Business Structures: Choosing the Right Framework

When starting a new business, choosing the appropriate legal business structure is crucial for establishing its foundation and determining the rights, responsibilities, and liabilities of the owners. The legal structure of a business not only affects how the enterprise is taxed but also influences decision-making authority, ownership flexibility, and personal liability. In this article, we will explore and provide an in-depth understanding of each business legal structure to help entrepreneurs make informed decisions.

For less common business structures such as B Corporations, Cooperatives, and Close Corporations, visit the SBA website.

A sole proprietorship is the simplest and most common form of business ownership. In this structure, a single individual owns and operates the business. The owner retains full control and assumes all responsibilities, including the business’s debts and legal obligations. However, the owner has unlimited personal liability, which means personal assets can be at risk in the event of business debts or legal claims. A sole proprietorship may be a good choice for a very simple business with little to no risk.

Taxation is straightforward. A Sole Proprietorship is considered a “disregarded entity” meaning taxes are passed through to the owner’s personal tax return. Revenue and expenses are entered onto a Schedule C with the net profit or loss flowing through to the owner’s personal tax return on Form 1040. Below are links directly to the IRS website where you can download the forms and schedules along with their instructions for Schedule C and Form 1040.

Click here to the see Schedule C on the IRS’s website – About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship) | Internal Revenue Service (irs.gov)

Click here to the see Form 1040 on the IRS’s website – About Form 1040, U.S. Individual Income Tax Return | Internal Revenue Service (irs.gov)

Partnerships involve two or more individuals who agree to share ownership, profits, and losses of a business. There are two main types of partnerships: general partnerships and limited partnerships.

In a general partnership, each partner shares equal responsibility for the business’s liabilities, debts, and management decisions. Profits and losses are distributed among partners according to the partnership agreement. General partnerships are commonly formed by professionals, such as lawyers, accountants, or medical practitioners, who collaborate and share resources, expertise, and profits in their respective fields.

Limited partnerships consist of partners who contribute capital but have limited involvement in decision-making and liability of the business. Some examples of businesses that are commonly structured as limited partnerships include real estate investment ventures, private equity funds, oil and gas exploration partnerships, and certain types of investment funds like hedge funds or venture capital funds.

The Partnerships entity is not taxed separately; instead, profits and losses flow through to the partners’ personal tax returns on Form 1040. Partnerships must file an information return to report their income, gains, losses, deductions, credits, etc. by filing Form 1065, but a partnership business structure does not pay tax on its income. Partners must include partnership items on their tax or information returns.

Click here to the see Form 1065 on the IRS’s website – About Form 1065, U.S. Return of Partnership Income | Internal Revenue Service (irs.gov)

A limited liability company (LLC) is a flexible and widely favored legal structure that combines features of a corporation and a partnership. LLCs offer limited liability protection to their owners, shielding personal assets from business debts and liabilities. The owners, known as members, enjoy the pass-through taxation benefits similar to partnerships and sole proprietorships.

LLCs have the advantage of allowing flexibility in management structure, as they can be member-managed or manager-managed. Member-managed LLCs involve all members participating in decision-making, while manager-managed LLCs appoint managers to handle daily operations. Depending on the state, an LLC may also be a single-member LLC where one person creates and performs all the operations of the company, similar to a sole proprietorship, but offers limited liability protection from the owner’s personal assets.

Consulting firms, retail stores, restaurants, real estate ventures, creative businesses, tech startups, and professional service companies are just a few examples of businesses typically created as an LLC business structure.

The formation of an LLC is different for each state, so it is important to visit your state’s website to determine the requirements when selecting this business structure. Most states do not restrict ownership, meaning that members are not limited to individuals, but may also include corporations, other LLCs, or even foreign entities. There is no maximum number of members, but as was mentioned above, most states also permit single-member LLCs with just one owner.

Depending on the member structure of an LLC, the IRS will classify the entity as either a corporation, partnership, or as disregarded entity (pass through the owners’ personal tax return). An entity with one member is usually considered a disregarded entity for tax purposes while an entity with two or more members is taxed as a partnership. An entity can elect to be taxed as a corporation if they wish to do so by filing out Form 8832.

Click here to the see Form 8832 on the IRS’s website – About Form 8832, Entity Classification Election | Internal Revenue Service (irs.gov)

Corporations are separate legal entities from their owners. Shareholders own the corporation by holding shares of stock and electing a board of directors to make major decisions. Corporations provide limited liability protection to shareholders, meaning personal assets are generally not at risk for business debts and legal claims.

Corporations have a more complex structure, requiring adherence to legal formalities, such as regular meetings and maintaining corporate records. One significant advantage of corporations is their ability to raise capital by selling shares of stock. They also allow for different classes of stock with varying voting rights and dividend preferences. Corporations are subject to double taxation, as profits are taxed at the corporate level and dividends are taxed again when distributed to shareholders.

