When starting a business, you get to decide what kind of entity you’re going to establish, as well as what kind of business you’d like to be taxed as. The type of business structure you choose will determine which income tax return form you file and may impact how you structure health benefits for yourself, your family, and your employees.
The six small business owner structures are:
- Sole proprietorship
- Limited liability company (LLC)
Let’s start off easy. The most basic type of business structure is a sole proprietorship (or "sole-prop"). A sole proprietor is someone who owns an unincorporated business by themself. 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 personally responsible for all of the business’s debts, losses, and liabilities.
For example, let’s say you take out a loan to start your own bakery. If the profits you earn from your bakery aren’t enough to cover the debt, you alone are expected to come up with the money out of pocket to pay off the loan. Likewise, if you have any personal debts unrelated to your business, a creditor could go after the profits or assets from your bakery to settle the debt.
Next up is partnerships. 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 information like income, deductions, gains, and losses from its operations, but it doesn’t pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes their share of the partnership's income or loss on their tax return.
There are three types of partnerships:
- General partnerships (all partners have equal liability)
- Limited partnerships (one partner has unlimited liability, and all other partners have limited liability)
- Joint ventures (a partnership created just for a single project)
No matter the type, partners aren’t considered employees, so they shouldn’t be issued a W-2 form.
Here’s one you’ve undoubtedly heard of before—corporations. Also known as “C-corporations” or “C-corps,” a corporation 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. So if the business goes bankrupt, the shareholders aren’t personally responsible for the debts and liabilities they would be if the business was a sole proprietorship or a partnership.
Corporations are more complex than other business structures because they tend to have more administrative fees (like paying executive-level salaries and benefits or covering regular inspections) as well as 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 example, C-corps are the only kind of corporate entity that can deduct contributions to eligible charities as a business expense, so long as they aren’t more than 10 percent of taxable income in a given year. 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 can’t deduct any loss of the corporation.
Here’s where it gets a little tricky, so let’s break it down. 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 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, which allows S-corporations to avoid double taxation on the corporate income. However, just like C-corporations, shareholders aren’t personally responsible for any liabilities or debt incurred by the business. 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 (where you only conduct business in your home country)
- Have only allowable shareholders, including individuals, certain trusts, and estates
- This may not include partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Be an eligible corporation
- Ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations
In sum, the biggest difference between a C-corporation and an S-corporation is taxation. If you’re prepared to be taxed at both the corporate and personal level, then becoming a C-corp could be a good option for you. However, if you’d rather save on corporate taxes and manage your profit and losses through your personal income tax, an S-corp is the better option.
A less common type of business structure is a B-corporation. Also known as a “B-corp,” this type of for-profit corporation is taxed in the same way as a C-corp, but is treated differently in purpose, accountability, and transparency. That’s because B-corps are mission-driven as well as profit-driven. Shareholders are expected to keep the company accountable to produce some kind of public benefit in addition to financial profit. Depending on the state, you may even be required to submit an annual benefit report to show your company’s contribution to public good.
A few B-corporations you might have heard of include Kickstarter, King Arthur Flour, and Patagonia. All of these companies care not only about making money, but also about helping people in their communities, whether it’s in helping small businesses, solving hunger, or advocating for the environment.
Limited Liability Company (LLC)
Finally, 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. 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 an 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.
How Does Business Structure Impact Health Benefits?
Many small business owners use a Section 105 medical reimbursement plan, such as a health reimbursement arrangement (HRA) to provide a tax-advantaged health benefit to their 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 both offer and participate in the reimbursement plan, whereas S-corporation shareholders with at least 2% ownership may offer a Section 105 plan but aren’t eligible to participate themselves.
PeopleKeep currently offers three types of HRAs to employers of all business structures, including:
- Qualified small employer HRA (QSEHRA)
- Think your sole proprietors and small partnerships
- Individual coverage HRA (ICHRA)
- Works for businesses of all sizes
- Group coverage HRA (GCHRA)
- Great for small to midsize employers offering group coverage
This article was originally published on August 3, 2012. It was last updated February 22, 2021.