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Choosing the right structure for your company affects more than just the title on your business card. It also impacts how much you pay in taxes, as well as your legal liability for debts incurred or business actions taken. Moreover, your entity choice could change as the business grows, takes on more risk, and requires more capital and partners. According to the IRS, the most common business structures are sole proprietorships, partnerships, corporations and S corporations. Let’s take a look at each one.
The most compelling advantage to a sole proprietorship is simplicity. For example, a sole proprietor doesn’t need to register the company or file with the IRS — though a license or permit may be required, depending on the business.
Essentially, the business and its owner are one and the same. That means the sole proprietorship itself isn’t taxed. Instead, all profits and losses flow to the owner’s personal tax return. On the flip side, a sole proprietor is responsible for all debts, losses and other obligations incurred.
Partnerships exist when at least two people share ownership of a business. Each contributes time, skills and money, and is entitled to a percentage of the profits or losses. To establish a partnership the partners usually register with the state, execute a partnership agreement and establish a business name.
One drawback is the “joint and individual” liability that partners assume for the debts and actions taken by the partnership. Each partner is liable for not only his or her own actions, but also those of the other partners.
A C corporation is a legal entity in itself. While C corporations raise funds by selling shares (or pieces of ownership) to investors, the organization itself is responsible for debts it incurs or actions it takes.
The safety offered by a corporate structure is a key attraction to many business owners. However, establishing one typically requires more administrative work than that of other business structures. This includes:
- Filing a number of documents with the state, including articles of incorporation,
- Obtaining an Employer Identification Number from the IRS, and
- Publishing annual reports (in many cases).
These requirements often mean higher startup and ongoing costs.
Another potential drawback to consider is that C corporations can be taxed multiple times. The organization’s profits are taxed, as well as any dividends paid to shareholders or owners. In addition, shareholders who are employees also pay income tax on their wages.
So the tax picture isn’t always as simple as the phrase “corporations are taxed twice.” C corporation income is taxed at the corporate rate, for which the top rate is currently 35%. In contrast, the highest personal rate is 39.6%. Thus, crunching the numbers may reveal that a company and its owners might save taxes by structuring as a C corporation.
As its name implies, an S corporation is a specific type of corporation. But, unlike C corporations, S corporations pass their profits and losses through to owners’ personal tax returns. Owners employed by an S corporation, however, must receive reasonable, or fair market, salaries. They also need to pay employment taxes on these wages.
Any remaining income from the business can be allocated to the owners as distributions, which aren’t subject to employment tax. Depending on the owner’s tax bracket, such distributions might not be taxed or may be taxed at a lower level.
A word of warning: The IRS frowns on S corporation owners who take little in compensation and receive most of their money as distributions, presumably as a way to avoid employment taxes. In certain cases, the agency has reclassified some distributions as wages.
Finding the right structure
Each type of business structure offers specific advantages and shortcomings. So, make sure you bring in an accounting professional when choosing or changing your company’s entity type.