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Business entities and tax obligations

Tax Day is behind us, but the recent tax scramble serves as an opportunity to discuss the tax obligations of businesses. The type of business structure directly impacts tax obligations. Entrepreneurs that are considering choosing a business structure are wise to review the tax implications of each option before moving forward.

How much of an impact can business entity choice have on tax obligations? A recent report finds that this can result in a difference of 10 to 40%.

What is the right business formation for my endeavor? The right business structure will depend on the details of operation, assets, ownership and other particularfs. Some common examples include:

  • LLC: A limited liability company offers flexibility when it comes to tax structure. The Internal Revenue Service (IRS) views an LLC as a legal structure, but not as a tax structure. As a result, an LLC can be treated as a sole proprietorship, an S corporation, a C corporation or a partnership for income tax purposes. Except in the case of a C corporation election, an LLC will not pay federal income taxes and is considered a pass-through tax structure.
  • Partnership: An entity taxed as a partnership for income tax purposes might be formed as an LLC or a limited partnership under state laws.  Partnerships are pass-through entities with somewhat different tax treatment from S corporations. 
  • S Corp: As a pass-through entity, there can be tax benefits to an S corporation. Business profits flow through to the owners who then pay all tax obligations on their respective returns. One significant restriction is that the number and type of owners of an S corporation are limited.This can severely limit the ability of S corporations to raise equity capital.
  • C Corp: The passage of the Tax Cuts and Jobs Act reduced the corporate tax rate making this a more favorable option than in the past and many business owners who are able to leave profits in the business are opting for this structure. Another potential tax benefit is the potential for stock to qualify as QSBS (qualified small business stock) which can result in significant exclusions of capital gain.

How should business owners decide which form of entity is best? Tax considerations play a significant role in your choice of entity type. These include not only federal income tax concerns, a few of which are outlined above, but also many other types of tax that may apply.  You should consult with an experienced law firm about your particular business and its structure and goals to determine the optimal choice for your situation.

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