Learn about the different ways to structure your business and how they affect your taxes.
When you’re starting out as a small business, the tax implications may not be top of mind. But all self-employed individuals need to pay self-employment tax as well as income tax, so it’s helpful to get a handle on your tax situation early in your journey.
And that starts with deciding the type of structure your business will use. There are numerous possibilities, including an LLC, LLP, S-corp, C-corp, or sole proprietorship.
The way your business is organized determines what taxes you pay and how you pay them, according to the IRS. In general, there are five types of taxes businesses pay:
- Income tax: Taxes on income received or earned.
- Estimated taxes: Taxes paid through the year by withholding or regular estimated tax payments. Includes income, self-employment, and alternative minimum tax.
- Self-employment tax: A Medicare and Social Security tax for individuals who work for themselves.
- Employment tax: Businesses that have employees must pay and file forms for taxes, including Social Security and Medicare taxes, federal income tax withholding, and federal unemployment (FUTA) tax.
- Excise tax: Taxes paid by small business in certain sectors, like manufacturing or wagering.
Read on to learn more about the tax requirements of different business structures.
Different structures, different tax implications
Not all small businesses have to pay all these taxes. That’s because the structure you choose affects which taxes apply to your business, your liability, how you run things, and your business’s growth potential. We break down the tax implications of four structures below; consult with a tax or legal professional before choosing a structure to determine your filing requirements and taxes at the federal and state level.
- Sole proprietorship
- Definition. Sole proprietorships are the simplest way to structure a business, where you, or you and a partner(s), have complete control of the business. Sole proprietorship may be suitable if you are the main person running your business, such as a grocery store owner, personal trainer, photographer, or freelance graphic designer.
- Tax implications. There is no separation between your personal and business finances in a sole proprietorship, which means your assets are on the hook for any business debts and obligations. You have to report business income or loss on your personal tax return and pay self-employment taxes. You may have to pay additional taxes depending on the nature of your business and the state you live in.
- Limited Liability Partnership (LLP)
- Definition. Businesses run by two or more people can choose to form an LLP. This structure is used to protect all partners from being personally liable for the debts and obligations of the business or any mistakes committed by other partners. LLPs usually have state rules governing which licensed professionals can own them, such as attorneys, accountants, or physicians.
- Tax implications. Each partner in an LLP must report their share of the business profit or loss on their personal tax return. They also must pay self-employment taxes.
- Limited Liability Company (LLC)
- Definition. An LLC can be owned by one or more people called members. This structure separates business and personal finances, protecting a member’s assets from business debts and obligations. State rules govern the specifics of creating an LLC.
- Tax implications. An LLC allows for more flexibility than other structures when it comes to taxes. You can set up the LLC to be taxed as a partnership, a corporation (see “S-corp” below), or as part of your personal tax return, known as a “disregarded entity”. You can also change the LLC’s tax election as your business grows — for instance, when your business is worth more or changes leadership structures down the road. The LLC must also pay self-employment taxes.
- Corporations (S-corp, C-corp)
- Definition. A corporation is what it sounds like — an independent legal entity, offering limited liability protection to its owners, but with more complex tax requirements. There are two main types: a C-corp (named for being in subchapter “C” of the Internal Revenue Code) or an S-corp (the “S” similarly stands for subchapter “S”).
- Tax implications. C-corps have to pay income tax on their profits twice. They pay corporate income tax when the company makes a profit, and shareholders also pay personal taxes when they receive dividends. C-corps allow greater flexibility in ownership structure, including foreign ownership, profit distribution, and company growth. An S-corp avoids double taxation because the owner can report business profit or loss on their personal tax return, similar to sole proprietorships, LLCs, and LLPs, but this structure carries more restrictions around ownership and growth.
Making the right choice for you
Now that you have an idea of the different ways to set up your business and the tax implications of each type, consult a legal or tax professional to pick the right structure for your small business.