Business Structures and Their Tax Implications

American businesses are the driving force behind the capitalistic economy of the United States. They are agents of both profit and purveyance, competing for consumer money and directing their revenues back into the economy from which it originated in the forms of labor and overhead. The movement of money in and out of businesses is crucial to their solvency. Consequently, so are the ways in which the U.S. government regulates and taxes American business incomes.

You may hear terms like “501(c)(3)” and “LLC” thrown around here and there and not know exactly what they mean. Let’s take a look at the process of and ways in which U.S. businesses can set themselves up as legal entities and how that process leads to a specific tax designation.

Incorporation: Not a Necessary Step

The first choice in associating a business with the federal government isn’t actually choosing a type of legal entity to become. Surprisingly, there is a much more basic question to ask: “do I want to incorporate at all?” 

Businesses in the US actually don’t have to register for a corporate status in order to comply with tax laws. The implication of running a sole proprietorship or partnership is that it puts any and all benefits and liabilities in the hands of the owner(s). Think about this as your typical “mom-and-pop” setup. They pay taxes only on their business income. But if somebody sues them, they can personally be held liable for any and all damages.

Yes, unincorporated businesses still have to pay Uncle Sam in the form of personal income tax. But this can be cost-effective because owners can rack up tax deductions by claiming business losses as personal expenses. However, the downsides of remaining unincorporated as an expanding business far outweigh the benefits in many cases: no deferring of taxes or corporate tax benefits, the inability to issue securities, and infinite personal liability to the owners.

The general idea is that as businesses move away from sole proprietorships and towards traditional incorporation, individual liability shrinks. Subsequently, the amount of regulation placed on the corporation and its owners — which expands to include shareholders — increases. Typically, this has the effect of making a business more immune to the will of a single owner, as well as treating the corporation like an entity separate from its employees.

Becoming a Small Business — or Creating Cascading Liability

Most incorporated small businesses in the U.S. originate from limited-liability frameworks. These can take a few legally-defined forms. Limited liability companies (LLCs) allow owners to set how much liability they are personally willing to take on, hence their name. There are a few interesting features of LLCs that position them to bridge the gap between partnerships and corporations. 

The advantages of setting up an LLC include limited liability to the owners, the option to either pay federal corporate tax or tax profits through owners’ personal tax statements, and the use of formal articles of organization that legally bind company practices, membership, owner powers, and the like to partners. LLCs can have ownership stake in other LLCs (when formally organized, these “chained” LLCs are called series LLCs), which creates defined cascades of liability.

As an extreme of this idea, holding companies are entities that usually don’t produce a service or good. Rather, they have purchased a controlling stake in what’s called an operating company. This is a legal entity that executes day-to-day business but does not hold its assets. Such a setup is most common in real estate (called a propco/opco arrangement) and helps insure the operating company from credit issues should they arise.

But wait, there’s more! If your goal isn’t to hire out external labor to manage your company, an LLP — limited liability partnership — might do the job for you. In an LLP, managing partners can be designated (who are designated the most liability of all partners), and similarly, partners can delineate how much liability they are willing to take while insuring themselves from the liabilities of other partners. Basically, this structure is less rigid when it comes to partnership status and liability and more defined with regards to who, or what, can be a partner.

Nobody Wants to Pay Taxes!

Depending on the mission of a business, it can be clearly in their best interest to apply for not-for-profit status under section 501(c)(3) of the IRS tax code. That status enables an organization to generate revenue but not pay corporate tax on it. But, the said organization must demonstrate that it operates to fulfill some kind of social need and/or intent to have a positive impact on a community. Similarly, the organization/business’s main motivation must not be to make a profit. Instead, its motivation should come from its mission.

Laws governing 501(c)(3) organizations are very well-defined, so some groups decide not to incorporate and dodge the filing fees and paperwork associated with becoming a legally-recognized nonprofit. While this is perfectly okay to do, there are time limits on how long an unincorporated non-profit can operate to fulfill its goal. This status (or lack thereof) is most useful for short-term action groups, like fundraising campaigns.

Making a Profit and Getting Tax Benefits Too

Have an itch to make a social change, but want to make a business venture out of it? Mixed-status corporations are able to benefit from having a socially-driven mission but are also allowed to pursue profit as a motive. Prominent examples of these balanced-benefit corporations are B corps., Flexible Purpose Corps (FPCs or SPCs — “social”; a special case from California), and low-profit LLCs.

The first item must provide a stated benefit to its workers, the environment, and/or a community, to give a few examples. The latter two aim to minimize the motive of profit and maximize its social benefit(s) as much as possible. FPCs/SPCs, however, are more targeted towards for-profit institutions that want to make a responsible business venture. This offers flexibility in determining both a profit motive and how that FPC measures its performance. 

