When venturing into the world of business ownership, there are a number of things to consider; one of the first things you’ll have to consider is what business designation you would like your company to have. There are actually a number of different business structures to choose from, and they all impact your company’s setup, growth, liability, and taxation status in a number of different ways. Here, we’ll take a closer look at how your business will be taxed, based on the business structure you choose to register under.
How Does the Structure Impact Your Business?
As mentioned above, there are a number of differences between the various business designations, and each means something slightly different for your company. While this article will focus on the taxation status for the most common company structures, it’s important to be aware that the designation you choose will also impact your business’s ability to grow and earn money, the cost of setting up your business, and who is held liable for debts, liens, and even lawsuits.
If you’ve already registered your company with a certain business designation, and decide after reading this article that you want a different designation, it is possible to change it. However, be aware that there can be consequences for switching your business structure, and it can get complicated. So, be sure to work with an experienced Provo business accountant before you do anything in this regard.
One of the most common business designations for new business owners is that of sole proprietorship. These are popular among first-time entrepreneurs because they’re simple and inexpensive to set up. They are also relatively easy to handle from a tax standpoint, in most cases.
Because sole proprietorships do not establish the business as a separate entity, you typically pay your business’s taxes via your personal tax return. This is because sole proprietorships do not establish your business as a separate, tax-paying entity. So, all you generally have to do is file a Schedule C and a Form 1040, along with your other personal tax documents, and your business’s taxes are done. Be aware that you will have to pay not only income tax, but self-employment tax on this income as well.
There are actually two different types of partnerships—limited partnerships (LPs) and limited liability partnerships (LLPs)—but the differences between these two largely relate to how liability is handled in the business. When it comes to taxation, both types of partnerships are handled in, more or less, the same manner.
Partnerships are considered pass-through entities when it comes to taxes. This means that the company’s profits and losses are passed on to the partners, who each receive a K-1 showing their share of the business’s income or loss for that year. Each partner then reports that profit or loss by using a Schedule E form on their personal tax return. This is then subjected to both income tax and self-employment taxes.
However, if you are a “limited partner” in your business, there is a slight difference in how you report the income or loss for you share of the partnership; for you, it would typically be considered passive income or a passive loss. This means that any income you receive from the partnership would only be subject to income tax, and not self-employment tax. However, passive losses can be limited and may only be used to offset other passive income.
There are a large number of different business designations that fall under this category, but the two most common types of corporations are C corps and non-profits. Corporations are recognized as separate, tax-paying entities by the IRS. This means that the business can take deductions, is taxed on its profits, and must file its own return.
Most corporations are taxed in the same manner as C corps. Because the business is a separate entity, income from the company is typically taxed twice; the business is taxed on its profits, and then the shareholders are taxed when they receive dividends from the company. Corporations are also required to keep very detailed records and accounting books, so if you choose this designation, we strongly recommend that you work with a professional business bookkeeper.
The one type of corporation that is taxed very differently from a C corp is a non-profit corporation—because non-profits are typically not taxed at all. If you’re starting a non-profit, you can register with the IRS for tax-exempt status. However, make sure that you fully understand the restrictions regarding how your profits are used, if you hope to retain that status.
Limited Liability Companies
Limited liability companies (LLCs) are considered pass-through entities, like partnerships. However, LLCs can be operated by either multiple partners or a single person, so they are taxed in different ways, largely based on the number of owners in the business.
Single-member LLCs are generally taxed in the same way as sole proprietorships; simply report your business income using a Schedule C and Form 1040 on your individual tax return. Multiple-member LLCs are taxed more like partnerships; profits and losses are passed on to the owners, who receive a schedule K-1 showing their share of the business, and file a Schedule E with their personal tax returns.
It’s important to consider which business structure will be most beneficial for you from a tax standpoint; however, there are many other factors that impact which designation is most appropriate for your company. If you would like to learn more about selecting the right business structure for your company, contact us to speak with a Provo business accountant.