Of all the decisions you make when starting a business, probably the most important one relating to taxes is the type of legal structure you select for your company.
Not only will this decision have an impact on how much you pay in taxes, but it will affect the amount of paperwork your business is required to do, the personal liability you face and your ability to raise money.
The most common forms of business are sole proprietorship, partnership, corporation and S corporation. A more recent development to these forms of business is the limited liability company (LLC) and the limited liability partnership (LLP). Because each business form comes with different tax consequences, you will want to make your selection wisely and choose the structure that most closely matches your business's needs.
If you decide to start your business as a sole proprietorship but later decide to take on partners, you can reorganize as a partnership or other entity. If you do this, be sure you notify the IRS as well as your state tax agency.
Sole Proprietorship
The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. If you intend to work alone, this structure may be the way to go.
With a sole proprietorship, your business earnings are taxed only once, unlike other business structures. Another big plus is that you will have complete control over your business--you make all the decisions.
There are a few disadvantages to consider, however. Selecting the sole proprietorship business structure means you are personally responsible for your company's liabilities. As a result, you are placing your assets at risk, and they could be seized to satisfy a business debt or a legal claim filed against you.
Raising money for a sole proprietorship can also be difficult. Banks and other financing sources may be reluctant to make business loans to sole proprietorships. In most cases, you will have to depend on your financing sources, such as savings, home equity or family loans.
Partnership
If your business is owned and operated by several individuals, you'll want to take a look at structuring your business as a partnership. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership's debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners.
Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership does not pay tax on its income but "passes through" any profits or losses to the individual partners.
Personal liability is a major concern if you use a general partnership to structure your business. Like sole proprietors, general partners are personally liable for the partnership's obligations and debts. Each general partner can act on behalf of the partnership, take out loans and make decisions that will affect and be binding on all the partners (if the partnership agreement permits). Keep in mind that partnerships are also more expensive to establish than sole proprietorships because they require more legal and accounting services.
Corporation
The corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements.
The biggest benefit for a business owner who decides to incorporate is the liability protection he or she receives. A corporation's debt is not considered that of its owners, so if you organize your business as a corporation, you are not putting your personal assets at risk. A corporation also can retain some of its profits without the owner paying tax on them.
Another plus is the ability of a corporation to raise money. A corporation can sell stock, either common or preferred, to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled. The corporate structure, however, comes with a number of downsides. A major one is higher costs. Corporations are formed under the laws of each state with its own set of regulations. You will probably need the assistance of an attorney to guide you. In addition, because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services.
Another drawback to forming a corporation: Owners of the corporation pay a double tax on the business's earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
One strategy to help soften the blow of double taxation is to pay some money out as salary to you and any other corporate shareholders who work for the company. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. However, the IRS has limits on what it believes to be reasonable compensation.
