If you’re asking this question with taxes in mind, you should know that the structure of your business decides how you will be taxed and how you can withdraw money from the business. It’s not just a question of ethics, it’s a legal question and you’re right to be asking it.
If you’re already in operation, you’re just going to have to learn the rules for the appropriate business structure. If you haven’t yet decided on a structure, make sure to familiarize yourself with the different types of businesses, how you are legally allowed to pay yourself because of the structure and how you will be taxed. That way you can make an informed decision and start the type of business that is best for you. The IRS website will provide you with up-to-date forms and guides appropriate to different business structures.
Sole proprietorships and partnerships are both more straightforward than Limited Liability Companies (LLC) and Corporations. However, unlike in a LLC or a corporation, you will be held personally responsible for any failings on the business’s part. That means that if you cannot pay a supplier, they will be able to come after your personal assets. LLCs and corporations on the other hand may take longer to setup, require a bigger initial investment and greater costs when it comes time to file taxes.
Your business structure decides how you can withdraw money and how you are taxed
If you’re a sole proprietor, how much money you take out of your business is entirely up to you. By definition, as the sole owner of the business, you are entitled to all profits. You are still liable for taxes and, because the government does not distinguish between you and your business, you are also liable for all business losses, liabilities and debts. The most straightforward business structure, it is also the most risky. However, if you’re just starting out, it’s a great way to test the waters and it doesn’t require the initial costs, filing requirements and paperwork that LLCs, corporations and partnerships do.
To run a sole proprietorship, you do not need to register as a sole proprietor. In fact, you may even be one without knowing it – if you are an artist or a freelance writer, designer or a consultant – if you are making money selling products or services. However, you will still need to register for the licenses and permits required of your job description by the federal government, your state and your local government. You can use the SBA’s license and permit check tool to do this. If you are planning on trading under a name other than your own – a fictitious or ‘doing business as’ (DBA) name – you can register the original name with your county clerk’s office or with your state government.
As a sole proprietor, your business is not taxed separate to you. The IRS website will list the tax forms that you need to file as a sole proprietor come March. While a sole proprietorship has the lowest tax rate of all business structures and allows you to draw directly from the business, it’s worth considering whether the risk and potential financial burden is worth it, in the event that things do not work out.
A partnership is a business in which two or more people share ownership. Like a sole proprietorship, all partners share liability. The business is not its own entity, and as such, does not pay income tax. Rather, the partners do, including listing income, losses, gains and deductions on their personal tax returns.
When you initially set up a partnership, you should work with a lawyer to develop a legal partnership agreement. This will state how you intend to divide profits, how you will dissolve the company (should the need arise), resolve disputes, change ownership and more.
In general, partners will have individual accounts that allow them to draw from and invest in the business. These are called drawing accounts and capital accounts, respectively. When a partner draws from the business, he or she reduces the overall business equity. As such, it’s important to keep records of expenses in order to reduce mistrust between partners.
There are three types of partnerships. A general partnership, in which profits and liabilities are split evenly between partners or, if partners have differing investment percentages, according to what was agreed in the initial legal partnership agreement. Limited partnerships by contrast allow partners certain partners to have limited liability, dependent upon their percentage of investment. Joint ventures are similar to general partnerships, though they are agreements formed between partners for a limited period of time or for a single project.
When it comes time to file taxes, partners will submit personal tax returns. This is because partners are not considered to be employees of the business. Rather, they are considered self-employed. Partners can also deduct business expenses such as travel and supplies from their individual tax returns.
Choosing a business structure – don’t just consider how you will pay yourself, consider your liability
Think carefully about what business structure is best suited to you. If you want to get into business quickly and easily, a sole proprietorship is one of the most straightforward routes to take. However, you will have to remember that if you default on payments or cannot pay a supplier or someone you owe, your personal assets will be at risk. If you’d prefer to go down the Limited Liability Company (LLC) route, you may incur significant setup costs, though you will not be held personally liable for the business decisions or actions of the LLC.
To find out more about Limited Liability Companies, see our LLC Guide: How Limited Liability Companies Are Taxed
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