When forming a business, you have to pay attention to many different details to succeed. However, while you might be focused on elements like operational procedures, supply chains, and employment practices, you also have to worry about your taxes. Depending on the type of business you operate, you might have to pay different taxes than what you’re used to. So, it helps to understand the various implications of each business entity so that you know what to expect.
To help you avoid the stress of tax season, we’ve compiled a list of entity types and what they can mean for you. Here is everything you need to know about how your business structure affects your taxes.
Business Structure Types
You can create four primary types of businesses – sole proprietorship, LLC, partnership, c-corporation, and s-corporation. You can also create a nonprofit, but since those organizations don’t pay taxes, we won’t talk about them here. Usually, what matters most is whether your business is treated as a separate legal entity or if it’s tied to you directly. If you’re running a business with someone else, you also have to consider your stake when paying taxes. Here’s a breakdown of each type.
A sole proprietorship means that you’re the only owner and operator of the business. This is the default setting for companies if you’re earning business income without registering with the IRS or your state. However, the best way to run a sole proprietorship is to make it official with business documentation.
As far as taxes are concerned, everything you earn from the company gets reported on your personal tax form. So, you’re taxed at your regular marginal tax rate, no matter what type of income you’re getting. For example, let’s say you have a day job with a $40,000 salary, and you make an extra $20,000 from your business. In this case, you’d report your total gross income as $60,000.
The downside of running a sole proprietorship is that you’re liable for any business debts. So, if your company defaults on a loan or a credit card, the creditors can come after you directly. Another disadvantage of this entity type is that you can’t hire employees or add a business partner.
LLC stands for limited liability company, and it’s often the best option for businesses both big and small. Starting an LLC is easy, and you can register your business online. You can start an LLC as an individual or with multiple partners. Either way, you must create and file articles of organization with your state. This document outlines how your business will run. It shows who’s in charge of what and the overall power structure.
The primary benefit of an LLC is that you’re protected from business debts and liabilities. So, if the company goes bankrupt, you won’t be affected personally. When it comes to taxes, what matters is whether you’re by yourself or with partners. Each type of direction (either a single-member LLC or a multi-member LLC) comes with some benefits, that depends on your business model. It’s advisable to consult a tax advisor when choosing how the IRS will treat you.
As an individual LLC owner, the IRS treats the entity as a sole proprietorship. While you can still hire employees and receive liability protection, the IRS treats business income the same as your regular earnings. All you have to do is file Schedule K-1 to combine them. If you have one or more partners, the IRS treats your LLC as a partnership (more on that next). So, what matters is each partner’s stake and income from the business.
To make it easier to understand, let’s pretend you own the business with one other person. You both agree to split earnings 50/50. So, let’s say you made $10,000 for the year, with $5,000 to you and $5,000 to your partner. In this case, you only have to report your half, even though the business made double that. Since you’re adding your company earnings to your personal taxes, you pay your standard marginal tax rate.
Another aspect of filing an LLC is that you can have it work as a corporation. If it’s a c-corp, you have to pay taxes on your income twice, but we’ll cover that later when discussing this entity type.
Partnerships are like a sole proprietorship but with two or more people involved. As with a sole proprietorship, you may enter a partnership without formally registering your business with your state or the IRS. In this case, all partners have an equal share in the profits. So, if you’re in business with three other people, you’re all entitled to 25 percent of the company’s earnings.
Instead, it’s much better to create a partnership agreement that outlines each partner’s duties, responsibilities, and stake. For example, one partner may put up more investment capital, so they receive a larger share of the income. You can also stipulate the rules for exiting the partnership. In some cases, for one partner to leave, the other partners have to buy their stake in the company. Once someone leaves the business, you must create a new partnership agreement.
Another way that partnerships are similar to sole proprietorships is that they offer no liability protection to the owners. However, if you want protection, you can form a limited liability partnership or LLP. You must make this distinction when starting the business, which is another reason to create a partnership agreement.
In the United States, corporations are treated as separate, legal tax entities by the IRS. So, a corporation must pay income taxes like any individual. In this case, forming a c-corporation means you’ll get taxed twice on your earnings. First, the company gets taxed, then you get taxed on your personal gains.
For example, let’s say the business earned $50,000. The corporate tax rate is 21 percent, so the company would pay $10,500 in taxes. Then, you would pay taxes on whatever earnings you took from the remaining balance. So, if you’re starting a business by yourself, it doesn’t make much sense to form a c-corporation. You also have to have a much more rigid company structure, which is challenging when you’re the only owner.
Unless you’re forming a large company, it makes more sense to establish an s-corporation instead of a c-corp. This is because s-corporations offer pass-through income, meaning the business doesn’t get taxed before you do. However, there are strict rules about how these entities can operate and which earnings can pass through. We recommend talking with an attorney before incorporating so that you can be sure you’re compliant.
Although taxes can seem daunting, they’re relatively easy to manage if you know what to expect. While we’ve discussed the tax implications of each business entity, there are pros and cons to each type. So, take the time to figure out which one is right for your needs.