Federal and state tax codes are famously complicated. Setting up your business with the wrong structure may cause you to pay more taxes than necessary, but that’s not all. It could also make you personally responsible for business liabilities, putting your home and other personal assets at risk.
By knowing the benefits, protections, and drawbacks of each small business tax structure, you can determine which one will offer you the least amount of tax liability and the greatest asset protection. It can also help you make the right day-to-day decisions and maximize your bottom line.
In this article, we’ll explain the three most common small business tax structures. We'll also describe why you might set your business up one way or another and what’s involved in the process for each. Let’s get started!
Why It’s Important to Understand Your Small Business Tax Structure
The way you structure your business dictates many aspects of it, such as how you distribute and report your income, what forms you need to file, what your liabilities are, what tax benefits you may receive, and how decisions are made.
Having a full understanding of your business’ tax structure will clarify what you’re liable for and if that liability carries over to your personal assets. It will help you avoid overpaying taxes, so you’ll have cash resources on hand when you need them. On the flip side, it will also help you avoid underpaying taxes and incurring fees and potential legal repercussions.
Each business structure requires accurate tracking and reporting. Affiliate Royale comes packed with essential tools to help you grow your business and stay compliant with up-to-date affiliate-related income and expense reporting. That’s one less thing you’ll have to worry about when it comes time to gather your tax information for filing.
3 Small Business Tax Structures Explained
The three tax structures we'll cover in this article are sole proprietorships, partnerships, and Limited Liability Companies (LLCs). We’ll begin with the easiest one to set up and maintain, the sole proprietorship.
1. Sole Proprietorship
In a sole proprietorship, you own the business yourself. It is not recognized as a separate business entity, so you are personally responsible for related liabilities, including all losses and debt. You report your business income and expenses with your personal income tax, using the appropriate schedules.
A sole proprietorship business structure is best for low-risk, smaller businesses, or new businesses getting started (if the risk is low). Advantages include:
- Easier setup. It's relatively inexpensive to form a sole proprietorship since you don’t need to draw up a contract with a business partner (and incur possible legal fees).
- Less regulated. Businesses that operate as separate entities (like corporations) are governed by statutory regulations, often in multiple jurisdictions. As a sole proprietorship, you bypass these more stringent requirements.
- Complete control. You are your own boss with no partner to consult, and no members, shareholders, or board of directors to satisfy.
As we’ll see, these advantages have a flip-side. By understanding each, you can evaluate the tradeoffs according to your own requirements.
Disadvantages of the sole proprietorship include:
- No protection of personal assets. Since the business is not a separate entity, all income and liabilities pass through to the individual. It’s possible that your personal assets may have to cover any losses incurred by the business.
- Few tax benefits. Corporations and LLCs have certain tax advantages that don't extend to sole proprietorships or partnerships.
As we said, setting up a sole proprietorship is fairly easy. You are automatically considered a sole proprietorship if you do not form as another structure. You may use your name or register a trade or Doing Business As (DBA) name.
Check with your local tax authority, county office, and Secretary of State for your particular requirements. Visit the IRS website to learn more about tax filing requirements for sole proprietors.
A partnership structure is two or more people doing business together without creating a formal business entity (such as an LLC). Income passes through to the partners, who report the income on their individual tax returns.
A partnership is the simplest tax structure for businesses operated by multiple people. There are different types of partnerships:
- General: All partners share income and liabilities and are personally responsible for business debts.
- Limited: Can offer limited liability to shield you from the liabilities of your partner(s), but these are more complicated.
Partnerships work well for smaller businesses with multiple owners and low risk. Advantages of the partnership business structure include:
- Not required to pay income tax as a business entity: As with sole proprietorships, a partnership is not recognized as an entity for tax purposes.
- Less regulated: Since it is not an entity, it does not have to comply with corporate statutory regulations or LLC requirements.
Disadvantages of partnerships include:
- No (or limited) protection of personal assets: Partners may be responsible for business losses, including those incurred by their partner(s) in the course of business.
- Few tax benefits: Other more complex structures (LLCs, corporations) have certain tax advantages not extended to sole proprietorships or partnerships.
If you choose to form a partnership, it’s best practice to create a detailed agreement outlining the roles, responsibilities, and liabilities of each partner for mutual protection. Visit the IRS website for more info about relevant tax filing requirements.
3. Limited Liability Company (LLC)
An LLC is a formal business entity owned by members. It has several advantages over partnerships, affords personal asset protection, and is much easier (and cheaper) to form and maintain than a corporation. Many small businesses find this an appealing option, especially when engaging in medium to high-risk business.
An LLC has benefits of both the partnership and corporation tax structures. Namely:
- It shields members from personal liability.
- An LLC may avoid paying tax as an entity and pass income to its members to avoid double taxation.
- It's more affordable than forming a corporation.
- There is no limit on the number of members allowed.
The main disadvantage is that members are treated as self-employed and must pay self-employment tax.
Each state may structure and regulate LLCs differently, so find out your state’s requirements to see if this type of business structure is the most advantageous for you. Check with the IRS for LLC tax filing requirements.
Choosing the wrong tax structure for your small business may be costly. Aside from increasing tax liability, it may cause you to incur the loss of personal assets, such as your home or automobile. Your tax structure affects every sphere of your business, so it's important to know the benefits and limitations of each.
If you’re in doubt, you may wish to seek advice from a certified tax professional. Being familiar with tax structures such as sole proprietorships, partnerships, and LLCs in advance will help you know what questions to ask and the risks and benefits involved in each.
Would you like to know more about any of these business structures? Let us know in the comments section below!