How to Choose a Business Structure for Your Small Business

How to Choose a Business Structure for Your Small Business

by | Accounting News, News, Newsletter, Small Business

As a business owner, the business structure you choose will determine your company’s legal, financial, and operational aspects. It’s not a decision to take lightly, but also recognize that down the road you might find that shifting to a different structure makes more sense as your company evolves. In this article we’ll explore the four different types of business structures to help you make an informed decision.

Sole Proprietorship

A sole proprietorship is the simplest and most straightforward business structure, and as a sole proprietor, you have complete control over your business decisions and operations. This business structure involves no separate legal entity, so there’s minimal paperwork and administration. Additionally, income from a sole proprietorship is typically taxed at your individual tax rate, which can be advantageous in some situations.

The main disadvantage of a sole proprietorship is that you have unlimited personal liability. If your business faces financial difficulties or legal issues, your personal assets are at risk.

Partnership

When you start a business with one or more partners, you are entering into a partnership, where the workload and responsibilities are shared among partners. Most states require the partners to sign a partnership agreement to outline the distribution of profits and liabilities. Partnerships, theoretically, can bring together individuals with complementary skills and resources, making it easier to grow and manage the business. Like sole proprietors, partners report their share of business income on their individual tax returns.

Similar to sole proprietorships, general partnerships come with unlimited personal liability for business debts and legal obligations. Additionally, disagreements among partners can lead to conflicts and, in unfortunate cases, the complete dissolution of the partnership.

Limited Liability Company (LLC)

LLCs offer limited liability protection to their members, shielding personal assets from business liabilities. They also offer greater flexibility in terms of management structure and tax treatment. Members can choose to be taxed as a partnership, a corporation, or even as a sole proprietorship in some cases. Keep in mind that each state has different rules and regulations relating to LLCs, so be sure to evaluate the specific requirements in your jurisdiction.

As for disadvantages of LLCs, there is more of an administrative burden than sole proprietorships or partnerships, but the obvious tradeoff is more protection of personal assets. Additionally, LLCs cannot issue stock to raise capital, which might limit their ability to attract investors.

Corporation

This is the most complex business structure. One of the main advantages of a corporation is that it offers limited liability protection to its shareholders. This means that personal assets are generally protected from business debts and lawsuits. And unlike LLCs, corporations can raise capital by selling shares of stocks to investors, making it easier to fund business growth.

When it comes to disadvantages of corporations, know that they require a heavy load of paperwork and administrative work, which typically necessitates keeping detailed records. Additionally, it’s possible that corporations may face double taxation, where the company’s profits are taxed at the corporate level, and then shareholders are taxed on their dividends.

How to Choose the Right Business Structure

Each option has its advantages and disadvantages, and the choice should align with your specific business goals. Seek legal and financial advice to ensure you make an informed decision that sets your business on a path to success. Consider the following factors when making your choice:

  • Liability Protection: If protecting your personal assets from business liabilities is a top priority, consider forming a corporation or LLC.
  • Tax Implications: Consult with a tax professional to go over the tax implications of each business structure and choose the one that aligns with your financial goals.
  • Ownership Managements: Partnerships and corporations offer more flexibility in structuring ownership and management within your business.
  • Capital Needs: How do you plan to fund your business? If you need to raise significant capital, a corporation may be the way to go.
  • Future Growth: Corporation and LLC business structures are better suited for growth and attracting investors, though you may run into some limitations in attracting investors with LLCs.
  • Costs: Understand the costs associated with setting up and maintaining your chosen business structure, including registration fees, taxes, and ongoing administrative expenses.

 

Small Businesses Need to Be Aware of These Red Flags That Can Trigger a Tax Audit

by | Accounting News, IRS, News, Tax

In general, the likelihood of an IRS tax audit for a small business is slim, but there are various factors that can greatly increase the chances of being targeted. The IRS checks for a range of red flags to pinpoint businesses that are more likely to have discrepancies in their taxes. Read on for seven triggers that could raise your odds of an IRS audit in the future.

Multiple Net Losses

If you report net losses in more than two out of five years of operation, your chances of an audit increase. After all, the purpose of a business is to generate income. Consistent loss of income is a red flag for the IRS. Sole proprietorships are even more at risk than other small businesses due to the commingling of personal and business funds that tend to occur in these setups. The IRS may want to investigate whether your sole proprietorship is actually a business or a hobby, as business expenses are deductible while hobby expenses are not. Be sure to keep detailed records for any deductions you are legitimately entitled to.

Filing Payroll Taxes Late

If you’re aiming to fly under the IRS’ radar, regularly missing filing deadlines is not the way to do it. Aside from penalty fees, late filing can lead to scrutiny that timely filing wouldn’t invite. It’s in your best interest to get ahead of the game in order to avoid dealing with IRS headaches in the future.

Low Shareholder-Employee Salaries

It’s a common move for small business owners to structure their business as an S-Corp instead of an LLC in order to avoid the 15.3% self-employment tax. S-Corp owners must offer their shareholder employees “reasonable” compensation, which is reported as wages on a W-2. The IRS specifically keeps an eye out for S-Corps with extremely low salaries paid to shareholder employees. Double check that all shareholder-employee salaries are within the average pay range according to position, company size, industry, and profitability. It is typically the individual tax return of a shareholder-employee that flags the audit, which then generates an investigation of the company.

Excessive Deductions

Though sole proprietors run a greater risk of scrutiny from the IRS, all small-business owners should be mindful of whether every meal and travel expense truly qualify as a business deduction. According to the IRS, this means the expense is “ordinary and necessary”. Be sure to review year-over-year deductions to remain consistent.

Business Use of a Vehicle

When deducting vehicle use as a business expense, choose between the actual vehicle expense (use the appropriate calculation for this) and the IRS standard mileage rate. Choosing both will alert the IRS. If your vehicle is used solely for business purposes, you may be able to claim a deduction for the depreciation on the vehicle. However, you’ll need evidence in the form of mileage logs that record the dates and purpose of every trip you made throughout the previous year.

Cash Transactions

It is difficult to track and verify cash business deals, thus large cash transactions, such as business equipment or investment property, tend to send a red flag to the IRS. It’s best to use a credit or debit card for these transactions, but if you choose to use cash, be sure to record your transaction meticulously to create your own paper trail. You will also need to file IRS Form 8300 to report any cash payments exceeding $10,000.

Calculation Errors

Make no mistake: the IRS checks your math. When small businesses do their own taxes, it might be easier to round numbers or use averages, but this throws off the math. Be sure to work in decimal points when you report earnings and expenses. Even small blunders, such as erroneous totals for expenses, missing 1099s, or transposed numbers can attract unwarranted attention from the IRS.