Legal vs tax structure for small business | DiMercurio Advisors

Business structure can be complex. Here’s how we like to think about it.

When you’re starting a business, there’s a million things to consider. You’ve got to define your business idea, research your market and competitors, find a location … but what about business structure? Once you set your business structure, it’s difficult if not impossible to change it, so this is one area where you don’t want to make a mistake.

There are two main components to business structure: legal structure and tax structure. We’ll walk you through what that all means, and what we usually recommend.

Quick look

Some legal structures – LLCs and corporations – can choose from multiple tax structure options. There's a lot of details to remember, so check out this chart for a convenient reference.

*On your portion of taxable income
**But owners can take "guaranteed Payments" which are pretty close

Business structure

Legal structure

Businesses are subject to an intricate legal system and the legal structure of your business determines how you navigate that system.

• Sole proprietorship: Business owned by a single person without any legal distinction between owner and business. Not even a business structure at all, really – if you have a side gig, freelance work, or just start selling a product or “doing something” you’re technically the owner of a sole proprietorship, no paperwork required. Lack of structure means lack of legal protection, which is why we don’t ever recommend this.
• Limited Liability Company (LLC): Establishes a separate business entity that shields owners and investors from some level of liability but is more flexible than full incorporation. Usually recommended for small businesses and larger businesses alike.
• Corporation (Inc.): Stricter rules than an LLC but may afford some legal advantages for large companies or certain startups.

Tax structure

Not every business pays taxes in the same way. Different tax structures determine how you file tax returns and who pays income tax on what. The four main types of tax structure are as follows:

• Sole proprietorship (filed on Schedule C of your personal Form 1040)
• Partnership (filed on Form 1065)
• S-corp (filed on Form 1120-S)
• C-corp (filed on Form 1120)

Why LLCs?

Limited Liability Companies (or LLCs) impart a combination of liability protection and tax flexibility that makes them the usual recommendation for most small to medium businesses. This legal structure creates a distinct entity for your business that leaves your personal assets less vulnerable to lawsuits and debt. Crucially, it also leaves you free to choose what works best from a variety of tax structures. With an LLC, you and your CPA have maximum flexibility during the first year of operation to make important decisions about the future of your business. An LLC must create an operating agreement that defines how it will be managed and file annual reports with the state.

Sole proprietorship (1040)

If you are the only owner of the business, you can elect to file as a sole proprietor, meaning that your business financials go on your personal Form 1040 tax returns using a supplementary form called Schedule C. This is also called a disregarded entity, or a Single-Member LLC (SMLLC).

Under this tax structure, instead of the business paying its income taxes, it’s just added to your own personal income tax. There’s no additional corporate income tax. You’re also not required to pay yourself a salary.  However, the total profits of the business are subject to self-employment tax in addition to your personal income tax.

Dividends and distributions are typically tax free.

Partnership (1065)

If your business has two or more owners it will automatically be considered a partnership and will file Form 1065. Unlike in a Single Member LLC, this isn’t added to your personal tax returns. Form 1065 is a separate document prepared for the business entity itself.

You aren't allowed to pay yourself a salary in a partnership. However, you can pay yourself with a guaranteed payment. It's almost the same thing as a salary, but instead of going through payroll taxes, the business just writes you a check for the entire amount. You still pay taxes on those guaranteed payments, it just goes on your personal tax return as self-employment tax and income tax. In addition, you are required to pay self-employment taxes and income taxes on any profits allocated to you from the partnership.

Once again, dividends and distributions will typically be tax free.

S-corp (1120-S)

The S corporation, usually referred to as an “S-corp,” is an option for your business up to a limit of 100 shareholders. All shareholders must be individuals who reside in the US (or certain eligible organizations or trusts), and stock can only be differentiated by voting or nonvoting.

S-corp LLCs file a separate tax return for the business using Form 1120-S, but the business itself does not pay income tax. Instead, you pay income tax on your individual portion of the taxable income. But unlike the previous tax elections, you’re required to pay yourself a “reasonable” salary.

Dividends and distributions are typically tax free to owners.

C-corp (1120)

The C corporation, better known as “C-corp,” is the only tax election available for LLCs that taxes the entity itself separately from the owners or shareholders. C-corps can have one or more owners, and file tax returns under Form 1120.

Unlike the other tax structures we’ve discussed, the C-corp will pay corporate income taxes on its revenue, and dividends and distributions will be taxed (usually at preferential tax rates) to the owners as well. There’s no salary requirement for owners or shareholders.

Other considerations

What about Inc?

Full incorporation (the kind that puts an “Inc” at the end of the name) tends to make sense at large scale, but we don’t usually recommend it for small business owners. You can choose to incorporate as a C-corp or an S-corp, and if you’ve got a lot of private equity investors, or plan on growing in the future – like a tech startup – this could make sense, as this entity structure offers some unique tax benefits (chat with your CPA on this!).

What state should I register in?

Non-LLC sole proprietorships don’t have to register at all, but LLCs and corporations do. There’s no clever tricks here: the business should be established in whatever state you’re headquartered in.  You might also need to register in other states if you have employees there, you travel there often, you open another office there, or you have a significant amount of revenue coming from there. It’s complicated stuff – with legal consequences – so make sure to talk to an attorney on this one.

What about the Delaware thing?

Contrary to popular belief, there are no tax advantages gained by incorporating your business in Delaware. The reason huge megacorporations do that is because Delaware courts are business-friendly, but most businesses don’t get sued enough for that to be necessary. Registering in Delaware could also have some adverse financial consequences as Delaware has significantly higher state filing fees (dubbed the “Franchise Tax Return”, though it’s not an actual income tax return). If you’re curious, talk to your attorney about it. 

Bottom line

Though they’re certainly interconnected, understanding the distinction between the legal structure and tax structure of your business will help you make the right choices.

Your legal structure will determine what taxation options are available, and that’s why the LLC is such a strong option. It provides the legal protections you’re looking for and allows you to choose whatever tax election is best for your situation.

To learn more about how you can structure your business, schedule a call with one of the tax experts at DiMercurio Advisors.