Given the constant media attention regarding tax law changes and tax reform, it’s an important question to examine. The way your business is structured generally affects the extent to which you and any other owners of the business are personally protected from liabilities of the business as well as how your business is taxed.
Nationally, the majority of businesses are organized as sole proprietorships. The share of businesses organized as regular C corporations has declined in recent years, while there has been an increase in hybrid forms of business, including S corporations and limited liability companies (LLCs). If you’re starting a business, or looking to change things up, here are some considerations with how your business is set up from a tax and liability standpoint.
If you are the only owner, you can operate your business as a sole proprietorship. (It is also possible for spouses to conduct business as a sole proprietorship.) A sole proprietorship offers no liability protection. For federal income-tax purposes, you report your business income and expenses on a Schedule C an attachment to your personal return (Form 1040). Net earnings from the business are subject to self-employment taxes as well as income taxes.
Limited Liability Company
A limited liability company (LLC) is a separate legal entity that can have one or more owners (called “members”). You might prefer an LLC or a corporation over a sole proprietorship if you are concerned about protecting your personal assets in the event your business is sued. An LLC’s income is taxed to the owners individually, and earnings are also subject to self-employment taxes.
A corporation is a separate legal entity that transacts business, buys equipment, borrows money, etc., in its own name. Although a corporation can be very large and have thousands of shareholders, even a small business with one owner can incorporate. Insulation from personal liability is often a key motivator for forming a corporation.
The corporation files its own income-tax returns and uses a corporate tax rate schedule to figure the taxes due. If the corporate earnings are distributed to the shareholders as dividends, that income is taxed a second time to the shareholders, and the corporation receives no tax deduction for the dividend payments. However, as a shareholder working for the company, you generally would take a reasonable salary, which lets you draw out corporate earnings on a tax-deductible basis.
Making a valid Sub-chapter S election for a corporation avoids the potential for double taxation at the federal level. An S corporation files income-tax returns but generally does not pay federal income taxes itself. Instead, the shareholders are taxed individually on their respective shares of the corporation’s taxable income. To avoid IRS scrutiny, S corporation shareholders working in the business should draw reasonable salaries and the appropriate employment taxes should be paid on those amounts.
A partnership always has more than one owner. Although it is similar to an LLC or an S corporation in certain respects, it must have at least one general partner who is liable for the partnership’s debts and obligations. Investors who won’t play an active role in the business can receive limited partnership interests. A limited partner’s liability risk is limited to the amount invested. Partnerships do not pay federal income taxes; business profits and losses are divided among the partners according to the terms of the partnership agreement and taxed to them individually. A partnership must file an annual information return with the IRS.
Prepare for Change?
What will you do? Are you a Minnesota entity? Should you be? What happens if you need to change? Talk to your trusted advisors, with all the tax law changes in recent years, it makes sense to review your options.
Disclaimer: All content provided in this article is for informational purposes only, and is subject to change. Contact a DS+B professional before using or acting on any information provided in this article