‍What is a business structure?

A business structure is the legal framework that determines how a business operates, is taxed, and is recognized under the law. It affects how much you pay in taxes, your personal liability, the forms you file, and your ability to raise capital.

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What are the most common types of business structures?

The four most common business structures are sole proprietorship, partnership, limited liability company (LLC), and corporation.

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Sole Proprietorship

A sole proprietorship is an unincorporated one person business. You are automatically considered to be a sole proprietor if you do business but don’t formally register it as another type of entity. In this structure, there is no legal separation between you and your business, meaning your personal assets are fully exposed to business liabilities. This means that any debts or obligations of the business can directly affect your personal assets.

Federal Taxes

Business profits and losses are reported on your personal tax return (Schedule C).

Payroll & Self-Employment Taxes

All business profits are subject to Social Security and Medicare taxes (Self-employment taxes).

Tax Flexibility

No tax flexibility. All profits are reported on your personal tax return (Schedule C) and taxed as personal income. You cannot shift income to lower income partners (like a Partnership), reduce Social Security and Medicare taxes (Self-employment taxes) (like a S-Corp), or retain profits in the business to defer taxes (like a C-Corp).

Compliance Requirements

Low compliance. Only personal income tax reporting (Schedule C) is required, with few formalities to maintain. No separate business filings or corporate formalities are necessary.

Maximizing Tax Savings

1. Consider forming an LLC for liability protection or S-Corp to reduce self-employment taxes.

2. Track all business expenses meticulously to maximize deductions.

3. Use retirement accounts and health insurance deductions to lower taxable income.

Ask Yourself

1. Am I paying more self-employment tax than necessary?

2. Do I have adequate liability protection for myself and my personal assets?

3. Are my business expenses and deductions fully documented?

Action Steps

1. Consult a CPA to estimate whether electing S-Corp taxation would reduce self-employment taxes.

2. Consult an attorney to evaluate whether converting to an LLC would provide liability protection.

3. Organize and categorize all business expenses (bookkeeping) and records systematically to ensure all tax deductions are captured.

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Partnership

A partnership is formed when two or more people come together to own and operate a business. Partners contribute money, property, labor, or skills, and share in the profits and losses of the business. Profits from partnerships pass through to the partners personal tax returns.

There are two common types of partnerships:

• Limited Partnership (LP): A limited partnership has one or more general partners with unlimited liability and additional partners with limited liability. The general partner must pay self-employment taxes on their share of the profits.
• Limited Liability Partnership (LLP): A limited liability partnership allows all partners to receive limited liability protection.

Federal Taxes

Business profits and losses are reported on each partner's personal tax return (Schedule K-1).

Payroll & Self-Employment Taxes

Each general partner’s share of partnership income is subject to Social Security and Medicare taxes (Self-employment taxes).

Each limited partner's share of partnership income is not subject to Social Security and Medicare taxes (Self-employment taxes), except for guaranteed payments for services performed.

Tax Flexibility

High tax flexibility. Profits and losses can be allocated among partners strategically to reduce overall taxes. High-income partners can absorb losses or low-income partners can receive profits. Allocations must be carefully documented in the partnership agreement, in addition to, maintaining capital accounts and meeting the substantial economic effect rules.

Compliance Requirements

Moderate compliance. Must file income tax return (Form 1065) annually, issue Form K-1s to all partners, and maintain accurate capital accounts. The partnership agreement should clearly define allocations to ensure substantial economic effect. Recordkeeping and documentation are critical to withstand IRS scrutiny of allocations.

Maximizing Tax Savings

1. Maximize the 20% QBI deduction for each partner by coordinating income allocations, timing of deductions, and distributions.

2. Structure profit and loss allocations strategically to reduce overall partner tax liability, ensuring allocations have substantial economic effect.

3. Monitor the timing of income and expenses to optimize each partner’s taxable income, accelerating deductions or deferring income where advantageous.

