Starting a business is exciting but also an exhausting venture. And while you may be too focused on running your business, marketing your products, and increasing revenue, one of the most important things you need to do when establishing your business is to choose a legal structure for your company.
Your business’s legal structure can have a significant impact on your operations as well as your taxation. In this article, you’ll learn the four types of business legal structures and their specific tax implications. Read on.
Table of Contents
1. Sole Proprietorship
Technically, a sole proprietorship is not a formalized business structure. However, it is where all new entrepreneurs and business owners start their journey.
In a sole proprietorship, there’s only one business owner and no legal distinction between the business entity and its owner. This means that the owner is not legally separate from the business. As a result, you don’t have any liability protections on your personal assets. Although, you can mitigate the risk with sound contracts and insurance. The business itself doesn’t file a tax return. Instead, all income and losses are reported on the business owner’s personal tax return through a Schedule SE (Form 1040).
2. Limited Liability Company (LLC)
In general, an LLC is considered a hybrid between a corporation and a partnership since it has the tax advantages and flexibility of a partnership plus the liability protection of a corporation. This means your personal assets are protected against legal liability for your business debts. So, if the LLC business faces a lawsuit or owes money, only the company’s assets are at risk. Creditors can’t go after the personal assets of the LLC owners except in cases of illegality or fraud.
An LLC is considered a pass-through entity. This means that the business income passes through the business and through LLC owners who report their share of profits and losses on their individual income tax returns. The business is only required to file an informational tax return, similar to a partnership. Single-owner LLCs are allowed to report their business expenses on Form 1040 Schedule F, E, or C. On the other hand, LLCs with multiple owners must file a partnership return Form 1065.
To form an LLC company, you need to pay a filing fee, ranging from free to USD$500, depending on your state. For instance, if you want to start an LLC in California, the filing fee is free until June 2023. Meanwhile, businesses in Massachusetts will need to pay USD$500 for LLC filing. You must also pass several requirements, including Articles of Organization and an LLC operating agreement, although not all state requires the latter.
A partnership consists of two or more business partners sharing management responsibilities, debts, and profits. It is a flexible form of business, making it a common choice when a business with several owners wants to formalize its business relationship.
Partnerships are easy to set up with little formality, but because there’s more than one owner involved, a partnership agreement should be created. Generally, you’ll have to hire an attorney to create a partnership agreement. The partnership agreement specifies the terms of the partnership and formalizes rules for ownership percentages, profit/loss sharing, management rights, and dissolution terms, among others.
Like LLC, a partnership is a pass-through entity. This means that there’s no taxation at the business level. Instead, taxes are passed through to the owners based on the profit-sharing percentages defined in the Partnership Agreement. So, with more partners to divide the income between, they’ll have less income to report.
This is the most complex business structure you can form. It has more accounting and legal requirements and requires a high level of oversight and governance by the board of directors. Corporations are legal entities separate and independent from the business owners, also called shareholders. A corporation can enter into contracts separate from that of its shareholders. However, it has certain responsibilities, such as tax payments.
In general, corporations are more appropriate for bigger companies with numerous employees or issuing shares of stocks. There are two primary types of corporations, each having different tax treatment.
- C-Corporation: C-corporations are subject to double taxation. Since they are recognized as a separate taxpaying entity, the company itself files its own tax return via Form 1120. In addition, shareholders also need to pay personal income tax on the business profits distributed to them.
- S-Corporation: Unlike c-corps, an S-corporation can avoid double taxation. It can elect to pass corporate losses, profits, credit, and deductions through its shareholders. However, the business itself still needs to report losses, incomes, credit, and deductions, among others, on Form the 1120S. Shareholders report their corporation’s losses and incomes on their personal tax returns and pay federal income tax at their individual tax rates.
These two primary types of corporations have their own advantages and disadvantages. Ensure you look at various considerations, such as their tax implications. This will allow you to choose one that best fits your business needs and goals.
As you can see, your business’s legal structure dictates how many aspects of your business run and how you file and pay your taxes. With several options, each having its own pros and cons, it’s crucial that you weigh your options while considering your business goals and plans for the future. This way, you can choose the perfect business legal structure to support and protect your business’s growth.
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