As an entrepreneur, choosing your business structure may well be the most important decision you make for your business. While it can be tempting to rush through this step in your eagerness to see your vision come alive, experts state thoroughly evaluating your options can literally make or break your business in future years. The reason for this is simple — taxes. Come tax time, the Internal Revenue Service (IRS) will not be concerned about the viability of your concept, your marketing strategy or your future prospects. All that matters to the IRS is collecting taxes. As it turns out, the business structure you choose and the amount of taxes you will pay go hand in hand.
The sole proprietorship is the simplest business structure you can choose. With a sole proprietorship, you are the sole owner, the sole responsible party and the sole taxpayer. You are also allowed to deduct net losses from your personal taxes at the end of the year. However, with a sole proprietorship, you are also personally liable for business tax expenses and fines. While a sole proprietorship is often the go-to business structure for entrepreneurs in a hurry, choosing this structure should be as carefully considered as the more complicated options like a partnership or a corporation.
A partnership is similar to a sole proprietorship but can accommodate more than one business owner. While “partnership” may sound like a structure set up to accommodate two persons, there can be more than two partners. There are two types of partnerships: general and limited.
- General partnership. In a general partnership, all owners bear equal risk and responsibility for paying taxes on year-end profits as well as honoring debts, fines, penalties or other fees. As well, all partners share equally in the company’s success. In a general partnership, if one partner leaves, the company must be dissolved and reformed when a new partner is brought in.
- Limited partnership. A limited partnership can have both general and limited partners. This makes limited partnerships more attractive to investors who know they are only liable for their share of investment into the business. In exchange for this, limited partners give up their right to manage the company. As well, limited partnerships can survive the departure of a partner without needing to dissolve and reform.
A corporation is by far the most complex business structure you can select, but there are several advantages for investing the extra work and effort into forming a corporation. For tax purposes, there are two main structures a corporation can have: nonprofit and for-profit.
- Nonprofit corporation. A nonprofit corporation may or may not be exempt from paying federal and/or state taxes, depending on its structure. The IRS exempts 501(c)(3) nonprofit corporations, which can be structured as private foundations or public charities, from paying federal taxes.
- For-profit corporation. A for-profit corporation will be legally liable for paying business taxes on profits.
There are many types of corporations. However, for IRS purposes, the three most common corporation types are as follows:
- Limited liability corporation (LLC). The LLC corporation is actually a cross between a partnership and a corporation. Owners bear less personal liability risk with an LLC structure but still do not have the full protection of a corporation when it comes to personally guaranteeing loans, lawsuits and taxes owed.
- S corporation. Named for the IRS Code Subchapter S, an S corporation stands apart from other business structures. Rather than paying taxes on profits, all profits are divided among the shareholders (as are any losses).
- C corporation. Named for the IRS Code Subchapter C, a C corporation is the most common type of corporation. While the number of owners of an S corporation must be fewer than 100, you can have unlimited owners in a C corporation. This is the most complex type of corporation but also the safest in terms of limiting personal liability.
After exploring these possibilities, it becomes clearer how important the business structure you choose is in terms of the benefits you receive, and the liability you bear, as an entrepreneur.
About the Author: Carl Lins holds an LL.M taxation degree. He oversees a business tax consulting business. Click here to find out more about what an LL.M degree prepares business consulting professionals to do.