Updated: October 24, 2010
There are many types of business structures to choose from when you’re starting an enterprise. And each one has its own merits and weaknesses.
I’ve already written about the different types of business structures before but that post didn’t quite touch the tax advantages and disadvantages of each structure.
Thus, I would like to share with you this article that exactly talks about this.
While the cases presented primarily refers to US Tax Laws, I still find it helpful and informative for anyone who might want to know the general differences of each business structure when it comes to taxation.
Choosing the appropriate business structure is an important decision for all business owners. The business structure you choose will not only have a great impact on your business, but also determine your legal and tax liabilities associated with your work.
Tax code is complex and there can be significant differences in amount of taxes paid under each entity structure. When deciding which entity type to use it is important to understand the tax advantages and disadvantages of each in order to determine which would best suit your business’s unique needs.
Sole Proprietorship
A sole proprietorship is the most standard form of business used for individuals that are self-employed. A sole proprietor is an individual that owns and operates a business that isn’t setup as a formal entity.
In the eyes of the IRS, the business and the owner of the business are considered one. When tax time comes, the business profits/losses are reported on the individual’s tax return. This form of business is used by about 70% of all self-employed individuals.
Tax Advantages
- One tax return to file: There is no separate business tax return to file, everything is filed on the individual’s tax return.
- Easy Setup: You do not need to make any special filings to be this type of entity with the IRS. You may need special state or local licenses for the field of business you are in, but nothing special needs to be done to be considered a sole proprietor.
- Easy to change entity type: If the business grows and you want to make it a more formal business there are not as many hoops to jump through.
Tax Disadvantages
- Unlimited liability: Biggest disadvantage to this structure. As a sole proprietor, you are responsible for all of business debts and obligations. This means that if you go into deep business debt there is a possibility of losing your car, home, boat, or any other assets you own.
- Increased audit rates: It is far more likely for a sole proprietor to get audited than any other entity type. Filing a schedule C will typically trigger many more audit flags than filing other types of tax forms.
- Must pay self-employment taxes: This means you must pay about twice the amount of social security and Medicare taxes as you would if you were an employee (additional 7.65%).
General Partnership
With a general partnership, two or more people run the business and split the profits or losses. Generally, each partner is personally responsible for 100% of the business liabilities.
Partnerships are similar to a sole proprietorship in the sense that they must report business profits or losses on their individual tax returns and they must pay self-employment taxes.
Like limited liability companies and S corporations, partnerships are also considered pass-through entities. As a pass-through entity, income taxes flow through the business to the owners, but the business must file an annual tax return for informational purposes.
Tax Advantages
- Considered a discrete asset: Can be transferred to other people, not like a sole proprietorship.
- Ease of being setup and maintained: You don’t need to register with your state and pay fees as corporation or LLC is required to do.
- Lower audit rates: Individuals that have their business structured under a partnership are far more unlikely to get audited than sole proprietors.
- No double taxation: The earnings of the partnership are not taxed at the business level. Income is only taxed at the individual level.
Tax Disadvantages
- Liability: Both partners are considered to be 100% liability for business liabilities, not just their share of the business.
- Lower audit rates: Individuals that have their business structured under a partnership are far more unlikely to get audited than sole proprietors.
- Two tax returns: The partnership is required to file IRS Form 1065. This is an informational return that is used since details of profits and losses that are passed to individual owners are not displayed in detail on their individual returns.
S Corporation
Choosing a corporate structure for your business takes more future planning than the alternative partnership or sole proprietorship. The legal and tax structure for these types of business entities are far more complex than other forms of businesses.
Most of the times individuals will choose to incorporate under an S Corp because they are able to shield their personal assets from business liabilities. This business structure is also considered a pass-through entity because all earnings are passed to the shareholders and taxes are paid by the individual level.
Tax Advantages
- Limited Liability: Shareholders/Owners of an S Corp have limited liability on business liabilities.
- Possible tax savings: Typically as owner of an S Corp you can be paid a “reasonable salary,” and only pay payroll taxes on the amount paid in the form of salary, the rest of the income potentially can be distributed as investment or dividend income, which will yield fewer taxes.
- No double taxation: An S Corp does not pay corporate taxes; all earnings are passed to shareholders and are taxed at the individual level.
Tax Disadvantages
- No retained earnings: After each tax year the owners must pay taxes on the profits made in the company. Even if the earnings remain in possession of the S Corp, the owners still need to pay taxes on them.
- Complex: Setting up an S Corp requires more planning than forming a sole proprietor or a partnership. Besides this factor, the S Corp is also required to file a separate tax return.
C Corporation
A C corporation (C Corp) is the most complex in terms of structure and tax structure. A C Corp has a lot of the same rights as a person; it can own assets, borrow funds, be sued, and enter into legal contracts.
A C Corp is taxed as a separate entity and taxed using corporate income tax rates. With a C Corp, taxes must be paid on profits made at the corporate rate prior to being distributed to the shareholders. The profits that are dispersed to the shareholders are then taxed at the shareholders’ individual income tax rate.
Looking at this structure from the tax perspective may make it appear less desirable, but typically this form of entity is chosen because of the other advantages it receives.
Tax Advantages
- Can have retained earnings: Unlike an S Corp, partnership, or sole proprietorship; a C Corp can keep most of the profits in the business (has to pay a small corporate tax on profits). This allows more funds to be kept within the business for future investments that could earn even more money.
- Lots of deductions: Most of the time the earnings of a C Corp are offset by all of the salaries, health insurance, life insurance, and other deductible expenses that most other forms of business do not take to the extent of a C corporation.
Tax Disadvantages
- Double taxation: C corporations are subject to double taxation because all profits are taxed at the corporate level and after that, the profits are paid out to shareholders in the form of dividends, which are then taxed at their individual income tax rate.
- Higher costs to maintain: The high costs associated with running a corporation can typically only be justified by larger businesses; smaller business don’t have the economies to justify the increased work load and expenses they will have to incur.
When determining the best structure to use for your business there are many different factors to be considered depending upon your unique situation. Taxes are one of the most important factors to analyze since they can significantly impact the bottom line of your company and have a huge impact on your future ability to grow.
This guest post was provided by BackTaxesHelp.com, a website that helps taxpayers resolve their tax problems. Visit their site to learn more about filing back taxes, installment agreements, IRS tax settlements, and more.
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Photo credit: 427 and alancleaver2000
