How you structure your business for the IRS is important. Here’s why.

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The business formation structure you chose at startup may no longer be the best one for your business. As you grow, the legal entity of your business can affect your tax bill, your personal assets, and your ability to attract investors, raise funds, and grow your business.

It’s a lot of variables, so let’s explore your options.

Related: Which Business Structure is Best for You?

Sole proprietorships

Most startups in the United States start – and stay – as sole proprietorships. Of 33 million American small businesses, the Internal Revenue Service (IRS) reports that 28.3 million are non-farm sole proprietorships.

Sole proprietorships are the simplest form of legal business entity. The setup process is simple. Although sole proprietorships without employees do not need an Employer Identification Number (EIN), it is recommended as many banks won’t let you open a business account without one.

There is, however, a downside. There is no legal separation between a sole proprietor and the business. Thus, you are personally responsible for all debts, obligations and lawsuits against your company. If your business is sued, your personal assets (property, bank accounts, etc.) may be at risk.

For tax purposes, sole proprietors report their profits and losses on their individual tax returns (IRS Forms 1040) and attach a Business Profit or Loss Schedule C, showing income, expenses, and allowable tax deductions. In addition to income taxes, sole proprietors pay self-employment taxes of 12.4% for Social Security and 2.9% for Medicare. Taxes are due April 15.

Partnerships

Many entrepreneurs start businesses with family or friends or seek partners as their business grows. As with sole proprietorships, there is no legal separation between the partners and the partnership, so the personal assets of the partners are at risk if something goes wrong.

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Unless otherwise specified in the partnership agreement, all partners are also responsible for paying taxes. Partnerships use IRS Form 1065, Schedule K, to list partners and business income and expenses. In addition, all partners must pay self-employment and estimated taxes. Partnership tax returns are due March 15.

Related: 5 Tips to Structure Your New Business Like a Pro

LLCs offer liability protection

As their businesses grow, many entrepreneurs feel uncomfortable with the risk of their personal assets being at risk and consider incorporating their business.

There are two ways to incorporate: form a Limited Liability Company (LLC) or a C Corporation. Both structures are considered separate legal entities and shield business owners from corporate liabilities, protecting their personal property.

LLC owners are called members. Single-member LLCs are taxed as sole proprietorships using tax form 1040 and Schedule C. Multi-member LLCs are taxed as partnerships and use tax forms Partnership 1065 and Appendices K and K-1. LLC members still have to pay self-employment taxes. You can also opt for an S Corp election (see below).

You must file articles of incorporation with your state to form an LLC. And although it is not mandatory, it is recommended to create an operating agreement. An operating agreement defines the roles and responsibilities of a multi-member LLC.

LLCs are becoming increasingly popular due to their relatively simple management structure, fewer compliance requirements, and flexible tax treatment. They are basically a “take your cake and eat it too” option. For example, multi-member LLCs can allocate percentages of the company’s profits and losses to members as they see fit.

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LLCs have fewer and less complex compliance responsibilities than C Corps. They don’t have to elect officers or a board of directors. There are some ongoing compliance requirements – check with your state to learn more.

The biggest downside of owning an LLC is that you can’t issue shares of the company, which makes it more difficult to raise funds.

C Corps offers strong liability protection

As your business grows, you may want better liability protection and choose to form a C Corporation. Although C Corps are more complex to form and operate, they offer the protection of strongest liability to the company’s shareholders. C Corps must file articles of incorporation in the state where you operate.

AC Corp is a separate business entity and files income tax on its profits and losses using IRS Form 1120. But owners/shareholders are considered employees of the company, receive W-2s and are taxed as individual taxpayers, often referred to as “double taxation”.

However, C Corps can deduct employee-related costs, such as salaries, health care, pensions, operating expenses, and employee benefits like company cars. Ultimately, C Corp’s current flat tax rate of 21% may be lower than what sole proprietorships and partnerships pay,

In C Corps, the company and its employees each contribute 6.2% of the employee’s salary to social security and 1.45% to health insurance. In addition, employers contribute to their state-run unemployment insurance funds (SUI).

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It is easier to raise funds and attract investors since C Corps can offer unlimited shares and multiple classes of shares.

C Corps typically have higher registration costs and more compliance requirements, including passing bylaws, submitting annual reports, holding shareholder and board meetings, and more.

Related: The 5 Biggest Tax Differences Between an LLC and a Corporation

The S Corp tax election

LLCs and C Corps can elect to be taxed as S corporations, allowing them to divide profits into salaries and dividends. Although dividend distributions are not subject to employment tax, shareholders must receive reasonable compensation as defined by the IRS. Choosing to be taxed as an S Corp can reduce your overall tax bill while maintaining liability protection. S Corps uses IRS Form 1120-S and tax returns are due March 15. To elect S Corp status, you must file IRS Form 2553 by March 15 of the tax year in which the election is to take effect.

However, only US citizens and residents can be shareholders of S Corp, and only 100 shares can be issued, so check with your accountant before going this route.

Take advice

It is crucial to weigh the pros and cons of different business structures. For many entrepreneurs, the liability protection and possible tax savings outweigh the added costs and complexity of incorporation.

With so much at stake, it is recommended that you consult your accountant or lawyer to help you determine which structure is best for your business today and for future growth.

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