Are You Using the Right Business Structure?

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How you calculate your income taxes will depend in part on the business structure (or business entity) you’ve selected, such as sole proprietor or LLC. Not only does that designation affect the tax forms you’ll file, but it also has an impact on how much personal liability you’re taking on. We’ll look at some of the differences here.

Sole Proprietorship

If you own an unincorporated business by yourself, you’re a sole proprietor. You’ll file an IRS Form 1040 or 1040-SR with a Schedule C (Profit or Loss from Business), as well as any other forms and schedules required. This is the simplest business structure and isn’t subject to all of the tax obligations and government regulations that others are. You’ll be taxed as an individual since you and your company are considered the same entity legally. This also means that you are personally responsible for any liabilities or losses (this is one reason why it’s a good idea to consult with a lawyer before going into business for yourself!).

Sole proprietors file a Form 1040 or 1040-SR and a Schedule C, in addition to any other needed forms and schedules.

Partnership

A partnership is composed of two or more individuals who engage in a trade or business together. Each contributes his or her skills and labor, money, and/or property. All parties share the company’s profits or losses — in a pre-agreed proportion. A partnership is what’s called a pass-through entity. That is, it does not pay income tax as a separate legal entity — but it does need its own EIN for filing. Then profits and losses are passed through to the partners, who report them on their personal tax returns.

Along with the EIN, it’s smart to have an agreement drawn up in advance (with advice from an attorney and a CPA) establishing foundational terms, such as who is investing what into the partnership, and who is responsible for what business entity responsibilities, and how the partnership income (or losses) will be shared.

Partnerships must file an annual information return, where they report their income, gains or losses, credits, deductions, etc. This is the IRS Form 1065, U.S. Return of Partnership Income. Since partners are not considered employees, they do not receive W-2s. But they’re required to file a Schedule K-1 — a statement of income allocation from the 1065 filing, which the partnership furnishes to the partners.

S Corporation

S Corporations must be domestic operations and have no more than 100 shareholders and one class of stock, among other requirements. They’re another kind of pass-through entity, passing corporate income, losses, credits, and deductions through to their shareholders for tax purposes. Shareholders report this pass-through income and losses on their personal tax returns and pay the assessed tax at their own individual income tax rates.

You will want to get qualified legal advice from an attorney and tax accounting advice from a CPA before opening this type of business. Similar to a partnership, but a bit more involved, it’s important to have agreements drawn up in advance establishing all organizational and operational terms, plus obtain the company’s EIN.

S Corporations must file Forms 1120-S, Schedule K-1, and Form 1120-W (estimated tax for corporations).

C Corporation

This is more complicated and is generally used by larger companies with numerous employees. We can help you understand if this is the entity you choose. Shareholders contribute money or property in exchange for shares of the corporation’s capital stock, and they pay taxes when dividends are distributed. Because the corporation is considered a separate legal entity and is taxed as such, its shareholders are partly protected from personal liability.

C Corporations file a Form 1120, U.S. Corporation Income Tax Return, and a Form 1120-W, Estimated Tax for Corporations, in addition to other forms and schedules required. This type of entity has complex administrative requirements. You will certainly want to get qualified legal advice from an attorney and tax accounting advice from a CPA before opening this type of business.  It’s crucial to have all agreements drawn up in advance establishing organizational and operational terms, plus obtain the company’s EIN.

Corporations must file an IRS Form 1120 or 1120-S, along with other forms and schedules.

For the special circumstance of a ROBS Arrangement (Roll-Over as Business Startup) — using a pre-tax retirement account to fund a new business — The C Corporation is the only legal business entity permitted for the new company. For deeper understanding of ROBS, please look here: ROBS C-Corporations

Limited Liability Company (LLC)

Individuals and other business entities can be structured as LLCs, which have different regulations depending on what state you’re in. Owners are referred to as members, and they can be individuals, other LLCs, foreign entities, or corporations, but some types of businesses, like banks and insurance companies, cannot be members. Membership is unlimited. The IRS considers an LLC a partnership, a corporation, or as part of the LLC’s owner’s tax return (a “disregarded entity”). If an entity doesn’t want to accept its default classification or simply want to change it, it must file a Form 8832, Entity Classification Election.

Understand Your Obligations

Before you select a business entity for the first time, or if you’re planning to change an existing one, please make sure you understand the relevant income tax and liability issues. We’d be happy to confer with you about this so you don’t make an unfortunate choice. At Baum CPA we’re always available to discuss tax-related issues with you. Just contact us, and we’ll set something up — click here for an initial consultation.