When starting a business, owners must decide what form of business entity to establish. The type of business structure determines which income tax return form you file, and may impact how you structure health benefits for yourself (the owner), your family, and your employees.
The five small business owner structures are:
- Sole Proprietorships
- Limited Liability Company (LLC)
A sole proprietor ("sole-prop") is someone who owns an unincorporated business by himself or herself. A sole proprietorship is the simplest and most common structure chosen to start a business, and there is no distinction between the business and owner. The owner is entitled to all profits and is responsible for all of the business’s debts, losses, and liabilities.
A partnership is a single business where two or more people share ownership. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business.
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.
There are three types of partnerships: general partnerships, limited partnerships, and joint ventures.
Partners are not employees and should not be issued a Form W-2.
A corporation (aka C-corporation or C-corp) is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.
Corporations are more complex than other business structures because they tend to have more administrative fees and complex tax and legal requirements. Because of this, corporations are more common with established, larger companies with multiple employees.
In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C-corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.
The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.
An S-corporation ("S-corp") is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S-corporation.
S-corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S-corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S-corporations to avoid double taxation on the corporate income. S-corporations are responsible for tax on certain built-in gains and passive income at the entity level.
To qualify for S-corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders including individuals, certain trusts, and estates and may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Since the federal government does not recognize LLC as a business entity for taxation purposes, all LLCs must file as a corporation, partnership, or sole proprietorship on their tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law.
FAQ - How Does Business Structure Impact Health Benefits?
Many small business owners use a Section 105 medical reimbursement plan to increase their personal and business tax savings, and provide a health insurance allowance to any employees. The tax benefits that owners are allowed to receive on Section 105 reimbursements varies by the business's structure.
For example, C-corporation owners may participate in the reimbursement plan, and receive reimbursements 100% tax free. Whereas sole proprietors may participate in a Section 105 plan platform for tracking purposes, but generally are not eligible to receive reimbursements tax-free.
Read more: Section 105 Plan Eligibility - By Owner Status.