corporate and partnership business structures. An LLC’s owners (called members) have “limited liability,” which means that under most circumstances, they are not personally liable for the debts and liabilities of the LLC entity.
For example, if an LLC were forced into bankruptcy and the company assets were not enough to pay the company debts, in most instances, the creditors could not go after the personal assets of the LLC members to repay the remaining LLC debts.
An LLC is established at the state level, and different state laws will apply. An LLC has less recordkeeping requirements than a corporation. Unlike most corporations, an LLC is often taxed as a pass through business.* The IRS taxation of an LLC is discussed here.
C Corporations: A corporation is a legal entity that is separate and distinct from its owners. Corporations enjoy most of the rights and responsibilities of an individual, including the right to:
Due to legal requirements, it can be more costly to form a corporation, but a corporation provides the strongest protection to its owners against personal liability. This is because a corporation is an entity apart from its owners.
For example, if a court judgement is entered against XYZ Corporation, saying it owes a creditor $200,000, only the corporate assets are at risk. The shareholders cannot be forced to use their personal assets to pay the debt.
Corporations pay income tax on their profits, unlike sole proprietorships and partnerships. Because of the corporate taxes, it is possible for corporate profits to be taxed twice: first, when the company makes a profit; then again after the distribution of dividends when a shareholder recognizes the income on their personal tax returns.
Corporations also require extensive record-keeping, operational processes, and reporting. An additional advantage of corporations is that they have an independent life separate from their shareholders. If a shareholder leaves the company or sells his or her shares, the C corporation can continue doing business relatively undisturbed.
Corporations also have an advantage when it comes to financing because they can raise funds through the sale of stock. The ability to issue stock can also be a benefit in attracting employees.
S Corporations: An S corporation, sometimes called an S corp, is a special type of corporation that’s designed to avoid the double taxation drawback of regular C corporations discussed above. S Corps allow profits, and some losses, to be passed through directly to owners’ personal income return without ever being subject to corporate tax rates.
S corps can be treated differently at the state level, but most states follow the federal government. However there are exceptions, with some states taxing S corps on profits above a specified limit, and other states treating the business simply as a C corp. S corps must file with the IRS to get the S corp status. This is separate from the additional process of registering with the state.
S corps cannot have more than 100 shareholders, and all shareholders must be U.S. citizens. S Corps still have to follow the strict filing and operational processes of a C corp. Like a C Corp, if a shareholder leaves the company or sells his or her shares, the S corp can continue doing business relatively undisturbed. For those businesses that meet the criteria, an S corp can be a good alternative to a C corp.
Nonprofit Corporations: Much less a choice of business structure, a nonprofit corporation designation is heavily dependent on the work it performs. Nonprofit corporations, also known as 501(c)(3) corporations, are organized for charitable, educational, literary, religious, or scientific work. Because they benefit the public, nonprofits can receive tax-exempt status; they don’t pay state or federal taxes income taxes on profits. In order to receive federal tax-exempt status, nonprofits need to apply with the IRS.
Similar to C corps, nonprofit corporations, need to follow special rules, including what they do with any profits they earn. Also similar to C corps, nonprofit corporations should register with their state.
The tax bill that was passed by the US House of Representatives on November 16, 2017 creates a tax cut of the top rate for corporations from 35 to 20 percent, but according to Wisconsin Republican Senator Ron Johnson’s objections, has a smaller tax benefit for pass through businesses like a sole proprietorships, partnerships, and S Corporations. The Senate has yet to pass a tax bill, but if the bill comes into law, understanding the tax consequences of the changes is an important consideration when determining the structure that is best for your business.
Deciding on a business structure is one of the most important early business decisions of an organization. It is a good idea to consult with an attorney when making this decision.
Getting the business structure right is important because changing business structures can be complicated and expensive, so be sure to proceed through this exciting process with a clear understanding of the wants and potential outcomes to you and your partners.
*unincorporated – not chartered as a corporation, lacking the powers and immunities of a corporate enterprise.
*pass through business – type of business where Individual owners pay taxes on income derived from that business on their personal income tax returns. Pass through taxation applies to sole proprietorships, partnerships, and S-Corporations.