After much debate and consideration, you’ve decided to take the leap and start your own business. While you may have a lot of startup costs to consider, there are numerous tax advantages that help offset the expenses of setting up and operating a business.
Like many new entrepreneurs, deciding on the right business structure for your product or service may seem confusing and daunting. Further complicating matters are the federal tax implications and IRS requirements you must consider when forming your company.
Before diving into the legalities of creating and running an organization, hire a qualified accountant or attorney to help steer you through the complex legal requirements of establishing a business. The following is a brief overview on the most common types of business structures, as well as some of the tax considerations unique to each entity.
A sole proprietorship is by far the simplest and most common type of business structure. Sole proprietorships are popular primarily because they’re the easiest and least expensive to establish.
However, as a business owner, sole proprietorships leave you the most legally vulnerable. Any business debts and liabilities will be the owner or sole proprietor’s responsibility. In addition, all company profits must be accounted for on your personal tax return. The same applies to any eligible write-offs and home office deductions. Although your business and personal assets are more vulnerable with a sole proprietorship, keeping all necessary paperwork to file and back up deduction claims can help you minimize potential risks.
- Sole proprietors are taxed at their own personal tax rate, which might be lower or higher than the corporate tax rate.
- Sole proprietors can protect personal assets and income from a tax audit by deducting only legitimate company expenses.
For additional information on tax implications for sole proprietorships, refer to the Sole Proprietorships page on the IRS website.
Corporations are the second most common business structure after sole proprietorships. In addition to being versatile, corporate structures are also popular because they’re considered separate legal entities from the owner. In other words, if you’re sued for unpaid debts, only your business assets are legally vulnerable (your personal assets remain separate). In rare cases of fraud or co-mingling of personal and business assets, this separation of liability can be legally breached; this is called “piercing the corporate veil.”
Although corporations can raise capital through the sale of stock or equity financing, the financial reporting requirements are more complex than a sole proprietorship. Accounting processes can also be expensive to establish.
- Corporations can be subject to a double tax, since dividends are paid to shareholders after taxes (i.e. any profit earned by the corporation is taxed). Shareholder dividend payments are then taxed a second time, since they’re recognized as income distributed to individual shareholders.
- In addition to taking the same deductions as sole owners and proprietors, corporations are eligible for special deductions since the IRS views corporate structures as separate taxpaying entities.
Corporations may be liable for taxes such as Social Security and Medicare. For a complete list, see the IRS tax guidelines for corporations.
S corporations, or “S corps,” are similar to regular corporations, but can only have a maximum of 100 shareholders. Furthermore, shareholders can only be individuals, estates and certain trusts.
An S corporation must be based in the United States and contain only one class of stock. Some business sectors, such as certain insurance firms, financial services companies and domestic international sales corporations, are ineligible to claim subchapter S status.
These restrictions are not meant to make it more difficult for startups to set up S corporations, but to prevent large, publicly held corporations from taking advantage of this alternative business structure. Likewise, S corporations must operate for a set time period before converting to a C corporation. The same is true for C corporations looking to convert to an S corporation.
- S corporations “pass through” taxation of profit, losses, gains and deductions to their shareholders. This means that shareholders are taxed only once, which allow S corporations to avoid the traditional “double taxation” on corporate profit.
- At the entity level, S corporations are responsible for paying taxes on certain built-in gains and passive income.
Refer to the S Corporations page on the IRS website for further guidance on tax forms and filing requirements.
A partnership involves two or more individuals who form a legal business entity. The individuals become co-owners of the company. When setting up a partnership, it’s best to consult a qualified attorney to draft a legal agreement detailing the business arrangement, partner responsibilities and ownership interests.
- Since each partner contributes financial capital and business resources to the partnership, each partner also shares responsibility for any profits or losses.
- Because partnerships are not taxable entities, profits and losses are “passed through” to the company’s owners and reported on each partner’s individual tax return.
- Partnerships must file an annual information return reporting the company’s income, gains, losses and deductions.
Refer to the IRS website’s Partnerships page for further guidance on the tax forms partners are required to file with the IRS.
Limited Liability Company
Often posed as an alternative to regular corporations, a limited liability company (LLC) operates like a partnership but limits owners’ liability risk for company debts (and shields their personal assets). Any profits and losses are passed to company investors depending on their level of ownership.
While both provide liability protection, an LLC offers more flexibility than a corporation. There’s no requirement regarding the type or number of owners within an LLC, and it offers simpler taxation that a corporate structure. Certain companies, such as banks and insurance companies, are ineligible to form an LLC. Generally, eligible owners can form one of two types of LLCs:
- A single-member LLC, which is owned by one individual or corporation and treated as a sole proprietorship for taxation purposes.
- A multiple-member LLC, which is owned by two or more members. Thus, the LLC is treated as a partnership, unless it elects to be taxed under a different status.
- LLCs are allowed by state statute and must be filed with the Secretary of State.
- By forming an LLC, you’re allowed pass-through taxation. Profits are taxed at the member (i.e. investor) level rather than at the LLC level, thus avoiding double taxation.
- As an LLC, you have wide flexibility when it comes to tax status elections. For example, LLCs can be classified as a sole proprietorship, partnership, corporation or S-corporation.
- Owners assume no personal liability for company debts.
Your filing requirements will depend on what entity classification you choose for your LLC. Refer to LLC Filing as a Corporation or Partnership on the IRS website for further information.
The considerations listed here are by no means an exhaustive list of the legal and tax ramifications of setting up a business. If you’re ready to establish your business entity, work closely with a qualified attorney and tax professional who can advise you on the best practices for building a solid foundation for your company. Finally, refer to tax resources, such as the article “Choosing a Business Structure” on the IRS website, for additional information on tax requirements for business owners.