4 Types of Business Structures -- and Their Tax Implications

Thursday, March 26, 2020

By Megan O'Brien, finance and business reporter
 8-minute read

In short:

  • When starting, a new business must select a business structure, which will have both legal and tax implications.

  • Sole proprietorships, partnerships, LLCs and corporations are the most common structures. 

  • Analyzing your business’s infrastructure and goals can help determine which structure will be the best fit.

 

 

Starting a new business is exciting. You get to build out your product, discover your potential market, choose a business location … and then you hit the legal portion. Your company needs to choose a business structure -- and often, it all sounds like legal gibberish.

The choice of business structure is a monumental step for a new company. It can affect ongoing costs, liability and how your business team can be configured. This topic becomes particularly timely during tax season, as your business’ structure has direct tax implications

Have no fear: Below, we outline the most common types of business structures and their respective tax ramifications. 

NOTE: On March 21, the Treasury Department and Internal Revenue Service (IRS) announced that the 2020 federal income tax filing due date is automatically extended from April 15 to July 15 due to the effects of the coronavirus. 

  • Sole proprietorships, C corporations and LLCs structured as a sole proprietorship or C corporation have until July 15 to file and pay their federal taxes in 2020. 

  • Partnerships, S corporations and LLCs structured as a partnership or S corporation should have already filed their federal taxes (or requested an extension) by their respective March 16 deadline. However, that income will be passed down to their individual tax return and they will have until July 15 to pay. 

  • For those businesses that owe them, state tax deadlines vary.

 

What are the four types of business structures?

 

1. Sole proprietorship 

A sole proprietorship is the most common type of business structure. As defined by the IRS, a sole proprietor “is someone who owns an unincorporated business by himself or herself.” The key advantage in a sole proprietorship lies in its simplicity. Here, there is no distinction between the business and the individual who owns it -- which means that the owner is entitled to all profits. However, it also means that the sole proprietor is responsible for all the business’s debts, losses and liabilities. This means that creditors or lawsuit claimants may have access to the business owner’s personal accounts and assets if the business accounts cannot cover the debt. Examples of sole proprietorship include freelance writers, independent consultants, tutors and caterers.

 

In terms of tax implications, sole proprietorships are considered a “pass-through entity.” Also known as a “flow-through entity” or “fiscally transparent entity,” this means that the business itself pays no taxes. Instead, taxes are “passed through” to the owner, who pays them in their personal returns under ordinary income tax rates on the typical Tax Day, usually April 15 (July 15 in 2020).  

 

 

 

2. Partnership

In business structure, a partnership is “the relationship existing between two or more persons who join to carry on a trade or business.” Partnerships have three common types of classifications: a general partnership, limited partnership or a limited liability partnership.

  • General partnership: Consists of two or more partners who share all liability and responsibility equally. This means the partners both take part in the day-to-day operations of the business. It also means that the partners are equally liable for any debts generated by the business. All partners are considered “general partners.”

  • Limited partnership (LP): Has at least one “general partner” and one “limited partner.” A general partner assumes ownership of the business operations and unlimited liability. A limited partner, also known as a silent partner, invests capital in the business. However, limited partners are not involved in the day-to-day operations and don’t have voting rights and therefore have limited liability.

  • Limited liability partnership (LLP): In this arrangement, all partners have limited personal liability, which means they are not liable for wrongdoings (i.e. acts of malpractice or negligence) committed by other partners. All partners in an LLP can be involved in the management of the business. It tends to be more flexible than the previous partnership forms because partners can determine their own management structure. 

Like a sole proprietorship, partnerships are considered a pass-through entity when it comes to taxation. In many ways, a partnership is like an expanded sole proprietorship -- but with the advantages and disadvantages that comes with a partner. A partner can provide expertise, skills and capital for the business. But while they can affect the business positively, they can also impact it negatively. You should be comfortable with whomever you enter into business with. 

Partnership tax returns are due the fifteenth day of the third month after the end of the entity’s tax year, which is typically March 15 (or March 16 in 2020).  However, while the taxes are filed in March, partners don’t tend to pay taxes on the business until the April deadline (July 15 in 2020) since it passes through to their personal tax return. 