Ask Yourself

1. Are profit and loss allocations structured efficiently to minimize overall partner tax liability?

2. Could adjusting the timing of income, deductions, or contributions across partners improve tax outcomes?

3. Are deductible benefits coordinated across partners for maximum tax efficiency?

Action Steps

1. Review and update your partnership agreement to ensure tax efficient profit and loss allocations.

2. Consult a CPA on entity election benefits and drawbacks.

3. Coordinate timing of income, deductions, and retirement contributions across partners.

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Limited Liability Company (LLC)

A Limited Liability Company (LLC) is a flexible structure that combines the liability protection of a corporation with the tax benefits of a partnership. LLCs are governed by state law, so rules may vary depending on where you form your business.

Owners of an LLC, called members, can include individuals, corporations, other LLCs, and foreign entities.

For federal tax purposes, an LLC can be treated in different ways depending on elections made by its members. A single-member LLC is generally treated as a disregarded entity, while an LLC with multiple members is typically taxed as a partnership. Members report profits and losses on their personal tax returns and must pay self-employment taxes for Medicare and Social Security contributions. Alternatively, an LLC can elect to be taxed as a C corporation or an S corporation, providing additional flexibility in managing taxes and optimizing profits. 

Federal Taxes

By default, business profits and losses are reported on each member’s personal tax return (Schedule C).

Payroll & Self-Employment Taxes

By default, each member’s share of LLC profits is subject to Social Security and Medicare taxes (Self-employment taxes).

Tax Flexibility

High tax flexibility. Members can elect S-Corp or C-Corp taxation. S-Corp treatment allows members to take a reasonable salary (subject to payroll taxes) and distribute the remaining profits as distributions (not subject to self-employment taxes), reducing overall tax liability. Alternatively, C-Corp treatment can be advantageous for retained earnings in the business or leveraging the potentially lower corporate tax rate, giving flexibility in timing and use of profits.

Compliance Requirements

Varies by state and tax election. LLCs must file annual state reports and pay fees or franchise taxes (where applicable). Recordkeeping must support chosen tax treatment and allocations. If taxed as a partnership, Form 1065 and K-1s are required; if taxed as an S-Corp or C-Corp, payroll, reasonable compensation, and corporate filings may also apply.

Maximizing Tax Savings

1. Maximize the 20% QBI deduction by monitoring total taxable income and timing business income and expenses to stay within thresholds for full deduction.

2. Consider electing S-Corp taxation to reduce self-employment taxes through a salary (ensure salary meets reasonable compensation rules) plus distribution of the remaining profits.

3. Consider electing C-Corp taxation for retained earnings or reinvestment in the business to take advantage of the lower corporate tax rate.

Ask Yourself

1. Am I maximizing the 20% QBI deduction by properly timing income and expenses?

2. Could electing S-Corp taxation reduce self-employment taxes?

3. Would electing C-Corp status provide tax advantages for retained earnings, reinvestment, or long-term growth?

Action Steps

1. Consult a CPA to balance timing of income and expenses to maximize the 20% QBI deduction.

2. Evaluate S-Corp versus C-Corp election based on profit levels, growth plans, and self-employment tax impact.

3. Maximize retirement plan contributions, health insurance deductions, and other fringe benefits at both the entity and personal level.

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Corporation (C corp and S corp)

C corporation (C corp)

A C corporation is a separate legal entity from its owners, meaning it can earn income, incur expenses, enter into contracts, and be held legally liable independently of its shareholders. Corporations provide liability protection from its owners personal assets.

C corps are more complex and costly to operate due to required record keeping, governance processes, and regulatory compliance requirements. C corps are subject to corporate income tax, and profits distributed to shareholders as dividends are taxed again at the individual level, creating double taxation.

C corporations are advantaged for raising capital because they can issue shares of stock to raise money from investors. Shareholders can exchange money, property, or both for the corporation’s capital stock, which enables the business to grow.

‍Federal Taxes

Business profits and losses are reported on the corporate tax return and taxed at the corporate rate of 21%. When dividends are distributed to shareholders, they are taxed again on your personal tax returns (Schedule D), resulting in double taxation.