Unlike the prior business structures, corporations must file their own tax return using Form 1120. The IRS views a corporation as a standalone business entity and must file returns as if it were a person itself. The shareholders of the corporation, on the other hand, must pay tax on the recognized gains and losses from the sale of their shares. Form 8949 is used to list the sale of each share that was sold. The subtotals on form 8949 are then carried over to Schedule D where gain or loss are be calculated in aggregate. Once Schedule D is complete, the net total of all gains and losses are then transferred to the shareholder’s individual tax return on Form 1040.

Click here to the see Form 1120 on the IRS’s website – About Form 1120, U.S. Corporation Income Tax Return | Internal Revenue Service (irs.gov)

Click here to the see Form 8949 on the IRS’s website – About Form 8949, Sales and other Dispositions of Capital Assets | Internal Revenue Service (irs.gov)

Click here to the see Schedule D on the IRS’s website – About Schedule D (Form 1040), Capital Gains and Losses | Internal Revenue Service (irs.gov)

An S corporation is a specific type of corporation that provides pass-through taxation benefits while still maintaining limited liability protection. To qualify for S corporation status, the business must meet specific criteria set by the Internal Revenue Service (IRS).

To qualify for S-corporation status, a business must meet the following criteria:

1. Domestic Entity: The business must be a domestic corporation or LLC operating in the United States.
2. Eligible Entity Types: The business can be a corporation, LLC, or certain other eligible entities, but it cannot be a partnership, a non-resident alien shareholder, or have more than 100 shareholders.
3. Shareholder Limitations: S-corporations can have a maximum of 100 shareholders, and all shareholders must be individuals, estates, certain trusts, or certain tax-exempt organizations. Non-U.S. residents, C-corporations, and most partnerships are not eligible as shareholders.
4. Single Class of Stock: S-corporations can have only one class of stock, which means all shareholders have the same rights and privileges.
5. U.S. Taxpayer Identification Number: The business must have a valid U.S. taxpayer identification number.
6. Consistent Fiscal Year: S-corporations must adopt the calendar year as their fiscal year unless they can establish a valid business purpose for a different fiscal year.
7. Shareholder Consent: All shareholders must consent to elect S-corporation status by completing and filing Form 2553 with the IRS within the designated timeframe.

In an S corporation, profits and losses pass through to shareholders’ personal tax returns, like partnerships and LLCs. However, unlike regular corporations, S corporations are not subject to double taxation.

Click here to the see Form 2553 on the IRS’s website – About Form 2553, Election by a Small Business Corporation | Internal Revenue Service (irs.gov)

Click here to the see Form 8832 on the IRS’s website – About Form 8832, Entity Classification Election | Internal Revenue Service (irs.gov)

A non-profit organization, also known as a nonprofit or not-for-profit organization, is a type of organization that operates for purposes other than generating profit. Non-profit organizations are typically dedicated to serving the public or specific charitable, educational, religious, scientific, or social causes.

Non-profit organizations are established to fulfill a specific mission or purpose that benefits the public or a particular group of individuals. This can include areas such as education, healthcare, poverty alleviation, environmental conservation, arts and culture, and more. To be eligible for tax-exempt status, non-profit organizations must meet certain requirements, such as operating exclusively for charitable, educational, religious, or other approved purposes. They must also ensure that their activities do not unduly benefit private individuals or entities.

Non-profits are typically governed by a board of directors or trustees who oversee the organization’s activities and ensure compliance with legal and ethical standards. They are also accountable to their stakeholders, donors, and the public.

Generally, fundraising efforts and charitable donations are the primary source of cash flow to support the organization’s operations and fulfill their mission. Donations made to eligible non-profits are generally tax-deductible for individual donors, subject to certain limitations and guidelines.

Non-profit organizations can apply for tax-exempt status with the Internal Revenue Service (IRS) to be recognized as exempt from federal income tax. This status is typically granted under section 501(c)(3) of the Internal Revenue Code, which is specific to charitable organizations.

Non-profit organizations are still required to file annual tax returns with the IRS, even if they are tax-exempt. Most non-profit organizations file Form 990, which provides information about the organization’s finances, activities, and governance.

In addition to federal tax requirements, non-profit organizations must comply with state and local regulations, which can vary depending on the jurisdiction. These requirements may include registration, reporting, and disclosure obligations.

It is important for non-profit organizations to understand and comply with the specific tax regulations and reporting obligations applicable to their jurisdiction and tax-exempt status. Consulting with legal and financial professionals who specialize in non-profit law is highly recommended to ensure compliance and effective governance.

Click here to the see Form 990 on the IRS’s website – About Form 990, Return of Organization Exempt from Income Tax | Internal Revenue Service (irs.gov)

Click here to the see the election requirements on the IRS’s website – Exemption Requirements – 501(c)(3) Organizations | Internal Revenue Service (irs.gov)

Selecting the right legal structure for your business is a critical decision that affects various aspects of its operations, taxation, and personal liability. Each business legal structure has its advantages and considerations, and the choice depends on factors such as the nature of the business, ownership preferences, liability concerns, and long-term goals. Consulting with legal and financial professionals is highly recommended to ensure you make an informed decision that aligns with your business goals.

Best of luck in making your business a reality!

Accounting Execs Team