When starting or managing a business, it’s crucial to understand the difference between legal structures and tax structures. These two concepts are connected, but they have different purposes. They also affect your business's liabilities, taxes, and compliance obligations in unique ways.
Legal Structures vs. Tax Structures: What’s the Difference?
A legal structure organizes your business and defines its recognition by the state, which affects liability, ownership, and operations. A tax structure dictates how the government taxes your business income at the federal and state levels. It’s important to note that a legal structure is chosen when forming your business, but tax structures can sometimes be elected later.
Understanding Legal Structures
Your business’s legal structure impacts personal liability, tax treatment, and compliance requirements. The most common legal structures include:
- Sole Proprietorship – The simplest structure, where the business and owner are legally the same entity. The owner has unlimited liability.
- Limited Liability Company (LLC Single or Multi-member) – Provides liability protection while allowing for flexible tax treatment.
- Corporation (C-corp) – Corporations are separate legal entities, offering strong liability protection but more regulatory requirements.
Key Aspects of Legal Structures:
- Filing with the State: All business entities must be registered with the state.
- Liability Protection: Corporations and LLCs create a legal divide between owners and their business. This keeps personal assets safe from business debts and lawsuits.
Understanding Tax Structures
A business’s tax structure determines how income is reported and taxed. Common tax structures include:
- Sole Proprietorship (Schedule C) – Income is reported on the owner’s personal tax return, subject to both federal/state income taxes and self-employment taxes (Social Security & Medicare).
- Partnership (Form 1065 & K-1s) – use pass-through taxation, allowing owners to report profits on their personal tax returns.
- S-Corporation (Form 1120-S) – A tax classification that allows owners to pay themselves a salary, reducing self-employment taxes.
- C-Corporation (Form 1120) – Profits are taxed at the corporate level. Dividends are taxed again on the personal level.
Schedule C vs. S-Corporation
Many small business owners start as sole proprietors and file a Schedule C with their personal tax return. However, as businesses grow, electing an S-corporation tax structure can offer significant tax benefits.
Schedule C Taxation:
- Subject to both federal/state income taxes and self-employment tax (Social Security & Medicare).
S-Corporation Taxation:
- Owners pay themselves a reasonable salary.
- The remaining business profits are subject only to federal and state income taxes.
Important Note: An S-corp is strictly a tax election and does not provide legal protection on its own. You must already have an LLC or corporation to elect S-corp status.
How to Choose the Right Structure for Your Business
Choosing the right structure depends on several factors, including liability protection, tax benefits, and business goals. Here’s how to decide:
- Consult an Attorney – Talk to an attorney within your state for advice on legal structures.
- Consult a Tax Professional – A tax advisor or accountant can’t provide legal advice but can give personalized guidance based on your income and business operations. When setting up a business, both need to be consulted for legal protection and tax planning.
How to Change Your Tax Structure
To change your tax structure, here’s what you need to know:
- The way you originally filed your business with the state determines your default tax structure.
- Aside from your default tax structure, you may only elect S-corp status.
- To elect S-corp status, you must file Form 2553 with the IRS within 75 days of the start of your tax year (March 15th for most entities) for it to apply to the current tax year.
Final Thoughts
Understanding legal structures and tax structures is essential for making informed business decisions. Choosing the right structure helps you protect your assets. It can also reduce your tax burden. If you’re unsure, consulting both a tax and legal professional is the best way to navigate these choices effectively.
Need help managing your tax structure or electing an S-Corp? Contact LedgerFi today to learn more about the best tax setup for your business growth!
