The new year brings with it a sense of reflection and a look toward things we want to accomplish in the new year. It’s also a great time to take stock in personal and professional business interests whether you have an existing business operation or plan to start a new business. The structure of your business is just as important as the employees you hire, the product or service you provide, and the connection with your local community. Your business structure provides the legal platform that defines the operation, provides for a tax structure, and determines the level of liability protection or exposure to you personally and to your business.
There are many options when it comes to business ownership. It is necessary to have a deep understanding of your business and goals and weigh those with the different types of business structures required to meet those goals. The most common ownership structures include the following:
– Sole Proprietor
– LLC (limited liability company) – Corporation
There are other variations of the above, and each state has its own laws regarding the types and requirements for legal business structures. Each state has its own business registration process, typically through the Secretary of State. For purposes of this discussion, I am examining some of the most common business structures.
There is often confusion between a business’s legal entity and structure and the IRS’s tax structure. The IRS’s most common tax structures for businesses are as follows. (This is not tax advice. There are many business tax intricacies, and you should contact a qualified CPA or tax advisor for any tax advice.)
– Disregarded Entity – Partnership
The tax structure and the business legal structure can be the same, but these may also be two different distinctions. It is important to note the differences. For example, I work with many professionals who frequently refer to a business’s tax structure rather than the business’s legal structure which can be confusing for some business owners.
A sole proprietor is a business owned by a single individual and is taxed by the IRS as a disregarded entity where the individual owner is responsible for all tax liability. From a liability perspective, there is no legal distinction between the business or individual. If the business gets sued, there is no liability protection for the owner. The individual owner is personally liable for any business liability such as debts, lawsuits, taxes, etc. Any and all liability of the business is borne entirely by the individual business owner.
A partnership is made of two or more people who are doing business together. A general partnership has the same liability risk as a sole proprietorship. The partners typically have no liability protection and are personally liable for any business liability such as debts, lawsuits, taxes, etc. Many states have variations of partnerships that may or may not offer some varying degrees of liability protection; however, it is important to know your state’s specific rules so that you fully understand your liability risk.
LLCs are the most often misunderstood business structure because the IRS does not recognize a specific LLC tax structure. Wyoming invented the LLC business structure to provide liability protection for business owners but at the same time, offering an alternative to the corporate structure. LLC owners are called “members” rather than shareholders (as in a corporation). All states now recognize some form of LLC, but each state has specific state laws and rules governing LLC formation and management that must be followed in order to shield individual owners from liability. Liability protection and business flexibility are the most often cited reason for business owners to choose the LLC business structure. The IRS allows the LLC owner to choose the tax structure. The default tax structure is a disregarded entity for single-member LLCs or a partnership for two or more members. LLCs may also elect to be taxed as an S-Corporation or C-Corporation. It is recommended that CPAs or tax advisors work with the LLC to determine the appropriate tax structure.
Corporations are one of the oldest forms of business structures in the U.S. and date back to the 1800s. Modern corporations are state specific with shareholders owning shares of the corporation. A board of directors and officers are elected by the shareholders to manage the business of the corporation. States have laws regarding business formalities that must be followed in order to maintain liability protection.
The IRS allows corporations to choose whether to be taxed as an S-Corporation or C-Corporation. Again, it is recommended that CPAs or tax advisors work with the LLC to determine the appropriate tax structure.
If you are starting a new business it is important to consider all the options to make sure the business structure meets your needs and goals. If you are an existing business owner, it is important to evaluate your business to make sure the current structure is still meeting the business’ needs and goals. As businesses grow and change, sometimes a business needs to be reorganized or modified to make sure the structure can facilitate growth and changes over time.
Regardless of your business situation, it is important to consult your attorney and tax advisor for appropriate advice and recommendations. The New Year is a fantastic time to get those businesses lined out.
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