Tax Guide

Get answers to all your questions about taxes, personal finance, insurance and more.

How to Structure a Startup

When starting a new business, one of the first things you’ll have to decide is what type of business you’re going to establish. Is it a corporation, an S corporation, sole proprietorship, partnership or a limited liability company (LLC)? There are important differences between them – and they all have different forms for reporting business activity to the IRS.

Sole Proprietors

Simply put, you’re a sole proprietor if you own an unincorporated business by yourself. Sole proprietors file a standard Form 1040 for their tax return, along with Schedule C – Profit and Loss from Business.

This is the simplest of all business entity types to get started. You may not have to do anything at all – you don't even need an Employer Identification Number unless you're going to have employees.

Partnerships

More than one proprietor? Now we're in the domain of partnerships, where two or more people join to conduct a trade or business. Each partner contributes money, property, labor or skill, and shares in the profits and losses of the business. Partnerships file a tax return for the business using Form 1065, Partnership Income. But the individual partners still file their own income tax return using Form 1040. That's because partnerships, along with S corporations, are pass-through entities – the income passes through to the partners or shareholders.

Corporations

The next step up the organizational ladder is the corporation. Here again, there are choices to make. And while we will cover the differences in very general terms, any decisions on whether to start a company either as a C corporation or an S corporation should involve a tax professional familiar with the territory.

Whether a C or an S, the structure is essentially the same: a separate legal entity that has limited liability and is owned by shareholders (rather than an individual). Most are governed by a board of directors, with officers managing the company.

What differentiates the two types are the tax implications. Profits from C corporations are basically taxed twice, since the corporation first pays tax on its income, then the shareholders pay income tax on the dividends from their company stock. S corporation net profits, on the other hand, are taxed only when they make it to the stockholder. As a pass-through entity, an S corporation passes corporate income, losses, deductions and credits to its shareholders for federal tax purposes.

There are limits to S corporation shareholders that make the organizational structure attractive to small business. S corporations can't have more than 100 shareholders, and the shareholders cannot be other corporations, partnerships or non-resident aliens. The company also must be based in the U.S.

Corporate income taxes are reported on Form 1120 for C corporations, and S corporations use Form 1120S.

Limited Liability Companies

Some small businesses find the best of both worlds in the limited liability company or LLC. An LLC has the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Unlike the other business structures, an LLC's structure depends on the state where it’s based. Each state could have different regulations, so check with your state if you're considering an LLC.

Owners of an LLC are called members; there’s no maximum number of members, and most states permit “single-member” LLCs, which have only one owner. Generally, a few types of businesses cannot be LLCs, such as banks and insurance companies, depending on the state.

Tax-wise, the IRS will treat an LLC as either a corporation, a partnership, or as part of the LLC’s owner’s tax return (called a “disregarded entity”). A domestic LLC with at least two members is classified as a partnership for federal income tax purposes, unless it opts to be treated as a corporation. And an LLC with only one member is treated as an entity and is regarded as separate from its owner for tax purposes, unless it chooses to be treated as a corporation.

For a more detailed look, check out what the IRS has to say about business structures, and IRS Publication 334, Tax Guide for Small Business.