If you have a business or are planning to create one, you’re most likely familiar with the different business entity structures such as a sole proprietorship, a partnership, an S corporation and a limited liability company (LLC). The structure you choose will depend on the size of your company, revenue goals, tax considerations, legal protections, etc. It is important to know all your options and which one is best suited for your business.

How Your Designation Impacts Your Taxes

Determining which business structure is right for your company from a tax perspective can be likened to the game of Jenga. Like the game, when forming a new business, you start by building a strong foundation. To achieve this, a company can start by examining its business layers and determining which structure is best suited for its short-term goals while also allowing it to grow in the long run. If you form a new company based on ease, this can cause more work in the long run and less than desirable results. It can also lead to legal complexities and a result that no one wants.

Whether you have an established business or are an entrepreneur scaling a new venture, having the appropriate business formation can ensure you have the tax structure that will set you up for success (and avoid any missing pieces or collapsing towers).

Different business structures come with specific tax-related advantages and disadvantages. Ultimately, businesses want to minimize their legal and tax liabilities. Choosing the right business structure is a vital factor in determining your long-term success as an entrepreneur. Through the process of aligning your skills, interests and goals with a business concept that carries high-growth potential, you are effectively setting yourself up for success.

Let’s look at the five most common business entity structures through a tax lens:

Sole Proprietorship

A sole proprietorship describes an unincorporated business owned by one individual. It’s also the most common form of business organization, according to the IRS. As the sole proprietor, you’re obligated to pay various taxes, including self-employment tax, and all business income and losses are filed on a personal income tax return. Examples of businesses that have adopted sole proprietorship status include freelance graphic designers and writers, photographers, house cleaners and personal trainers.

• Tax-related Advantages: There are fewer requirements for business taxes. For example, as a sole proprietor, you do not have to pay federal income taxes.
• Tax-related Disadvantages: Since you are an employer and employee, self-employment tax can be higher. You are also responsible for Social Security and Medicare taxes.

Partnership

Unlike a sole proprietorship, a partnership — much like it sounds — involves two or more people involved in a collaborative trade or business. Each year, a partnership files what’s called an annual information return. This is a report on the income, deductions, gains and losses of the business operations. Accountants, architects, consultants and lawyers are examples of partnership business structure professions.

• Tax-related Advantages: A partnership does not have to pay income tax. Instead, the profits pass through the company to the partners, which is why it’s considered a “pass-through tax entity.”
• Tax-related Disadvantages: Because the taxes due on business profits are passed through to the business partners, they are still liable for taxes on their individual shares of the business profit.

Corporation

In the simplest terms, a corporation is a business that is legally separate from its owners. The IRS adds, “In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock.” Most recognizable examples of corporation-structured businesses include nationally recognizable Amazon, Apple, Google and JP Morgan Chase.

• Tax-related Advantages: There are several advantages of a corporation designation. First, unlike sole proprietorships and partnerships, corporations can take advantage of lower tax rates. For example, a corporation can reduce taxes by taking income in dividends in lieu of salary. Losses can also be carried forward, lowering taxes each year the losses are dispersed.
• Tax-related Disadvantages: One of the major disadvantages of corporation designation is double taxation. This happens when a corporation’s profits are taxed at the personal and corporate level.

S Corporations (S Corp)

S Corporations are similar to partnerships in that corporate income, losses, deductions and credits are passed through to their shareholders for federal tax purposes. Also like a partnership, an S Corp does not pay income tax, but instead, files an information return. Examples of S-Corp businesses are banks, car dealerships and retail stores.

• Tax-related Advantages: Because business income and many tax deductions, credits and losses are passed through the owners, the S Corp avoids being taxed at the corporate level.
• Tax-related Disadvantages: Some of the disadvantages of filing as an S Corp can be greater scrutiny from the IRS as well as missteps in meeting requirements as an S Corp (which ultimately result in termination of S Corp status).

Limited Liability Company (LLC)

A limited liability company (LLC) is a business structure designed to protect the assets of its owners from lawsuits and creditors concerned with the company’s business debts. Types of professions that establish LLCs vary widely from physicians and chiropractors to lawyers and engineers, as examples.

• Tax-related Advantages: Similar to partnerships and S Corps, profits and losses are passed to the members without the business being responsible for federal taxes.
• Tax-related Disadvantages: Unlike a corporation, an LLC is required to recognize profits as soon as they are earned. Additionally, members of an LLC are required to pay self-employment taxes.

When in Doubt Seek an Expert Out

The bottom line: When deciding which structure is right for your business it takes time and careful consideration of which structure is best. Choosing the wrong structure for your enterprise will have implications for how the IRS taxes your business profit which can negatively impact your finances.

Whether you’re a new entrepreneur or an established business looking to change your tax structure, eeCPA can provide valuable business insights.

Contact us today to learn more about our business solutions and strategies.