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Business Form and Taxation: Pros and Cons

When you're starting a business, one of the first decisions you'll have to make is whether to be a sole proprietorship, partnership, corporation, limited liability company (LLC), or nonprofit organization. The type of business form you choose will depend on the nature of your business, its goals, and other factors, including taxation.

While taxes should not be your only consideration when choosing a business legal structure, it's a good idea to compare the tax obligations and regulations of each. The taxation pros and cons of each type of business form are listed in the following chart.

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Understanding Business Forms and Federal Tax Law

Understanding how federal tax applies to different business forms is essential for small business owners, entrepreneurs, and taxpayers. This guide breaks down the concepts, helping you navigate the complexities of business taxes.

Business Form

Pros

Cons

Sole Proprietorship
  • Easy to set up
  • No double taxation
  • Income reported on personal income tax return
  • Taxes are paid on the income of the business and not on the business as an entity
  • No personal limited liability protection
  • You pay twice the amount of Social Security/Medicare taxes as you would as an employee
  • No life insurance deduction; partial health insurance deduction
Partnership
  • No double taxation
  • All income is taxed proportionately to each of the partners, who report it on their personal tax returns
  • No personal limited liability protection (unless a limited partner in a limited partnership
S Corporation
  • S Corporation may elect to be treated as a partnership for federal tax purposes, with shareholders reporting their share of the corporation's separately listed items of income, deductions, loss, and credit on their personal tax returns
  • Shareholders have personal limited liability
  • S Corporation may not have more than seventy-five shareholders
  • Shareholders and those owning 5 percent or more in stock have limited employee benefits
C Corporation
  • Shareholders have limited personal liability
  • Health insurance premiums and group life insurance up to $50,000 in benefits are fully deductible by the corporation and not taxable to the employees
  • The corporate tax rate doesn't go as high as the individual rate (what a sole proprietor or partner would pay on an individual tax return)
  • Double taxation, meaning the corporation pays taxes on its income, and the shareholder pays taxes on dividends
  • Shareholders cannot deduct the losses of the corporation
Limited Liability Company (LLC)
  • Personal limited liability of members
  • No double taxation
  • May have more than seventy-five members
  • Under IRS "check-the-box" rules, a limited liability company may choose whether to be taxed like a partnership or a corporation
  • Active members are subject to self-employment tax for Social Security and Medicare
  • Limited liability companies are a relatively new business form, and the laws are still evolving

Key Elements of Business Taxation

Understanding the various taxes that apply to businesses is essential. C corporations (C corps) encounter corporate income tax on their net income. This is a distinct feature from individual income tax, which applies to small business owners of pass-through entities who report their business income on personal tax returns.

Beyond income taxes, businesses must be aware of sales tax, often levied by states on the sale of goods and services. They must also know about payroll taxes, which are mandatory for businesses with employees. These taxes cover contributions to Social Security and Medicare. In specific cases, businesses may also be subject to excise taxes applied to certain products or services.

Tax Preparation and Filing for Businesses

Navigating the tax preparation and filing process requires understanding several key terms and concepts. The tax year, whether a calendar or fiscal year, is the 12-month period for which taxes are calculated. Gross receipts represent the total revenue before deductions. Taxable income is what remains subject to tax after exemptions and deductions.

Tax credits, which reduce the tax bill dollar-for-dollar, differ from deductions that reduce taxable income. Small businesses often have to pay estimated taxes throughout the year based on the expected tax due. It's crucial to be aware of filing requirements, including due dates such as April 15th for individuals and March 15th for most corporations. You should also know the specific tax forms required for different types of taxes.

State-level considerations, such as franchise taxes or the role of the comptroller in tax collection, vary by state. Staying informed about income tax rates is important for accurate record-keeping. Seek a tax professional for professional assistance in navigating the complexities of business taxation.

Additional Resources

For additional guidance on structuring and managing your business, see the articles below.

Get Help With Your Business Taxation Concerns

There are many factors to consider when deciding on the best legal structure for your business, including tax implications. Rather than trying to figure it all out on your own, consider using a reputable DIY business formation service, or reach out to a lawyer.

An attorney can help determine the right business structure and prepare the necessary paperwork to set it up. There are tax law attorneys near you who can help you make the right choices for your business.

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