Tax Benefits of Different Types of Business Formations
Different business models are able to take advantage of tax benefits based on their structure. Business owners should keep in mind that the type of business formation chosen impacts costs, liability, and team configurations.
Choosing the right model can set your business up for success because you understand the lay of the land, and avoid paying unnecessary taxes when the time comes. Let’s discuss the different business types and tax models associated with each.
What are the Different Business Types?
There are four types of business formations:
1. Sole Proprietorship
This is the most typical structure businesses choose because the individual owns the entirety of the business him or herself. Any income you generate from this business, you can claim as personal income, rather than being required to file a business return.
With sole proprietorship comes the responsibility for business debts, losses, and liabilities. Freelance workers are often sole proprietors.
2. Partnership
Businesses with partnership structures have a relationship between two or more people who carry out business responsibilities. They can be classified as:
- General partnerships
- Limited partnerships
- Limited liability partnerships (LLP)
3. Limited Liability Company (LLC)
A Limited Liability Company is structured based on state regulations. An LLC in California will have different standards than an LLC in Georgia. Netsuite explains, “Depending on elections made by the LLC and its characteristics, the IRS will treat an LLC as either a corporation, partnership or as part of the LLC’s owner’s tax return (i.e. a “disregarded entity” with many of the characteristics of a sole proprietorship).”
4. Corporation
A business corporation is a group of people who have the authorization to act as the legal entity for the company. There is a distinction between the owners and the business itself, unlike a sole proprietorship. Corporations are separated into two categories:
- C corporation (C Corp): not a pass-through entity
- S corporation (S corp): a pass-through entity
How do Taxes Vary in Different Business Types?
Not all businesses pay the same taxes. Depending on their classification, different business types are structured to file differently. Consider the different structures, and which is most advantageous for your business before choosing your business type.
Sole Proprietorship
These are considered pass-through entities, which means the business does not pay taxes. Taxes are “passed through” to the owner to file annually on tax day, April 15th.
Other advantages include:
- There are minimum tax reporting requirements
- The sole proprietor does not pay corporate business taxes
- It is an easy and relatively inexpensive structure to set up
- They pay taxes on the annual tax day: April 15th
Disadvantages are:
- Personal tax liability
- Cannot take advantage of perpetual existence
Partnership
In a business partnership, the responsibility of the business is held between the partners- however many or few partners there are. Partnerships can benefit a business by providing expertise and added skills, but they may also impact the business if the partnership isn’t cohesive.
The majority of partnerships pay taxes by the calendar year. According to IRS, “The partnership tax return is generally due by the 15th day of the third month following the end of the tax year.
Advantages are:
- They are considered a pass-through entity
- They are not subject to business taxes
- It is an easy and relatively inexpensive structure to set up
Disadvantages are:
- Unlimited personal liability
- Cannot take advantage of perpetual existence
- There must be a partnership agreement
Limited Liability Company (LLC)
In a limited liability company, the business owner’s financial liability is a fixed sum, based on their investment, not on their personal assets.
Advantages are:
- Limited liability protects business owner’s assets
- There is a flexible management structure
- Ability to choose a tax structure
- They do not pay corporate business taxes
Disadvantages are:
- They are not recognized outside of the United States
- They cannot take advantage of perpetual existence
- Rules and regulations are mandated on a state, not a federal level
Corporation
There are different tax advantages for C Corp and S Corp. C Corps pay taxes on the 15th day of the fourth month, which is typically April 15th since corporations generally follow the calendar year. S corporations also follow the calendar year and pay on the 15th day of the third month, which usually lands on March 15th.
C Corp Advantages:
- The business owners are privy to limited liability
- The business can have an unlimited number of shareholders
- They can take advantage of perpetual existence
- IPO and outside investors prefer C Corps
C Corp Disadvantages:
- The business must pay taxes twice: employee taxes and corporate business taxes
- Not a pass-through entity
- They are more difficult and expensive to start
- They face more regulation and oversight
S Corp Advantages:
- The business owners are privy to limited liability
- Pass-through entity
- They can take advantage of perpetual existence
- Do not have to pay corporate business taxes
S Corp Disadvantages:
- Do not have unlimited shareholders- they can only have 100 shareholders
- They have strict qualifications
- Not recognized outside of the U.S, and not by all U.S. states
A Final Word
Each business structure comes with advantages and disadvantages. Choosing the right structure depends on which fits your business model best. Learn more about the different tax rates each entity experiences in our article, here.
