Choosing the right structure for your business can save big money at tax time.
Savvy business owners understand the value of making wise tax decisions: there’s simply no good reason to pay more than you have to. Understanding the tax code and how it affects businesses is the first step in ensuring your tax burden is appropriate to the size and nature of your company. It’s all about structure.
Business structures and taxes
On the surface of its definition, a business’ structure is exactly what it sounds like – the way a company is organized. Of course, by the time the IRS and legal industry get involved, identifying the genres of business organization becomes a little more complicated. While you’ll want to consult with your tax advisor before committing to a structure, here’s a thumbnail sketch of the types of businesses and their tax advantages.
Limited Liability Company (LLC). Typically LLCs are favored by companies looking for the legal protection of a corporation without all the red tape involved with a full corporation.
LLCs can be owned by as many owners as the LLC sees fit, and they qualify for pass-through taxation: the owners are taxed at the individual level, rather than taxed at the corporate level, where the company is taxed on the profits and the owners are taxed again on the dividends/salary they receive from those same profits. This helps prevent what’s referred to as “double taxation.” In this case, the owners make payments quarterly to the IRS, and are required to submit Form 1065 or 1120S (if an election was made) annually. The pros and cons for forming LLCs vary from state to state: for example, some require LLCs to pay property taxes.
Corporations. As you might have guessed, corporations provide the same legal separation as LLCs. However, they’re taxed separately from their owners. Along with the reduced liability LLCs provide, corporations garner more credibility with financial institutions.
Corporations come in two flavors: C and S. C corporations expose business owners to the double taxation LLCs avoid; therefore, they’re ideal for business owners who intend on investing a majority of their profits back into the company. S corporations are essentially C corporations with a shareholder cap of 100 – shareholders pay individual taxes rather than corporate tax rates, and the company is exempt from paying taxes on profits.
Sole proprietorships are simple to establish, and the owner only pays taxes based on their income. Unlike LLCs and corporations, the owner assumes the same legal liability as the company. The main advantage of this structure is a lower tax rate than most other businesses. On the other hand, sole proprietorship owners also have to pay self-employment taxes, such as Social Security and Medicare payments.
Partnerships. Most partnerships are considered “general partnerships” (GPs), but other varieties include limited partnerships (LPs), and limited liability partnerships (LLPs). GP partnerships offer the pass-through benefits of LLCs and corporations, without the liability protection. Other variations protect certain partners from personal liability while restricting their involvement with the company.
Nonprofit organizations (NPOs). If your business is exclusively for the benefit of the general public, the IRS will return the favor with a tax exempt status. To qualify, NPO candidates must submit an application 15 months prior to their legal formation, and are required to provide financial and operating information to the general public. NPO candidates also need to ensure the absence of any income not related to its exempt status to stay clear of its tax implication.
Choosing a structure that’s best for your business is a strategic first step towards success. Ultimately, there’s not a one-size-fits-all solution to a business structure. And while tax benefits should be an important factor in your choice, your company’s current goals and objectives as well as future expansion plans can also play a big a role in deciding what type of business to choose.
As with any decision impacting your organization, the future, and that of your employees, it’s always better to take some time to do your research, talk with professionals and fully weigh all the options before making that leap to the next level of success.