25 Mar How to Examine Tax Structures When Forming Your Business

Business formation and tax structures

You finally have the perfect idea for a business. You know what you need to do, and how to execute it.

Except you don’t – not without knowing how to properly form a business.

As a business owner, it doesn’t matter how good your idea is, without the right structure, your small business is going to flounder. That’s why it’s so important to understand tax structures and choose the right one for your business. Making the wrong decision could lead to extra taxation and liability.

If you’re not sure which structure is right for you, don’t worry, we’ve broken it down for you. Here’s what you need to know about business and tax structures.

The Types of Business Structures

There are four types of business structures you should consider when forming a business: sole proprietorship, partnership, limited liability company, and corporation. Let’s break down the four types and compare and contrast them.

Sole Proprietorship

As the name implies, a sole proprietorship is when a single individual owns an unincorporated business by themselves. The business owner is entitled to all of the profits, but they are also responsible for all of the debts and losses. Many small business owners are the sole proprietor of their business.

Partnership

A partnership is when two or more individuals carry on a business together. A partnership could be a general partnership, limited partnership, or limited liability partnership.

A general partnership is when two or more partners share the responsibility and liability equally. That means that each partner is a “general partner” who has a stake in the day-to-day operations of the business.

A limited partnership has one or more general partners, but also a limited partner. A limited partner may also be known as a silent partner. A limited partner does not have a stake in the day-to-day operations of the business,

A limited liability partnership (LLP) means all partners have limited personal liability. That means a partner is not responsible for the wrongdoings (either intentional or negligence) committed by other partners. An LLP is more flexible than other partnerships since the partners can determine their own liability by how much work they put into the business.

Limited Liability Company

A limited liability company (LLC) is similar to a partnership. However, it distributes earnings to the individual partners as income. Partners are then required to report this income on their personal tax returns.

In an LLC, the partners are not responsible for company debts or liabilities. Also, a partner can deduct company losses from their income, potentially reducing each individual partner’s tax burden.

Corporation

Corporations can be complex. A corporation can raise capital by issuing stock, unlike other business structures.

There are two types of corporations: C corporations and S corporations. By default, a business that incorporates is a C corporation.

A C corporation has to pay corporate income tax. When distributing profits to owners or shareholders, it is taxed again.

Anyone can own a C corporation. This type of corporation can have any number of shareholders.

An S corporation can only have a maximum of 100 shareholders. All owners of an S corporation must be U.S. citizens.

The big advantage of an S corporation is that they don’t pay corporate tax. Instead, any investors or owners file their own income tax and claim profits or losses there. In order to achieve S corporation status, you need to file Form 2553 with the IRS.

Types of Taxes You Need to File

A business will be required to pay federal and state or local taxes. While the exact amount will vary depending on the company’s location and structure, a few general rules apply.

Federal

Federal taxes include employment and income taxes. Income tax is a tax applied to earned income. Employment tax includes unemployment taxes, as well as Medicare and Social Security taxes.

If your business sells fuel, tobacco, or alcohol products, you may also be required to pay excise tax. This is an additional tax on top of income tax. Excise taxes can also apply to more niche or specific industries, such as tanning salons and coal mining.

Finally, if you are self-employed, you have to pay self-employment tax. The self-employment tax rate is 15.3%. This tax consists of 12.4% for Social Security, and 2.9% for Medicare.

Basically, as a self-employed individual, you are paying taxes as both the employer and employee. The good news is that you can deduct the employer portion of your self-employment tax when you adjust your gross income. A self-employed individual can also deduct the cost of their health insurance.

State and Local

Along with the federal government, states may also have their own excise taxes. With the exception of a few states, most charge income tax.

Most also charge sales tax on goods and services. Employment tax is also common, meaning you will have to withhold and report your employees’ taxable income.

A business can also be subject to property tax based on its property holdings. This real property tax includes anything attached or native to the property, unlike your personal property which you can take with you.

Local taxes could include county taxes and taxes from your local municipality. Your state or local government site will have information on what taxes are required to be paid, and by what date.

Which Tax Structure Is Right for Me?

So which one of the business or tax structures should you choose? If you desire to retain control of your company, a sole proprietorship or LLC is a good choice. For a small business owner, a sole proprietorship is often ideal.

An LLC will provide you will more protection from personal liability. This is especially important if you have assets you wish to protect, such as your house. While you will not have to pay corporate tax, you will have to pay self-employment tax.

Obviously, if you have another person you want to go into business with, you will need a partnership. However, as a general partner, you would need to pay self-employment taxes, as well as taxes on any profits. Any limited partners would not be required to pay self-employment taxes.

Corporations may pay more in tax, but they act as separate entities from their shareholders. If a shareholder leaves the business, the corporation can continue to operate as normal. Plus, the ability to go public and offer stock is a huge appeal of this business structure.

Regardless of what business structure you choose, always keep records. Good record-keeping is essential to prove your business’ income, assets, expenses, and inventory.

Get Ongoing Tax Help When Forming Your Small Business

No matter what type of structure you choose for your small business, you’re going to have to pay taxes – and it’s probably going to be confusing. That’s where a local CPA like Dempsey Vantrease & Follis can help. It doesn’t matter if you have a sole proprietorship or a dozen partners in your business, we can help you navigate both federal and local taxes, ensuring that your business formation is a successful one.

Our four decades of experience enables us to help you with your tax preparation and business planning needs. Contact us for all of your tax services and bookkeeping needs.