What Are The Different Types Of Business Structures?

By Lauren Crum  Email Lauren

When starting a new business, choosing your legal structure is one of the most important decisions you’ll have to make. The structure you choose will influence many areas of your business including your tax filing, your personal liability and your ability to receive funding. As a business owner, you can structure your business as a sole proprietorship, a partnership, an LLC, a S-Corporation, or a C-Corporation.

The sole proprietorship is the most basic type of business entity. Under this structure, all the assets and liabilities belong to the business owner. Because of this, your business income is your income, and you report it on the Schedule C of your Form 1040.

If you are in a business with one or more partners, you could consider a partnership. Unlike a sole proprietorship, a partnership needs to register with the IRS, state, and local tax revenue agencies. The partnership itself does not pay income tax because the profits pass through to its owners. A partnership provides a Schedule K-1 to each of the partners, who then file it with their Form 1040.

If you’re looking to have your business taxed separately, you can establish a S Corporation (S Corp). Since the S Corp is taxed as its own entity, a business owner can obtain tax savings because they are taxed only on their wages.  An S Corp reports income on Form 1120S.

Structuring your business as a C Corporation (C Corp) is less popular among small businesses because it is more complicated and costly due to administrative fees. Additionally, it has a major drawback, referred to as “double taxation.” The C Corp is taxed and then its shareholders are taxed again upon distribution of dividends. This structure is usually more popular for small start-up companies because C Corps can offer stock in exchange for an ownership stake. A C Corp files a Form 1120.

A Limited Liability Corporation (LLC) combines the tax pass-through of a partnership and the limitation of liabilities like a corporation. LLCs have the most flexibility when it comes to filing taxes. They can be taxed like a sole proprietor (for one member), partnership (for two or more members), or a corporation (C or S).

The legal structure you choose will have a continuous impact throughout the life of your business. Consulting with a legal and financial expert can help you make the best decision for your situation.

It Is Your Business, How Should You Pay Yourself?

By Lauren Crum  Email Lauren

If you ask a tax advisor this question, you will probably get their favorite answer: “It depends.” They’ll tell you this because the structure of your business entity determines how income is reported for income tax, social security, and self-employment tax purposes.

Entities formed as sole proprietor LLCs take distributions from their business as cash flow allows. There are no reporting requirements for these distributions. Rather all business income and deductible expenses are reported on Schedule C. Self-employment tax is computed and paid with the filing of Schedule SE, along with Form 1040.  

Members of partnership LLCs may also take distributions from the business as cash flow allows. These distributions are not taxable income to the partner but they are reported on the Schedule K-1 as part of the reconciliation of the respective partner’s capital account. Partnership LLCs with multiple owners report taxable income on Form 1065, Partnership Return of Income. Earnings from the business will then be considered self-employment income and self-employment tax will be calculated on Schedule SE I.

If the entity is formed as a corporation or LLC and elects to be taxed as an S-Corporation, the owners of the company pay themselves compensation similar to an employee. Payroll taxes are withheld from their pay and W-2s are filed with the Social Security Administration by the business. When it comes time to file taxes, the owner reports W-2 wages on their personal tax returns. S-Corporation owners may also take distributions, which are not taxable, however reasonable compensation must be paid first.

If an entity is formed as a corporation and does not elect to be taxed as an S-Corporation, it will be taxed as a C-Corporation. Owners/shareholders providing services to a C-Corporation are compensated through wages reported on W-2s. Distributions to the shareholders are taxable dividends and the corporation is required to file a 1099-DIV with the IRS, reporting such dividends. Most closely held businesses do not opt to be taxed as a C-Corporation due to the fact that earnings are taxed twice, once as income to the corporation and again as a dividend to the shareholder.

According to Lorilei J. Roberts, CPA, MSBA, CGMA, Tax Manager at PBMares, LLP, the most tax sensitive entity for compensation purposes is the S-Corporation.

“The tax code requires payment of "reasonable compensation" for the type of work that you’re doing for the company. As a guideline, the IRS suggests basing your own compensation on what you would compensate an outside person to perform your job. In the event of an IRS audit, distributions may be reclassified as wages and payroll taxes could be assessed if the examiner determines that insufficient wages were reported based on the services the owner provided to the company. It is recommended that business owners consult their tax advisor to determine the most appropriate compensation plan for their situation,” advises Roberts.

The funding source for a business may have certain “employment” and payment requirements for business owners as well. A ROBS (Rollover Business Startup) funded business will require the investor to be a W-2 employee of the business. A self-guided investment however, may require that the investor have no part in the day-to-day operations and ONLY takes a distribution.

As you can see, there is no simple answer to the “how should I pay myself” question. BKE recommends you consult with a tax professional to determine the best the legal structure for your situation.

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