Payroll & Self-Employment Taxes

Payroll taxes apply to all employee salaries, including shareholder-employees. Corporate profits to shareholders (Dividends) are not subject to Social Security or Medicare taxes (Self-employment taxes).

Tax Flexibility

Moderate tax flexibility. Profits are taxed at a flat 21%, which may be lower than personal rates, and fringe benefits (like health insurance and retirement contributions) are fully deductible. However, distributions (dividends) are subject to double-taxation, limiting flexibility in distributing profits.

Compliance Requirements

High compliance. Corporations must file income tax returns (Form 1120), maintain corporate formalities (board meetings, minutes, bylaws), track detailed accounting, and comply with state corporate filings. Payroll, benefits, and distributions must be properly documented to comply with tax law.

Maximizing Tax Savings

1. Maximize deductible fringe benefits such as retirement contributions, health insurance, and other employee perks.

2. Manage timing of income, deductions, and capital expenditures to minimize coporate taxation.

3. Consider the impact of retained earnings versus dividend distributions to minimize double taxation.

Ask Yourself

1. Does my growth or capital-raising plan require issuing stock or attracting investors?

2. Am I taking full advantage of deductible fringe benefits to reduce corporate taxable income?

3. Have I planned for the impact of double taxation on dividends versus retained earnings?

Action Steps

1. Review owner and employee compensation to ensure tax efficiency.

2. Track and maximize all deductible corporate benefits.

3. Consult a CPA on timing of income, expenses, and capital investments to minimize double taxation.

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S corporation (S corp)

A S corporation is a special type of corporation designed to avoid double taxation of a C corporation. Like a C corporation, it is a separate legal entity, but it allows profits, losses, deductions, and credits to pass directly through to shareholders' personal tax returns. This allows shareholders to report income and losses at their individual tax rates, avoiding the corporate level tax.

S corps require an election with the IRS to receive this status and must meet eligibility requirements. The state taxation of S corps varies from state to state, as some states tax S corps on profit above a certain threshold, while others may not recognize the S corp election at all and treat the business as a C corp instead.

Federal Taxes

Business profits and losses are reported on each owner's personal tax return (Schedule K-1).

Payroll & Self-Employment Taxes

Payroll taxes apply to all employee salaries, including owners. Distributions of profits to owners (Dividends) are not subject to Social Security or Medicare taxes (Self-employment taxes).

Tax Flexibility

Moderate tax flexibility. Owners can adjust salary and distributions to reduce Social Security and Medicare taxes (Self-employment taxes) while complying with reasonable compensation rules. Profits pass through to personal tax returns, avoiding double taxation (that a C-Corp is subject to), and owners can use personal deductions and retirement contributions to offset taxable income.

Compliance Requirements

High compliance. Owners must run payroll and pay reasonable salaries subject to payroll taxes, file income tax return (Form 1120-S), issue Form K-1s to shareholders, and comply with corporate formalities. Adequate documentation is required to support salary versus distribution strategy and ensure IRS compliance.

Maximizing Tax Savings

1. Maximize the 20% Qualified Business Income (QBI) deduction by strategically balancing owner compensation, distributions, and business income.

2. Optimize owner compensation through reasonable salary plus distributions to minimize self-employment taxes.

3. Maximize deductible benefits, including retirement plans and health insurance, to offset taxable income.

Ask Yourself

1. Am I maximizing the 20% QBI deduction by balancing salary, distributions, and business income?

2. Is my salary versus distribution allocation optimized to reduce payroll taxes while remaining reasonable?

3. Am I maximizing deductible benefits, including health insurance, retirement contributions, and accountable plan reimbursements?

Action Steps

1. Consult a CPA to balance salary, distributions, and net business income to maximize the 20% QBI deduction.

2. Consult a CPA to review and verify that owner salaries are reasonable and optimized to minimize payroll taxes.

3. Implement or fully fund owner and employee retirement plans.