Low-profit LLCs, or L3Cs, are very similar to FPCs and B corps., but their intent is to more easily facilitate philanthropic and private donations. L3Cs and FPCs follow the definition of a “program-related investment” (PRI), and neither are exempt from normal corporate taxes by the 501(c)(3) code. The IRS specifically defines PRIs. They often must fulfill that definition in order for an L3C to maintain its mixed status. Therein is a great example of the key to what makes mixed corporations different from non-profit and regular ones: their mission and requirement to fulfill certain fiduciary and social obligations.

Statuses for the Basic Corporation

For businesses with a traditional corporate structure and mainly for-profit motive, the C corp. designation is the standard. It’s a moniker that classifies any corporation that pays corporate income taxes separate from its owners. Typical examples of these corporations appear in abundance as stocks because the public can trade them.

Before 2018, corporate tax rates ranged from 15% of income up to roughly 35% for corporations with $18+ million in income. As a result of the 2017 Tax Cuts and Jobs Act, C corps. now pay a flat rate of 21%, regardless of their taxable income. Read about the impact of this controversial bill here.

There are ways to combine the for-profit motive and size benefits of a C corp. with the partnership aspects of an LLC. S corporations are a subset of C corporations. Their main difference is that they exist to serve a small number of shareholders — typically up to 100. Any profits the S corp. makes don’t get corporate tax. Instead, its shareholders pay personal income tax on a pro-rata (per share) basis because corporate profits pass directly onto them. If this sounds a lot like an LLC to you, you have the right idea, because LLCs can get the same taxes as S corps.

This type of corporation has a lot of restrictions. Shareholders must be U.S. residents and must be individuals or certain 501(c)(3)s, trusts, or estates. The corp. can only issue one class (link) of stock (i.e. all common or all preferred) and certain dividend deductions are not available. At the end of the day, this status is most appealing for the way it avoids “double taxation” — paying both corporate tax and personal income tax — for shareholders.

Special Case One: Trusts

The federal government (in particular, the IRS) restricts what kind of organizations can receive benefits by claiming certain tax statuses. Personal trusts, for example, are funds made up of assets and set up by a trustor and overseen by a custodian — typically a wealth management firm. Both revocable (changeable within the trustor’s lifetime) and irrevocable (unchangeable) trusts pay capital gains tax on the income they distribute to their beneficiaries. If the income on the trust is made and not distributed, the tax on that income will replace income tax on the beneficiary later. 

Essentially, your deceased great-grandfather can’t hand you a check through a trust without the IRS taking a chunk out of it unless the principal value of the trust is declining. Even trusts that designate non-profits as beneficiaries compel the non-profits to pay taxes on distributions.

Special Case Two: Certain “Charitable” Groups

If you decide to donate money to a charitable organization, you can often claim a tax deduction on your personal income forms (read the rules here). The term “charitable organization” is often used interchangeably with “non-profit” because they are defined as 501(c)-categorized institutions. However, while 501(c)(3)s allow you to take tax deductions from your donations, 501(c)(4) organizations, for example, do not. By definition, a 501(c)(4) organization is for a social welfare cause. This can include neighborhood associations, civic advocacy groups, and organizations participating in political affairs to a certain extent.

The tax code becomes rather ambiguous when it comes to “political education groups,” which falls under the definition of a 501(c)(4) organization. To achieve not-for-profit status, such a group can participate in political lobbying, endorsing or opposing public officials, and campaigning, but must not make these kinds of activities a focus (more than 50%) of their total operations. The group must pay income tax on funds used for any campaigning or lobbying purposes. 

Note that a 501(c)(3) organization can do none of these things unless the action is nonpartisan, nonspecific, and nonpolitical. The National Center for Responsive Philanthropy provides many examples of and more information about 501(c)(4)s.

In total, there are 29 distinct 501(c) designations. Some of them are oddly specific, but they all serve to help organizations with a charitable cause carry out their mission. You can find the definitions of all 29 here.

Choosing a Tax Status: More Complicated Than It Looks

To wrap this mess of information up, there are many different ways that business owners can pay the federal government. The options can be broad or limited based on the scope of a particular business. Generally, the bigger an organization is, the more it should attempt to use the IRS’s tax laws to its advantage. Retrenching a business or fund through the use of not-for-profit statuses, a trust, or a holding company can save that entity significant amounts of money in tax benefits, deductions, and more. 

It’s always worth discussing your options with an experienced accountant who you know you can trust and who has your goals in mind. Not all corporate structures are available in every state. It’s crucial to be wary of how the rules may change for an FPC, L3C, or other designation across borders.