Tax Implications of Business Structures

Let’s look at the tax differences between different business structures, including sole proprietorships, partnerships, LLCs, S Corps, and C Corps.

Sole Proprietorship

A sole proprietorship is one of the easiest businesses to form and you, as the sole proprietor, carry all the assets, liabilities, and responsibilities of your business.

However, you can’t sell stock in your business as a sole proprietor, and banks are hesitant to lend to you.

With sole proprietorships, you don’t even need to register the business with the IRS. You can just use your personal Social Security number for the business tax ID.

The profits from the business are not “paid” to the sole proprietor in wages, they are just included in the total amount of personal income tax that is applicable on the taxable profits of the business.

Many freelancers, independent contractors, and consultants fall under this business structure, which means that if you are a business that operates as or uses contractors, you will need to request or file the proper forms, like the 1099-NEC, when reporting income.

Partnership

A partnership is formed when two or more individuals want to create a business together. They can either be limited partnerships (LPs) or limited liability partnerships (LLPs).

Limited partnerships have one general partner with unlimited liability, while the other partners have limited liability pertaining to the business. The partners with limited liability also generally have less control over the business.

With limited liability partnerships, everyone has limited liability. It protects everyone from debts against the partnerships and actions of other partners.

In regard to taxes, partnerships are very similar to sole proprietorships, with a few additions for the multi-owner status. The profits don’t have to be split equally between partners (something you should discuss before entering a partnership agreement). This also means that, like sole proprietorships, all profits are subject to FICA taxes. This is because you don’t run payroll for a partnership, you receive guaranteed payments.

Limited Liability Company – LLC

Limited liability companies (LLCs) give you the best of both worlds when it comes to corporation-based benefits and partnership-based perks.

LLCs protect you and your personal assets from liability. They are legal entities that are not recognized as a taxpaying business structure.

Since LLCs are legal entities and not tax entities, you must choose a tax entity: proprietorship, partnership, C corp, or S corp.

You don’t need to create an LLC to create any of the other business structures. There’s also the added bonus of flexibility. Your LLC can pivot from a partnership to an S corp anytime.

C Corporation

A C corporation is a legal entity that is completely separate from its owners – it’s generally used when a business grows and becomes more complex. Corporations can be taxed, make profits, and be held legally liable for certain practices.

This business structure is unique because the C corporation pays its own income taxes. Any stockholders of the C corp also must pay taxes on any dividends they take out. This is considered double taxation.

The benefits of having a C corporation, from a tax perspective, include the low tax rate on profits and the potential for a tax-free stock sale should a stockholder wish to exit the company.

S Corporation

For small and mid-sized businesses, an S corporation business structure is often the perfect fit.

With an S corporation, you still file a tax return, but there’s no income tax owed on that return. The taxable income of the company is allocated to the owners using Form K-1, which is then reported and taxed on the owner’s personal return using Form 1040. The business income is then tabulated on a Schedule C, E, or F.

This structure is beneficial because S corps (like partnerships and sole proprietorships) are pass-through entities. Your taxes pass through the business and are reported on personal returns. But that means profits can be withdrawn as tax-free dividends.

The big difference between S corporations and the partnership or sole proprietor model is that owners here are required to pay themselves a reasonable wage (which will have FICA taxes come out of it) but the rest of the profits are only going to be subject to income tax.

Some of the reasons a business may choose the C corp over the S corp, however, are that S corporations are limited to a maximum of 100 stockholders and only one class of stock is allowed.

Choosing the Best Business Structure for You

Each business structure is subject to the same federal laws and taxes. However, the three main things to consider when choosing your business structure include:

how profits are taxed
the complexity and expenses associated with setting up the business
liability assignment, specifically in reference to personal assets of the owner(s)

There are factors outside of taxes that should also guide the decision to build any business in a specific structure.

Toptal has a great article that breaks down the pros and cons of each business structure.

No Matter What Business Structure You Choose, Taxes Still Apply

Taxes are a part of everyone’s personal and business life. And the more your business grows, the harder it is to keep the right tax forms straight and to dedicate your time or an employee’s time trying to figure out how many of which forms need to be filed, whether they need to be mailed or electronically submitted, and more.

eFile360 makes it easy for you. Store all your electronic tax forms, make updates and additions, and e-file your taxes with ease. And if you get stuck, you can reach out to any of the experts on our team – we’re always waiting to help you whenever you need us.

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