These are not all there is to a business, however; there is also a lot of paperwork and legal procedures involved in setting up a company. When you’re just starting out, it helps to know the different legal structures for businesses, as each one has different tax requirements. Let us look at the four legal structures of most startup companies.
A person who owns their entire business is a sole proprietor. This is the most common type of small business entity in the U.S, and is one of the foundations of the American Dream; you save some money, open a store, and reap the benefits! Plenty of multimillion-dollar companies in the U.S. started out as sole proprietorships. Examples of these are J.C. Penney, Walmart, and eBay.
It’s easy to start this type of business since you technically have just one employee. However, it is also risky since you are the only one responsible for all financial and legal affairs.
Sole proprietorship taxes are not difficult to prepare. Individuals can report business income and losses from this type of company on their Form 1040 using Schedule C. Just add your company profits to ‘Other Income’ on your personal tax return. Sole proprietorships allow a 20 percent tax deduction on the company’s net income, which results in reduced liabilities.
A corporation is comprised of shareholders or people who have divided among themselves the ownership of a company. There are three types of corporations that we will discuss; S corporations, C corporations, and LLCs.
An S corporation is one that chooses to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. To qualify as an S corporation, a company must have 100 shareholders or less, all of whom must be U.S. residents. Each member must report their business income, expenses, losses, and deductions on personal tax returns. This is to avoid double taxation on the firm’s profit and on shareholders’ income.
S corps can also avail of the 20 percent deduction. However, shareholders must pay taxes on business profits at their personal income tax rates.
Another type of company is a C Corporation. This refers to any corporation that has a tax return separate from its shareholders. Traditionally, C corps are the big, Fortune 500 firms, with dense organizational structures that have governors, officers, directors, and employees. A smaller business can still be structured as a C corp, though, especially if it plans to quickly transition from being a startup into a larger company.
C corps pay a 21 percent corporate tax rate. In contrast to S corps, where shareholders directly report profits and losses on tax returns, C corp shareholders receive dividends, for which they must pay personal taxes.
This double taxation scheme is too demanding for startups, which is why many founders opt to structure their companies as Limited Liability Companies or LLCs. Members of this type of company don’t have double taxation and they can deduct business losses.
LLCs are only taxed through members’ personal tax returns. They also have a potentially unlimited number of shareholders, which makes it easy to raise capital and grow the business. Multiple-member LLCs must decide the ownership percentages for the members, and choose if they will be taxed as a partnership or a C corp.
Meanwhile, single-member LLCs are automatically taxed as sole proprietors. Note that different states have different rules regarding annual operating taxes for LLCs. Despite this, the tax advantages and flexibility offered by an LLC makes it a go-to for startups.
A company’s tax situation, organizational structure, and financial capabilities would determine the best legal entity for it. When doing your research, you must consult specialists like corporate accountants, who can advise you on these matters.
Get in touch with us at Pattar & Co. CPA for the best CPAs in Indianapolis. We have been helping local businesses and individuals with tax and accounting needs for the past 20 years. Talk to us today to learn more!