The way your business is organized–what financial and legal professionals call your ‘business structure’–is an important consideration for every small business owner.
Your chosen business structure is important first, because it determines how the Internal Revenue Service (IRS) taxes your profits. And second, because business structure may define your level of ‘personal liability,’ that is, whether vehicles, investments and other property you personally own is protected when creditors or others demand money from your business.
Your chosen business structure will also affect how much paperwork your company is required to submit, and how much time is needed to properly prepare it for government review. Business structure comes into play for long-term planning, including capital and bank loans.
Typically, the business structure identifies who owns the company and how profits are distributed.
While a small-business tax expert like Vitae® Tax Advisors can help with tax planning and preparation, you should consult with a state-licensed attorney to help understand legalities involving the different business structures available to you.
Primary business structures recognized by the IRS include the sole proprietorship, as well as different types of partnerships and corporations. This article focuses on the tax treatment of the three most common entities operating in California: The C-Corporation (C-Corp); the S-Corporation (S-Corp); and Limited Liability Company (LLC).
Benefits of Choosing the Right Corporate Structure
Regardless of which corporate structure you decide on, there are universal benefits you gain from choosing wisely. These include:
- Optimal Tax Burden: Aligning your entity with your business goals and practices can minimize your total tax obligation, so you only pay your fair share.
- Reduced Audit Risk–Understanding which taxes apply to your entity and how to comply with applicable reporting and payment schedules
- More Access to Capital: Compared with other business structures, structuring an entity can open the doors to future bank loans, lines of credit and even outside investors.
Overview of the C-Corp
Structure: The C-Corp is a separate legal entity which is owned by shareholders, pays taxes independently, and in which owners enjoy reduced legal and financial liabilities.
Taxes: C-Corps are required to pay federal, state and sometimes, local taxes. They are also taxed on their profits.
Advantages: Compared with other structures, C-Corps may help raise capital via the issuance of different types of stock. Corporate tax rates may also be lower than personal rates.
Disadvantages: In any given year, corporate profits may be taxed twice–once when the C-Corp makes the profit and again when shareholders receive distributions from the entity (eg. reported dividends on their personal tax returns). Owners who consider this ‘double taxation’ unfair sometimes choose a different business structure.
Overview of the S-Corp
Structure: Owners who elect to be taxed as an S-Corp may find it attractive because it helps them avoid the double taxation issue mentioned above. The structure allows profits (and certain losses) to be passed directly through to the owner’s personal tax returns, without being subject to corporate taxes. S-Corps can have up to 100 shareholders and only issue one type of stock.
Taxes: While an S-Corp is not taxed on its profits, owners must pay taxes on their proportional shares of the corporation’s profits. Also, to avoid possible tax penalties, the owner may be required to pay estimated quarterly taxes.
Advantages: Potential tax savings and from the tax stand point, a separation of shareholders from the company itself. Distributions directly related to previously taxed earnings and to capital contributions may be received free of taxation.
Disadvantages: Stricter operational processes than other structures, and numerous ownership/shareholder restrictions. Reasonable compensation must be paid to employee shareholders.
Overview of the LLC
Structure: A Limited Liability Company is a hybrid entity that combines some of the best features of other business structures. They may provide owners (called ‘members’) with personal liability protections similarly to what corporations provide, while avoiding the financial burden of double taxation. This entity can operate under a single (Disregarded Entity) or multi membered (Partnership) structure.
Taxes: While an LLC is not taxed on its profits, owners must pay taxes on their proportional shares of the entity’s profits. Also, to avoid possible tax penalties, members may be required to pay estimated quarterly taxes. LLC members may be subject to paying self-employment tax to cover mandated Medicare and Social Security contributions.
Advantages: LLCs limit liability for members and managers, while also taxing members’ profits at their personal, rather than corporate, level. Some financial experts consider LLCs a superior structure for holding real estate, stocks and other appreciating assets. They also offer less annual record keeping burdens (e.g. Minutes, etc.).
Disadvantages: LLC owners may not issue shares of stock to attract prospective investors, thus limiting their potential for future business growth. Plus, states’ treatment of LLCs can vary greatly, creating a lack of uniformity that complicates long-term planning, and in some cases, requires payment of taxes. LLC members may be subject to paying self-employment tax, as mentioned above.
Have Questions? Schedule a Free No-Obligation Consultation
Vitae® Tax Advisors can help you better understand your business’ annual tax obligations. Contact us today for a free, no-obligation consultation with a Business Tax Advisor (BTA). As small-business tax experts, we’ve helped thousands of companies, of nearly every business structure. Learn about our complete suite of business tax services, including how we support your returns with fully documented tax accounting.
You may also benefit from reviewing this SBA article on business structure, and this information from the IRS.