Structuring Your Business: How Business Structure Affects Taxes and Personal Liability

One of the first decisions you make as a business owner is how to structure your business. Selecting the proper business structure often boils down to a handful of considerations such as:

• Legal liability – not all business structures provide the same protection from liability. Generally, corporations and LLCs offer the greatest protection. For more information, check out our blog post Corporations and LLCs: How to Protect Your Personal Assets as a Business Owner.

• Cost to form and maintain – some business structures are easier to start and maintain than others. For example, corporations often have high costs of formation, time-consuming paperwork, and extensive record-keeping requirements.

• Tax Planning – some business structures are taxed at the personal income level, while others are taxed at both the personal and business levels. The tax obligations of the most common business structures are discussed in further detail below.

Types of business structures

Sole Proprietorships

A sole proprietorship has a single owner. The owner and the business are legally the same. This means that the owner is personally liable for the business’s liabilities, debt, and losses. From a tax perspective, a sole proprietorship is not a taxable entity; instead, the owner will report the business’s assets, liabilities, income, and losses on his or her personal tax return.

General Partnerships

A general partnership is essentially a sole proprietorship owned by two or more people. The partners share responsibility for the business’s assets and liabilities. The partners are each personally liable for liabilities of the business. Finally, partners share the business’s profits and losses. Each partner will report their respective share of the business’s assets, liabilities, income, and loss on their personal tax return.

C Corporations

C corporations (often referred to simply as “corporations”) have shareholders instead of owners. Unlike sole proprietorships, corporations are separate legal entities from their shareholders. Corporations provide shareholders the greatest projection from personal liability – shareholders are not liable for the business’s debts and liabilities. However, these protections do not come without their drawbacks. As mentioned previously, corporations have high costs of formation, time-consuming paperwork, and extensive record-keeping requirements. The assistance of accountants and attorneys is often necessary to comply with these complex regulatory requirements.

The income of the corporation is passed to the shareholders via dividends. From a tax perspective, corporations are considered to be double-taxed. First, the corporation’s income is taxed at the corporate level using the corporate income tax rate (which is set at 21% for 2021). Next, each shareholder will report their share of dividends on their respective personal tax return – thus being taxed a second time at the shareholder’s personal tax rate.

S Corporations

S corporations offer many of the non-tax benefits of C corporations (like personal liability protection). However, unlike C corporations, S corporations are not double-taxed. With an S corporation, business profits and losses are passed directly to shareholders, thus bypassing corporate income tax. Like a sole proprietorship, shareholders are responsible for reporting dividends on their respective personal tax returns. S corporations are, however, subject to different requirements than C corporations. For example, every shareholder must be a U.S. citizen, and the S corporation cannot have more than 100 shareholders.

Limited Liability Companies (LLCs)

LLCs are very flexible business structures. LLCs offer many of the personal liability protections provided by corporations. However, LLCs are unique because they can elect their tax treatment. LLCs can elect to be treated as a C corporation, partnership (if multiple owners), or sole proprietorship (if one owner) for tax purposes. How the LLC is structured will often dictate its tax treatment. For helpful information regarding LLCs, see our blog posts Why You Should Have an Operating Agreement for Your LLC and Does my new limited liability company need a Federal Employer Identification Number?.

Choosing the right business structures can be intimidating and confusing. Whether you are starting a new business, winding down your existing business, or anything in between, the business law attorneys at McNeelyLaw are ready to help.

This McNeelyLaw LLP publication should not be construed as legal advice or legal opinion of any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer on any specific legal questions you may have concerning your situation.