Choosing the Right Organizational Structure for Your Business
- In This Quick Guide:
- Sole Proprietor
- Partnerships
- Limited Liability Companies
- Corporations
There are a number of ways you can structure your business—as a sole proprietor, as a partnership, or a corporation, to name a few. But which one is right for you? In this guide, we will review what each organizational structure means for your business and what types of reporting your accounting system needs to provide for you, your shareholders, your partners, and the IRS.
Sole Proprietor
If you are operating the business as a single owner, sole proprietor is definitely the easiest designation to choose. In fact, the IRS assumes you are a sole proprietor if your business has only one owner unless you have incorporated the business under state law.
The sole proprietor is not a taxable entity in the IRS’s eyes. All your business assets and liabilities belong to you and are reported to the IRS as part of your individual tax return on Schedule C, “Profit or Loss from Business,” or Schedule C-EZ, “Net Profit from Business.” Any net profit or loss from the business then becomes part of your income on the first page of your 1040, and you pay any taxes based on your current income tax rate.
You’ll also have to fill out another form, the Schedule SE, “Self-Employment Tax.” The form is used to calculate your Social Security and Medicare taxes, which total 15.3 percent. When you were working for someone, your employer paid half of those taxes. Unfortunately, now you have to pay it all, but you can use half of the amount to adjust your total income downward in the adjustment section on the first page of the 1040.
Two other forms may come into play for sole proprietors in specialized businesses. Farmers use Schedule F, “Profit and Loss from Farming.” People who own rental property, but otherwise don’t operate a real estate business, use Schedule E, “Supplemental Income and Loss.” Farming income is subject to self-employment tax, but rental income is not.
Partnerships
When more than one person starts a business, it is usually started as a partnership. Just like a sole proprietorship, the IRS considers a business started by two or more people a partnership unless they incorporate under state law. Partners can also elect to be taxed as a corporation by filing IRS Form 8832, “Entity Classification Election.”
A partnership files its own tax return on IRS Form 1065, “Partnership Return,” but this form is only for information purposes. The return shows income, deductions, and other tax-related business information, but the partnership pays no taxes. The return also lists all the partners and each partner’s share of the taxable income. Form 1065 has to be filed only if the partnership receives income or incurs expenses.
If there is no activity in any one year, the return does not need to be filed, but you may want to file anyway. You could eventually receive a notice from the IRS assessing a nonfiling penalty ($50 times the number of months late). If so, you would have to prove that there was no need to file a return. To be safe, you may find it easier to just file every year and show zero income.
The partnership Form 1065 includes a Schedule K-1, “Shareholder’s Share of Income, Credits, Deductions, etc.” for each partner. The partners use this form to report their income and expenses on their individual tax returns. Like a sole proprietorship, the partnership is not a taxable entity.
Limited Liability Companies
You can limit your liability as a sole proprietor or a partnership by establishing your company as a limited liability company or LLC. This designation falls somewhere between a corporation and a partnership or sole proprietorship. An LLC is a state entity organized under state laws. How limited your liability is under this organizational structure depends on the laws in your state. Most states give LLCs the same protection from liability as they give corporations.
The IRS can treat LLCs as sole proprietorships or partnerships, but you can ask to have them treated as a corporation for tax purposes if you file Form 8832. LLCs do enjoy limited liability when it comes to claims, but frequently owners have to take on debt by giving personal guarantees to financial institutions that make loans to the LLC, especially if the business is new. Owners of a new corporation could be faced with the same problem when debt is needed for the new business.
Corporations
A corporation offers you the greatest liability protection because it is a separate legal entity. As an individual, you are protected from getting sued or facing collections because of actions taken by the corporation. This may sound attractive to you, and if you are in a business that has a high risk of getting sued, your attorney will probably recommend you set up the business as a corporation.
You must form a board of directors when you start a corporation, even if you include only your spouse and children. (Imagine what those family meetings will be like!) The board of directors can be made up of owners and nonowners. The board members who are not owners may receive director’s fees for serving on the board.
You also must divvy out ownership shares in the form of stock. You don’t have to sell that stock on the stock exchange though. Most small businesses do not trade their stock on an open exchange.
Corporations are a separate tax entity and must file tax returns. For tax purposes, the two types of corporate structures are C and S. You can avoid corporate taxation by filing with the IRS as an S corporation. The S corporation is purely an IRS designation that does not affect the legal status of the corporation. S corporations do not pay taxes. For tax purposes, they are treated primarily as a partnership with profits and losses passed through to the owners. All income and expenses are passed through to the owners/shareholders, even if they include you, your spouse, and your children.
A big disadvantage of an S corporation is that you have less flexibility in how you pass through the profit and losses. Whereas a partnership can determine its own distribution formula, an S corporation must distribute its profit and losses based on percentage of corporate ownership of each of its shareholders. This arrangement can create an imbalance if, for example, one owner has a lot of cash to get the business started and the other owner contributes unique knowledge. A partnership can more easily adjust for these differences than an S corporation.
C corporation dividends are taxed twice—once at the corporate level and once at the individual level. Business owners can avoid the corporate level tax on this money by paying themselves and their employees (even if the employees are their spouse and children) a reasonable salary.
Now that you know the different types of business structures you can choose which is best for you. Good luck!
From The Complete Idiot’s Guide to Accounting, Third Edition, by Lita Epstein, MBA, and Shellie L. Moore, CPA
