Tax Implications of Different Business Structures

A major consideration for anyone starting a business, or whose business has grown beyond a certain size, is choosing the right structure for tax purposes. This article compares how sole proprietorships, partnerships, LLCs, C corps, and S corps are taxed and how business owners can decide which structure works best for them.

What Is a Business Structure?

A business structure is a legal classification that indicates how a business is owned and how it operates. As the U.S. Small Business Administration (SBA) points out, it “influences everything from day-to-day operations, to taxes and how much of your personal assets are at risk.” For that reason, the SBA adds, “You should choose a business structure that gives you the right balance of legal protections and benefits.”

The most common business structures are sole proprietorships, partnerships, limited liability companies (LLCs), C corps, and S corps. Here is a look at each type, including their advantages and disadvantages from a tax perspective.

Sole Proprietorship

A sole proprietorship is the simplest and most straightforward of all business structures and the way that many businesses start out.

With a sole proprietorship, you don’t set up a separate legal business entity (unlike the types of businesses described below). For tax purposes you report the profit or loss from the business on your individual income tax return, using Schedule C of Form 1040.

Your profits (if any) are taxed like any other earned income, and your losses can be used to offset other income, up to certain limits. In addition, you will typically be subject to self-employment taxes to cover Social Security and Medicare.

Partnership

When two or more people want to start a business together, they will typically form a partnership. A partnership is a legal entity that can be structured in several different ways.

In a limited partnership (LP), one partner becomes the general partner, taking on unlimited liability for the company (much like a sole proprietor). The other owners, known as limited partners, have limited liability and usually less of a say in how the business is run.

The other major type of partnership, a limited liability partnership (LLP), works similarly. The primary difference is that all of the partners have limited liability.

Partnerships, like sole proprietorships, are “pass-through” entities, meaning that any profits or losses from the business are passed through to the individual partners, who must then report them on their personal tax returns, in this case using Schedule E. Partners can also deduct certain partnership-related expenses they incurred if they were not reimbursed for them. 

Since the partners are individually responsible for any taxes, partnerships are not subject to separate business taxes. They are, however, required to file an informational tax return (Form 1065) with the Internal Revenue Service each year, showing the partnership’s income, expenses, deductions, and other information.

Limited Liability Company (LLC)

A limited liability company (LLC) offers owners even greater protection from personal liability resulting from the operation of the business.

LLCs are often described as a sort of hybrid between partnerships and corporations. Like a partnership, they can pass their profits and losses on to the individual owners, known as “members.” (Members report that income or loss on their individual tax returns and may also be subject to self-employment taxes.) Like a corporation, LLCs are considered a separate legal entity, creating a protective wall between the owners’ assets and the business’s assets in the event of a bankruptcy, lawsuit, or other financial calamity.

Anyone from a sole proprietor (a single-member LLC) to a large corporation can create a limited liability company by registering it with their state. Sole proprietors often go the LLC route if they have a lot of assets to protect or are engaged in an unusually risky business or profession.

Corporations may elect to became LLCs to avoid the “double taxation” that results when corporate profits are taxed twice—first when the corporation pays taxes on its income, then when its shareholders pay tax on their dividends.

LLCs can also elect to be taxed as either C corps or S corps, each of which has advantages and disadvantages, as explained in the next two sections below.

C-Corporation (C Corp)

A C corp is what many people think of when they hear the word corporation. A C corp is a legal entity unto itself. Unless they happen to work for the company, its owners are simply shareholders with virtually no liability for the company’s debts. The worst that can happen is that their shares will lose value or become worthless.

C corps are not pass-through entities. They must file corporate tax returns every year and pay taxes on their profits. In fact, they must generally file a tax return even if they didn’t turn a profit. If they distribute any portion of their profits to shareholders in the form of dividends, the shareholders are taxed on those individually—a form of double taxation as described above.

C corps tend to be larger enterprises and can be costly to set up and administer. Their advantage over other business structures, in addition to their greater liability protection, is that they can issue shares of stock as a means of raising capital and there is no limit to how many shareholders they can have.

S-Corporation (S Corp) 

S corps are a type of corporation designed to get around the problem of double taxation by passing their profits and losses through to shareholders, who then become responsible for any taxes. As with partnerships, this information is reported on Schedule E of the shareholder’s personal tax return.

The rules on S corps can vary from one state to another, and some states do tax their profits over a certain level.

S Corps must register with the IRS and meet a list of requirements, such as having no more than 100 shareholders.

Other Factors to Consider When Choosing a Business Structure

While taxes are an important consideration in choosing a business structure, they are not the only one.

Depending on the nature of your business, your potential for personal liability should also be high on the list. If you have significant assets to protect, are in a risky line of work, or both, one of the structures other than a sole proprietorship could be your best bet. Of course, adequate liability insurance could be another safeguard in that situation.

Also consider how important hands-on control of the business is to you. A sole proprietorship or LLC will give you the greatest control, a C corporation the least—unless you are a majority stockholder. In a partnership you’ll need to consider the personal dynamics of how well you and your partners are likely to get along.

It’s also worth thinking long-term. If your goal is growing the business to a substantial size, a C corp could be your best bet because it will allow you to sell shares to raise capital. S corps can also issue stock, but they can only sell one class of shares and are limited to 100 shareholders. If large-scale growth isn’t a priority, another business structure will be easier and cheaper to establish.

Finally, if you’re looking ahead to an exit strategy and don’t have heirs in line to take over for you, you’ll want to consider what happens when you sell. Selling a sole proprietorship is a relatively straightforward process, as is selling a single-owner LLC; the deal is basically yours to negotiate with a buyer. However, if you wish to sell your interest in a partnership or an LLC with multiple owners, the specifics of your partnership or operating agreement will come into play. Many businesses have a buy-sell agreement in place for this purpose.

Both C corps and S corps can be more complicated. If you are an everyday shareholder you can just sell your stock if you can find a willing buyer. However, if you’re a sole owner or one of a small group of owners you have additional options for structuring the sale that may be more profitable or reduce your taxes.

The Bottom Line

Each of these business structures has its own tax implications, not all of which could be covered in this overview. So before choosing a structure or changing from one to another, consulting a knowledgeable tax advisor would be money well-spent. What’s more, legal and tax advice fees are generally deductible if they are for business purposes.