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How Your Business' Legal Entity Affects Employees and Taxes

How Your Business' Legal Entity Affects Employees and Taxes

There is a lot of overwhelming information that comes at you when you’re trying to get a startup launched. One of the most stressful is how to file taxes and make sure all boxes are checked with the IRS.

As a startup, how your taxes are filed depends on what your business’ legal entity is. In this article, we will show you the most common legal entities and how that may affect how you file your taxes each year. 

What is a Legal Entity?

A “legal entity” is simply any individual, company, or organization that has legal rights and obligations. One of the main obligations it has is filing taxes. Being a legal entity allows this company or organization the right to enter into contracts as a vendor or a supplier, and it means they can sue or be sued in a court of law. 

Without a legal entity, the line between business finances and liabilities, and your personal finances and liabilities disappears. Being a legal entity provides personal protection in the event that you are sued or go into debt. Being a legal entity means you cannot be found personally liable should you be sued or you go into considerable debt. 

The Internal Revenue Service (IRS) identifies 5 different business structures for tax purposes. They are:

  • Sole proprietorship
  • Partnerships
  • Corporations
  • S Corporations
  • Limited Liability Company (LLC)

How Does Your Legal Entity Affect Taxes?

Depending on which legal entity your business is categorized as, you will have different obligations when it comes to filing your taxes. As such, your taxes should be a major deciding point when choosing which entity is best for you.

Sole Proprietorship

As a sole proprietor of your business, the good news is that your taxes are simple. In this entity, there are no separate taxes for your business, and all taxes are filed under your personal taxes. Under this type of business, you will be taxed on all of your revenue regardless of if you take a paycheck or not. You are taxed as though your business income is your personal income. 

You can also take all expenses for your business as a deduction including advertising, operating expenses, business travel, and insurance.

Partnerships

Filing taxes as a partnership is viewed as a sole proprietorship for more than one person. Prior to filing, each partner’s percentage of losses and revenues should be laid out in a general partnership agreement. After, these amounts should be reflected in each partner’s own personal tax return. The process of filing will be slightly different as well. Along with filing annual information such as income, deductions, losses, and gains, a partnership must also file this information separately on their personal income tax return using the appropriate forms. 

Corporations

Unlike sole proprietorship or partnership, a corporation is a separate legal entity, and that means that it files its own tax return separately from any personal income tax return. As a corporation, you have a different tax rate system. As the owner, you are not taxed on your corporation’s profits directly, but you are taxed on what the corporation pays you in either dividends or salary. In other words, the corporation gets taxed and you get taxed on your income. 

S Corporations

Even with the word “corporation” in the title, only certain businesses qualify as S Corporations. Most of those qualifications have to do with the size of the business. An S corporation is a combination of sole proprietorship and a corporation. While this designation gives some of the benefits of a corporation like legal liability protection, filing your taxes is as simple as sole proprietorship filing as you are being taxed on your own personal tax return. With an S corporation, you are responsible for any income taxes on your profits even if those profits are not sitting in your personal account. 

Limited Liability Companies

Finally, LLCs get to decide how the IRS looks at them from a tax standpoint. LLCs can either be treated as corporations, partnerships, or as part of the LLC owner’s individual tax return. How it’s treated by the IRS depends on how the LLC is structured. Any LLC can elect to be treated as a corporation. However, an LLC with at least two members can be seen as a partnership. An LLC with one member has their income taxes part of the owner’s personal tax return. 

If you’re trying to decide what type of legal entity you want to designate your business, looking at how it will affect you during tax time is a good place to start. 

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