How Does My Business Structure Affect My Taxes

Jun 17, 2021 | Business Consulting

Business professional reviewing documents
Your business structure can affect everything from your everyday expenses and yearly taxes to your personal legal liability. Whether you’re just forming your business or wondering if your current business structure is right for you, it’s important to understand the unique tax benefits and considerations each business structure offers.

To help you learn more about what business structure may be right for your company’s next phase, we’re sharing the most common structures, what they mean, how they impact your taxes, and what to do if you want to change your business classification.

Sole Proprietorship

What It Means: A sole proprietorship means there is no distinction between you and the business. As a sole proprietor, you’ll take sole ownership of the company and won’t need to work out agreements with other partners. As such, you are entitled to all your profits, but you’re also responsible for all of your business’s debts, losses, and liabilities. This means if someone sues your sole proprietorship, your personal assets are at risk.

How It Affects Taxes: Since there isn’t a separation between the owner and the business, you’ll report your business income and losses on your personal income return. You’ll be taxed on all the profits for the year, even if you keep funds in your business’ bank account rather than your personal accounts. As a sole proprietor, you’ll pay self-employment taxes and will be responsible for your social security and Medicare contributions.

Limited Liability Company (LLC)

What It Means: The LLC is a hybrid between a sole proprietorship and a corporation. Unlike a sole proprietorship, an LLC separates owners (called “members”) from the business, offering protection against lawsuits and business debts. LLCs can have one member or multiple.

How It Affects Taxes: LLCs are considered “pass-through” entities, meaning members pay taxes on their share of the profits through their personal tax returns. This structure requires you to pay taxes on all profits from the year, even if you keep funding in your business bank account. Similarly, members are taxed on their entire distributive share each year, whether or not the LLC distributes some, all, or none of the money to the members. In addition to paying taxes on profits and distributive shares, members will also pay self-employment tax. Some states require additional state taxes for LLCs, so it’s a good idea to check with a tax expert to ensure you file correctly.

Partnership

What It Means: As the name suggests, these structures are owned and operated by two or more people. There are several types of partnership structures, but in every variation, the partners manage the company together and share responsibility for profits, losses, and liability. The most common types of partnerships include:

  • General partnerships: Unless otherwise agreed, each partner equally shares profits, losses, and management responsibility. Partners also assume responsibility for the partnership’s debts.
  • Limited partnerships: Limited partnerships are more structured and must have at least one general and one limited partner. A limited partner serves as an investor for the business and typically doesn’t assume as many risks, responsibilities, or decision-making rights as the general partner.
  • Limited Liability Partnership (LLP): LLPs operate like general partnerships, but this structure offers more protection against errors and omissions of fellow partners. Partners still share profits, losses, and management responsibilities.

How It Affects Taxes: Partnerships are not subject to Federal income tax. As a pass-through entity, each of your partners will be taxed on their share of profits through their personal income return. However, your business must file Form 1065 and a Schedule K-1 with the IRS, which helps the IRS determine if the partners are correctly reporting their income. In addition to paying income tax, partners must pay taxes on distributive shares, regardless of how much money was withdrawn from the business. This business structure also requires partners to pay self-employment taxes.

Read More: Does Your Business Have A Tax Saving Strategy?

C Corporation

What It Means: A C corporation is the default corporation business structure. C corporations are separate legal entities owned by their shareholders, which protects owners from legal and monetary liability. Compared to S corps, C Corporations have much fewer regulations on ownership. These structures can allow you to name as many owners as you’d like and owners don’t need to be U.S. citizens.

How It Affects Taxes: Since C corporations are separate entities, the business must pay federal, state, and sometimes local taxes. These businesses can sometimes pay taxes twice: once when the company pays corporate income tax and again when dividends are paid to shareholders. C corporations pay 50% of their employees’ social security and medicare taxes, although they can deduct the employer portion of Medicare and payroll taxes using Form 1120. Additionally, C corporations can deduct 100% of their charitable donations on their corporate tax returns if the donations don’t exceed 10% of the company’s income.

S Corporation

What It Means: S corporations are structured similarly to C corporations with several important differences. Like a C corporation, owners gain limited liability protection, which protects your personal assets in the case of debt or legal issues. However, an S corporation limits ownership to 100 shareholders who must be U.S. citizens. In addition, an S corporation is not a completely separate taxable entity, and the profits and losses of the business will be reported on your personal tax returns.

How It Affects Taxes: Since profits and losses of an S corporation will be reported on your personal tax return, you can avoid the double taxation that C corporations are often subject to.

As an S corporation owner, you can deduct up to 20% of your business income on personal tax returns, and write off your business’ losses on your personal return. The IRS tends to keep a closer eye on S corporations than C corporations, so it’s important to ensure your personal tax return is filed correctly and you complete the right tax forms for your business each year.

Are you ready to start your business or change your business’ current structure? 4Corner’s Business and Tax services team will partner with you to help you determine which structure is right for you. Then, we’ll help you correctly file and submit your personal and business taxes to maximize your tax return and provide year-round tax planning to help you save more all year long. Get started today by scheduling your free consultation!

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