Are You Using the Best Business Structure?
Whether you’re launching a new company or you’ve been in business for 10 years, at some point, you selected – or will select – a business structure. This is simply an organizational framework that legislates what income tax forms you’ll file and how the company must operate in order to be in compliance legally.
If you’re just starting out, this is one of the most important decisions you’ll make as you form your new venture. And if you’ve been a business entity for a long time, you may assume that the one you chose at the beginning is still the optimal one for you. This may not be the case, but it is possible to reorganize under a different structure.
This issue screams for guidance from a financial advisor, especially if you’re still in the formative stages. It’s much easier to start off with the right classification than to discover six months down the road that you made a poor choice.
Each type of business structure has its own set of rules that governs concerns like your tax obligations, your company’s liability, ownership, and profits. Here are some defining characteristics of the most common ones.
The internet and its countless e-commerce sites like Etsy and eBay have spawned millions of businesses that consist of one individual. This is the simplest type of business structure and the one most often employed by entrepreneurs who want to own and manage their own company. Anyone who makes money that isn’t reported on a W-2 form from an employer is a sole proprietor, whether or not they’ve incorporated.
Sole proprietors file their income taxes using the IRS Form 1040, the document familiar to anyone who has ever filed personal income taxes. They must file a Schedule C to report their business income and expenses — their profit or loss — which become a line item on the 1040.
Unlike individuals employed by a company, sole proprietors must pay all of their own income taxes. The IRS requires that they estimate the taxes due each quarter and make payments that would represent the taxes due for those three months. They must also file a Schedule SE with the Form 1040, which calculates the amount of self-employment tax that is owed for the year.
Sole proprietors must take responsibility for their company’s liabilities. And they may find it difficult to procure a business loan.
Corporations must file the IRS Form 1120, among other forms, rather than the 1040.
Corporations are more complicated, but they don’t carry the personal liability risk that sole proprietors do because they’re separate legal entities, not tied in with any individual’s personal tax obligation. Because the laws and regulations governing them are so complex, and their administration fees higher than those of a sole proprietor, they tend to be in place at larger companies with many employees.
Corporations have another major advantage over sole proprietorships: They can raise money by selling stock. And they may be able to attract and retain the best and brightest employees who want the best benefits and the possibility of stock options.
But there is a major downside, other than the onerous paperwork and the administrative time: double taxation. Corporations must pay corporate income tax, and shareholders are required to pay taxes on dividends on their individual returns.
Partnerships (multiple types)
Partnerships are formed when two or more people want to pool their money and skills to build a business and share in its profits and losses. It’s something of an unusual business structure. Partners are not employees, and the partnership is not required to pay income taxes, though it must file an informational Form 1065, which reports on things like income and deductions.
Profits or losses are “passed through” to the partners, who must then file a Schedule K-1 as a piece of the 1065. They file their own income taxes using the Form 1040, and, like sole proprietors, they’re required to pay self-employment taxes and submit quarterly estimated taxes. Partners are also personally liable for the partnership’s obligations and debts.
There are other types of business structures, like the S Corporation and the Limited Liability Company (LLC). Each has its own benefits and drawbacks, and one of them may be a better option for your company. And while the differences among all of the possibilities may be confusing to you, financial advisors live to help clients make such decisions. So start a discussion with yours.