October 7, 2020 | Last Updated on: January 8, 2024
DISCLAIMER: This article was written in 2020 and has not been updated. For more up to date information about small business funding products and options, please browse our recent articles.
Small business owners start a new business out of passion, excitement, and energy. Whether it’s building business relationships, scaling products, or launching a new website, a quickly growing venture focuses on driving revenue and chasing ambitious goals. In all this hubbub of actually doing business, the question of how to legally structure a business is often left by the wayside. Questions about bylaws, managing a board of directors, official business names, and other things can be quite boring for entrepreneurs.
But this usual lack of consideration of your business’s legal structure can really hurt a business owner in the long term. Carefully choosing your business structure has important implications for your relationship with the IRS, your corporate taxes, personal liability, how you apply for business loans, how you get paid, and more. Getting this right is essential for setting your small business up for long-term success.
There are many different types of business structures. Below, we’ve put together a quick guide on four of the top business structures detailing what they are, their tax implications, and how they relate to getting paid as a small business owner.
A sole proprietor is someone who owns an unincorporated business all by themselves. The vast majority of small businesses without employees are set up as sole proprietorships.
You don’t really have to do anything besides starting your business to be considered a sole proprietorship. They’re a simple way to get up and running.
Tax Implications
In a sole proprietorship, the business’s assets are not separate from your personal assets. There are two main changes come tax time:
Additionally, since you and your business are a single legal entity, tax deductions connected to your business can sometimes be applied to your personal form 1040.
How You Get Paid
This is quite simple. Most sole proprietors will write themselves a check from the business bank account totaling the balance of profits. In the eyes of the IRS, a sole proprietor’s business profits and their personal income are the same things. The profits (or losses) “pass-through” to you. The business’s profits will show up on your personal income tax return.
After you’ve deducted any business expenses, the remaining profit is yours to keep! Of course, you won’t be paying yourself once per year. Smart sole proprietors will keep a close record of revenues and costs, create projections for profits, and make personal payroll determinations on a regular basis.
A partnership is quite like a sole proprietorship. While there are a few forms of partnership, we’ll focus on a “general” partnership. Other partnerships include Limited Liability Partnerships (LLPs) between limited partners, which provide certain personal liability protections by creating a separate legal entity.
A general partnership is an unincorporated business owned by two or more people, usually equally. Usually, as a part of the business plan, partnerships will define a clear partnership agreement that splits up duties between general partners, details profit-sharing, and other important information.
Tax Implications
Since general partnerships are unincorporated and don’t pay corporate income taxes, we have a similar situation to the sole proprietorship. The profits and losses, again, pass through to you and your partners.
The partnership will have to file a Form 1065 to report income, deductions, gains, and losses to the IRS. Additionally, the partnership must file a Schedule K-1 which reports how much of the partnership’s income each partner is responsible for. You will also have to pay self-employment taxes.
How You Get Paid
Based on an agreement between yourself and your partners, you will be able to disburse a share of the business’s profits to your personal accounts. Again, in the eyes of the IRS, the business’s income is your (and your partners) income.
An LLC structure is a hybrid that does two key things: limits the personal liability of the business owners (or “members”) and while preserving the pass-through tax structure of partnerships and sole proprietorships.
LLCs are entities separate from their owners, which is why they provide certain liability protections. Because of this, forming an LLC is a bit more of a formal process. You’ll have to file articles of incorporation, get an employer identification number (EIN), put together an operating agreement, and more.
The ability and process to form an LLC and the eligible businesses vary from state to state. It’s a good idea to check your state’s (potentially) unique rules surrounding LLCs if you’re interested in forming this type of business entity.
Tax Implications
Again, LLCs use a pass-through taxation system (unless you choose to be taxed as an S corporation, or “s corp”). The LLC itself doesn’t pay any business tax. Instead, for tax purposes, the profits or losses are applied to the personal tax returns of the LLC’s members.
You’ll have to pay self-employment taxes unless you file to be taxed as an s corp.
Like a partnership, you’ll have to file a Form 1065 to report the business’s income and Schedule K-1s to report the share of income to each member.
How You Get Paid
Here, again, the profits are disbursed directly to the LLC members. Based on your business’s performance and financial projections, you and your partners (members) will make decisions about owner pay.
An S corporation is a special type of corporate structure that was made specifically for small businesses. S corporations are a totally separate entity from their owners and have crucial federal tax benefits over the other business structures we’ve discussed and more complex corporate structures like C corporations (avoiding “double taxation”).
S corporations provide more liability protection than an LLC, but also have several other complications. These include management of payroll and payroll taxes, the types of people who can be shareholders in the business, and many other things. Managing an S corp requires a lot more administrative work, very diligent record-keeping, and caution around legal complications. Anyone thinking about applying to file as an S corporation should review the IRS guidelines in detail.
Registering as an S corp is a bit more complicated. The Small Business Administration (SBA) has a directory of state agencies that you can refer to get started. While the exact name of the agency you need to contact can be different from state to state, most of the time the relevant agency to contact is the state’s Secretary of State’s office.
Tax Implications
A key benefit of an S corp is the tax savings. While you’ll still have to pay payroll taxes on actual wages paid, both to yourself and any employees, you won’t have to pay these taxes on distributions (the earnings and profits that “pass-through” to you as an owner).
But tax season is more complicated for S corporation tax preparers. The S corporation itself will have to pay income taxes, estimated tax payments, employment taxes, and excise taxes. Additionally, S corp shareholders (owners!) will have to augment their Form 1040’s and consider the information reported on their Schedule K-1.
This guide from the IRS breaks everything down and links to all the relevant forms and instructions.
How You Get Paid
In an S corporation, you’ll get paid a salary from the business entity. You get to decide how much you’ll pay yourself as an employee. However, you must pay yourself what the IRS considers a “reasonable salary”. Basically, the IRS doesn’t want you to just pay yourself in “distributions” to avoid certain taxation.
The general rule of thumb is that you should pay yourself a salary comparable to what a similar professional would pay themselves. So, if you’re a tax accountant and in your state, they’re usually paid around $70,000 a year, your personal salary paid by the S corp should be close to that.
In the end, your S corp will pay you (and your employees) a set wage, and the corporation will pay payroll taxes and give you a W2. How often you’d like to get paid is totally up to you!
