It’s no secret that as a business grows its needs evolve. If your company has experienced recent financial or organizational growth, tax season may present a timely opportunity to reevaluate your business classification. Choosing a structure that best meets your business’ current or impending needs can be a challenging decision, but making the transition at the right time can offer major tax benefits.
If you’re considering changing your business’ structure, it’s important to understand the different types of business classifications and the tax implications that come with each. Below are the five most common types of businesses and some quick tax facts to consider.
Most Common Business Structures
A sole proprietorship is an entity with only one owner who is legally responsible for all the business’ taxes, profits, and debts. Creating a sole proprietorship is often the easiest and quickest way for a new business owner to get started, but it doesn’t offer any protection or separation of your personal and professional assets, which can present challenges as your business grows.
From a tax perspective, a sole proprietorship is a pass-through entity, which is taxed at the individual level. This means the business is only taxed once through the business owner’s personal income tax return and not subject to corporate taxes or double taxation.
Limited Liability Company (LLC)
A limited liability company (LLC) is generally thought of as the simplest entity type that helps an owner separate personal liability from the business’ liabilities. LLC’s provide similar liability protection as a traditional corporation; however, the setup costs are substantially lower. While this option offers the business owners protection from assuming personal liability for the company’s debts, it is also a pass-through entity, meaning the business is taxed on the individual level, not the corporate level.
A partnership is similar to a sole proprietorship where the owners’ personal and business assets are not separated or protected, but this type of business is formed between two or more people rather than one. A partnership is also a pass-through entity, but it has slightly different tax nuances than a sole proprietorship or LLC. All partners must include the business on their personal income tax forms and each partner is subject to pay taxes in proportion to their share of the company. Meaning, if you have a majority in the company, you will be responsible for the bulk of the business’ taxes.
C Corporation (C Corp)
A C Corporation (C Corp) is a common structure for larger businesses and operates as a separate entity from its owners and shareholders. While this business structure offers the most liability and asset protection to its owners, it is one of the most involved business structures to create. C Corps are typically a strong option to consider if you’re looking for venture capital funding, in need of flexible profit-sharing options or want to offer stock options to employees.
Regarding taxes, C Corps are subject to double taxation. Before a C Corp can pay profits to its shareholders it must pay a corporate income tax. After corporate taxes are paid, any profits distributed to shareholders are also subject to the recipient’s personal income tax rate. While there are some ways to avoid double taxation, this is a key issue to keep in mind when considering establishing a C Corp.
Subchapter S Corporation (S Corp)
If you’d like to avoid the double taxation problem C Corp’s face, but retain a similar amount of liability protection and the ability to offer stock to the public, a Subchapter S Corporation (S Corp), may be the right option for your business. Like a C Corp, an S Corp operates as a separate entity from its owners. However, it is subject to pass-through taxation. Some of the biggest limitations to an S Corp classification are the strict restrictions on the number and types of shareholders the business may have.
Looking for Some Help?
If you’re a business owner considering a change in your company’s structure, it may prove beneficial to evaluate your options before filing your taxes. Our team of advisors and tax solutions are here to make the decision easy and ensure full compliance along the way.
Lety Rodarte, CPA
Senior Tax Accountant