Are you thinking of starting your own business or buying an existing one? The first thing that you need to look at is its structure. This is because choosing the right structure will have a major impact on your estate planning as well as your personal taxes.
Today, we’re going to look at three of the most common business structures along with their tax implications.
If you are just starting your business or have a small enterprise, then setting yourself up as a sole proprietorship can be a good option. This is the simplest form of a business organization and it is also inexpensive to set up.
A sole proprietorship lets you get all of the profits and allows you to have full control over your organization.
Remember, in this structure you are legally responsible for the obligations and debts of the business. This means that both your business and your personal assets could be claimed by creditors. This is referred to as “unlimited liability”.
Tax Implications of a Sole Proprietor
- You need to file a personal tax return showing the income or losses from your business to report your business income.
- Since your business income is taxed as personal income, you won’t have many options available for tax planning.
- On the plus side, you might be able to deduct your business losses from your other income sources.
Partnerships are also inexpensive and easy to set up. The main advantage of having a partner is that they bring additional resources and expertise into the venture. It also means that there is a division of authority in this structure which might create a possibility of friction between the partners.
A written partnership agreement is a good solution to minimize any friction. It states the terms of the business, protects the interests of the individual partners in case of a disagreement and defines how the partners will share the profits.
It’s also possible that your partner’s decisions might be legally binding on you, so it’s important to discuss both legal and tax implications with your professional advisor before investing in a partnership.
Tax Implications of a Partnership
- A partnership is not a taxable entity.
- So instead of the partnership paying the tax, its income or losses are directed towards the individual partners.
- These partners then have to report their share of income or losses in their personal tax returns.
A corporation is a very popular business structure and has the following advantages.
- It is a separate legal entity.
- It offers greater business continuity as its shares can be sold or bought without affecting business operations.
- Corporations can easily attract specialized management expertise.
- It is also easy to raise investments for a corporation.
- As an owner-manager who holds a share in the corporation, your liability will be limited to your shareholding. In this way your personal assets are protected from the corporation’s creditors (unless you’ve provided personal guarantees for loans to the corporation).
Corporations are closely regulated so it is important to get professional advice before acquiring or setting up a corporation.
Tax Planning Benefits for a Corporation
As an owner-manager, you can benefit from the following tax planning opportunities available to your corporation.
- By incorporating you might have the opportunity to split income and reduce taxes by paying dividends to adult family shareholders in certain situations.
- If your business qualifies as a Qualified Small Business Corporation (QSBC) then all or portion of any gain realized on the sale of shares could be sheltered from personal taxation using the capital gains exemption.
- The small business deduction can provide possible tax-deferral opportunities and a reduced corporate tax on active business income up to the small business limit that is retained in the corporation. Remember, there are various rules that reduce the corporation’s ability to claim the small business deduction.
- Adding other family members as common shareholders directly or through a family trust (called an “estate freeze”) can allow you to transfer future tax liability to on the growth of the company to lower-income family members and multiply the use of capital gains exemption on the sale of QSBC shares.
The table given below provides an overview of the various benefits and drawbacks of each business structure.