Launching the business of your dreams is an incredible feeling. If you don’t plan your taxes well, this high can quickly become a financial disaster. There are many ways to reduce your tax bill in an ethical and responsible manner!
Inside of that many pages of tax complexity leaves a lot of opportunity to reduce your tax bill. Our experience shows that most business owners do not understand their tax plan. Many business owners get confused by the different ways that a business can be managed and structured.
In general, the structure of your business will directly impact how much you pay in taxes, how you declare income, which deductions you can claim, and whether you’re exposed to audits or liabilities. A single mistake can have a significant impact on your financial plan if you are managing a large amount of wealth or multiple businesses.
This guide will outline the most common business structures, and their tax implications. You can then identify the impact of each structure on legal risk, compliance load, control and, most importantly, your bottom line.
Understanding the major types of business structures
Each business structure has its own unique mix of administrative, legal and tax considerations. Some offer flexibility and minimal paperwork, while others demand greater compliance for better liability protection and easier access to capital.
Sole proprietorship
A sole proprietorship is the easiest way to begin a business, but also one of the most risky. Legally, you and your business are legally the same. You report your business income in your personal tax return. However, you are still liable for any business debts or legal issues. The system is easy to manage and set up, but offers no protection for your personal assets in the event of a disaster.
Partnership
In a partnership, two or more individuals share a business. Profits and losses are passed directly to each partner’s personal tax returns. You will file an informational report to file your overall business activity.
In a general partnership, all partners are jointly liable. Limited partnerships (LPs), and limited liability partnership (LLPs), on the other hand, provide an additional layer of protection.
LPs separate general partners (who manage and assume liability) from limited ones (who invest). While LLPs protect each partner against the actions of their partners, which is particularly helpful for professional practices such as law or medicine.
Limited Liability Company (LLC)
An LLC combines the ease of pass-through taxes with the legal protection provided by a corporation. Single-member LLCs will be taxed the same as sole proprietorships, and multi-members LLCs as partnerships. The tax treatment of LLCs is either S corporation or C corporation.
The LLC is a flexible and widely recognized entity that shields personal assets from the red tape corporations are often subjected to. In some states, however, compliance and fees can be very substantial.
C-Corp
A C corporation is a separate legal entity that pays its own tax and protects you from liability. This is the best option for growth, with stock options, external investors and unlimited shareholders. Double taxation is a downside. The first is the corporate tax, and then the second is the dividend tax.
This is the best setup for those who plan to reinvest their profits, raise outside funding or go public.
Running a C-corporation comes with additional paperwork and formalities such as board meetings and resolutions. It also requires strict record-keeping. If you want to build a big company, then this is a good option.
S-Corp
An S-corporation allows you to transfer income, losses, deductions and credits directly to your shareholders. The company does not pay corporate income tax. Instead, it shifts that burden to the shareholders who then report the income flow-through on their personal returns.
The C-corporation structure does not allow you to avoid double taxation. The IRS does not give out S-Corp status freely. Your corporation must meet certain requirements to qualify.
- Your company must be located and incorporated in the US.
- There can be no more than 100 shareholders
- There can only be one class of stock
- The shareholders of the company must be either individuals, certain trusts, estates, or qualified non-profits
Even after approval, S corps may be subject to taxes on selected built-in gains and excessive passive income at the entity level, so you’re not entirely off the hook.
Benefit corporation (B-corp)
Benefit corporations allow you to pursue profit while also pursuing a public benefit that is legally defined without compromising on either. You still have shareholders, who are expecting returns, unlike a non-profit. However, your mission is legally built into your charter
You can therefore prioritize social or sustainability impact, without having to worry about lawsuits by investors who are solely focused on the bottom-line.
Benefit corporations can either be taxed as a C-corp, or they can elect the S-corp status based on IRS classification. It comes with additional transparency requirements such as biennial reports on your environmental or social goals.
This structure also allows for greater flexibility when you are looking to raise capital and still stay true to your mission. This is the best business structure if you don’t want to choose between purpose and profit.
Closed Corporation
Consider this structure if you prefer less formality but want to have more control over your company. Closed corporations are exempt in many states from formalities such as the annual meeting. However, state laws vary.
The ownership is also restricted to a small group of individuals, usually the founders, managers or family members. which means less outside interference but also less access to outside capital. The shares are not publicly traded and, if the owner wishes to sell, they can buy their own shares back from the company or other shareholders.
You still get limited liability, and if you elect S-Corp status, you can benefit from pass-through taxation. Note that liquidity is limited, and you’ll trade growth potential for tighter control.
Non-profit organization
Do you strongly advocate for a cause but need to operate like a business to make an impact? You can do this with a nonprofit corporation. Its primary goal is to fulfill a social or public mission, rather than generate profit for its owners or shareholders.
You can receive tax-deductible contributions if you meet IRS requirements. This helps to build public trust, and opens up funding opportunities. The surplus income must be reinvested in your mission, rather than being distributed to the founders, employees, or board members.
In most states, nonprofits are required to have a board and adhere to transparent financial practices. It can be a heavy administrative burden, but it is necessary to protect your nonprofit’s credibility and eligibility for donations and grants.
Nonprofit corporations can be ideal for organizations that are focused on the public good rather than financial gain. In exchange for a greater level of scrutiny, paperwork and oversight, you will gain credibility and tax benefits that will fuel your impact.
Cooperative
A cooperative is an organization owned and controlled entirely by its members. They work together in order to meet their daily needs and benefit from their collective efforts. Like a democratic governance system, each member has the right to vote regardless of how much they invested. This equal control may slow down the decision-making process, but it also ensures an equitable and balanced distribution.
Cooperatives either reinvest their profits in the business, or they distribute them to the members. This keeps economic gains within the local community. The tax treatment is different for each cooperative, but most qualify for pass-through taxes. They thrive in sectors like agriculture, retail, and housing, where shared ownership drives sustainable growth and mutual success.
Wealth starts with structure
The structure of your business can have a significant impact on profitability, growth and success over the long term. Understanding the tax implications of each entity type will help you develop smarter and more flexible strategies to grow your business.
Remember, you do not have to figure out everything on your own. Parr & Ibarra CPA in Keller, Texas offers tax planning and business entity planning to all of its clients. We cater to high-net worth individuals with complex needs and ambitious goals. Make your business structure work to your advantage. Contact our financial planners to get started today!