 

 

3. Limited liability company

Now, a limited liability company (LLC) is where things start to get a little dicey. The IRS states that an LLC is a “business structure allowed by state statute.” That means it is formed under state law and the regulations surrounding LLCs vary from state to state. 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). 

An LLC is considered a hybrid legal entity because it has traits of numerous other business structures, depending on the elections made by the owners. This lends it more protections and flexibility than some of its business structure counterparts. From a protections perspective, members of an LLC are not personally liable. Because the LLC is an entity created by state statute, it has flexibility in regards to federal tax treatment. For instance, a single-member LLC can be taxed as a sole proprietorship or a corporation. A multi-member LLC can be taxed as a partnership or a corporation.

The aforementioned flexibility causes some discrepancies when it comes to the federal tax due date. 

  • An LLC that chooses to be viewed federally as a sole proprietorship or C corporation (find more on C corporations types below) will typically have a federal tax filing and payment due date of April 15 (July 15 in 2020). 

  • However, an LLC being taxed as an S corporation or partnership will typically have a federal tax filing due date of March 15 (March 16 in 2020) and a payment deadline in line with their individual income return. 

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4. Corporation

Corporations are a company or group of people authorized to act as a single legal entity. This means that the company is considered separate and distinct from its owners (i.e. there’s no personal liability here). However, a corporation is eligible for many of the rights that individuals possess, hence why it is sometimes referred to as a “legal person.” For instance, a corporation can sue or be sued, enter into contracts and is entitled to free speech. 

The IRS splits corporations into two separate classifications: the “C corporation” and the “S corporation.”

  • C corporation (C corp): A C corporation is considered the default designation for corporations. All corporations start in the “C” classification when filing articles of incorporation with the state's business filing agency . Unlike our preceding business structures, C corporations are not a pass-through entity. They are subject to corporate income tax. Owners still must pay personal income tax on profits, which is referred to as double taxation.

  • S corporation (S corp): An S corporation is distinctively different from a C corporation because it is a pass-through entity, allowing it to avoid double taxation. However, the IRS institutes strict standards for companies looking to qualify for S corporation status, particularly around shareholders. For instance, an S corporation can only have 100 shareholders, and they must be U.S. citizens/residents. (It’s not unusual for startups to issue 100,000 shares of stock at their outset.)

Like partnerships, an S corporation must always file its annual federal tax return by the fifteenth day of the third month following the end of the tax year, generally March 15 (March 16 in 2020). The income is then passed down to its members individual returns, which adhere to the normal April Tax Day (July 15 in 2020). 

Corporations are the only business tax structure allowing for perpetual existence. This means that its continuance is not affected by the coming and going of shareholders, officers and directors.

  

What are the tax pros and cons of each business structure?

Business structure

Tax pros

Tax cons

Sole proprietorship

--Pass-through entity

--Easy/inexpensive business structure to set up

--Minimal reporting requirements

--No corporate business taxes

--Unlimited personal liability

--Difficult to get business financing

--No perpetual existence

Partnership

--Pass-through entity

--No corporate business taxes

--Easy/inexpensive business structure to set up

Unlimited personal liability (depending on partnership classification)

--No perpetual existence

--Must create an official partnership agreement

Limited liability company (LLC)

--Limited liability

--Flexible management structure

--No corporate business taxes

--Flexibility to choose tax structure

--Not recognized outside the U.S.

--No perpetual existence

--Not recognized on a federal level -- dictated by state statute

C corporation

--Limited liability

--Unlimited number of shareholders

--Preferred for IPO and outside investors

--Perpetual existence

--Double taxation

--More difficult and expensive to start

--Increased regulation and oversight

S corporation

--Limited liability

--Pass-through entity

--Perpetual existence

--No corporate business taxes

--Only 100 shareholders permitted

--Strict qualification standards

--Only recognized inside the U.S.

--Not recognized by all states

 

 

The bottom line

Choosing a legal business structure is a critical step in your business’s lifecycle. It will affect everything from the ability to attract investors to personal liability to the paperwork involved.  

Businesses should weigh their own personal circumstances and goals against the possible legal structures. Most importantly, all decisions should take into account expert advice from business and legal counsel prior to proceeding.