Hang a shingle outside your back door and you’re in business, right? Well, maybe, but knowing your responsibilities as a business owner is truly another beast entirely. Your business structure defines the legal status of your business. Each business structure comes with its own advantages and disadvantages as well as consequences for tax. It is important that you choose the arrangement that is best for both your business and personal goals.
Sole Proprietorship – This is the simplest business structure that typically entails one individual who owns and runs the business. Owners can also more freely mix personal and business assets and don’t need to pay unemployment insurance tax on their own wages (but do need to pay it on any employees).
Advantages: You make all the decisions and control every aspect of the business and you report the profits and losses on your own tax return, preventing double-taxation on both business and individual.
Disadvantages: You are considered personally liable for your business, meaning if your business incurs a debt, then your own personal assets could become at risk in a legal dispute. Sole proprietorships also rarely survive the death of loss of the owner and therefore, retain little or no value.
General Partnership – This structure is formed by two or more individuals, is managed by all partners and each partner takes responsibility for the debts and obligations of the business.
Advantages: Profits and losses of the business are passed through to the individual partners. When tax time comes around, the partnership is obligated to report profits and losses. At the same time, each partner reports their portion of income and loss from the business on their individual tax returns, using Schedule K-1 of Form 1065.
Disadvantages: The owners are personally liable for the business’ debts.
Limited partnership – This structure consists of both general and limited partners, which means that there are partners that own and run the business and are responsible for business liability, as well as partners that only invest in the business but nothing more.
Advantages: This structure is beneficial for limited partners because they have limited personal liability in the partnership – they will not be responsible for the debts and obligations amassed by the business.
Disadvantages: A limited partnership may not be the best choice for a new business because it can be quite complex in terms of administrative responsibilities and involves a lot of paperwork. A general partnership may be just fine for two or more owners who will be very involved with the business.
Regular Corporation – A corporation can be owned by one individual or many individuals, and is recognized as one separate entity.
Advantages: Owners are not personally liable for business obligations and debts, so an owner’s personal assets are not at risk within a corporate structure. A corporation also has the benefit of keeping some of its acquired profit without paying taxes on those profits. Corporations also have greater potential to save money – they can sell stocks, for example. Corporations additionally can exist eternally – it does not matter if a shareholder dies, or sells the shares. Also, in a corporate structure, certain fringe benefits are eligible for deductions as business expenses.
Disadvantages: It is considered a separate entity, apart from its owners, and requires a lot more rules, regulations, and tax requirements. Because of this, it can also prove to be much more expensive and complex, requiring the assistance of an attorney, and corporate accountants. Owners of the corporation are also susceptible to double taxation. The corporation is taxed a corporate income tax at both the federal and state level, and then shareholders are individually taxed on the dividends they’ve received from corporate earnings.
S Corporation – This is basically a regular corporation with a special tax status and certain limitations.
Advantages: Owners possess limited liability, which means that they may not be held personally liable for business-related debts. They are also enabled to report their share of corporate profit or loss on personal tax returns, which avoid the regular corporation double-tax status. Additionally, the profit can be split amongst owners so that they endure a lower tax rate overall.
Disadvantages: This type of business structure requires more paperwork and more expenses to form and maintain. Additionally fringe benefits are limited for those owners owning more than 2% of shares.
Professional Corporation: This is a kind of corporation owned by those of particular professions.
Advantages: There is no liability if other owners are implicated in malpractice.
Disadvantages: This is a generally expensive form of business, requires plenty of paperwork, and all the owners have to belong to the same profession
Nonprofit Corporation: This is essentially a nonprofit that chooses to incorporate.
Advantage: One of the biggest advantages is that the corporation does not have to pay income taxes. Also, donations to a charitable corporation are tax-deductible. Furthermore, the corporation is eligible for fringe benefits regarded as business expenses.
Disadvantages: Only certain organizations can receive full tax benefits (charities, or educational, scientific, literary, and religious organizations). If the corporation dissolves, its assets must be transferred to another nonprofit.
Limited Liability Company –This business structure is allowed by some states and can possess variable traits. A professional limited liability company (PLLC) is the same kind of company but limited to certain professions such as medical, legal and engineering firms. In addition, state licensing boards may need to review the professional licensing of every member and approve of the company’s formation.
Advantages: This structure gives limited liability to business partners. LLCs are now allowed to make a choice whether they want to be taxed as a partnership or a corporation. PLLCs can also create retirement plans that allow for higher contribution limits than partnerships. PLLCs also enjoy perpetual existence, meaning that even if one of the partners retires or dies, the firm will continue to exist.
Disadvantages: This business type tends to be more expensive to form and maintain. The latest changes in federal tax laws may not be reflected by state laws.
While making your initial business structure decision may seem overwhelming, know that you can always shift the structure from one form to another over time. It is always wise to see guidance from both a business advisor and a tax professional prior to any decision so that you understand fully the responsibilities and tax obligations for each business structure type.
PASBA member accountants bring the collective resources of a nationwide network of Certified Public Accountants, Public Accountants, Enrolled Agents and other practitioners available to answer your tax and financial questions and streamline your business accounting, bookkeeping, and payroll operations. To find a trusted accountant in your area, visit www.SmallBizAccountants.com.
Please be advised that, based on current IRS rules and standards, any advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS may assess related to this matter. Any information contained in this article, whether viewed or subsequently printed, cannot be relied upon as qualified tax and accounting advice. Any information contained in this article does not fall under the guidelines of IRS Circular 230.
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