Companies come in several flavors: sole proprietorship, corporation, partnership and more. The type of business entity you choose will have a huge effect both on how you pay taxes and how much tax you pay. It's wise to consider the pros and cons of each business structure before making a final decision.

Most types of business structures are what's known as pass-through entities. These businesses don't pay income tax; instead, all the money they make is passed through to the owners, who then pay individual income tax on it.

The sole exception is the C corporation, which is legally considered to be a separate entity from its owners and pays taxes itself. The biggest catch tax-wise with owning a C corp is that you end up paying taxes twice – first the corporation pays taxes on the revenue it makes, and then you pay individual taxes on whatever money you took out of the business.

On the other hand, C corps get to deduct a wide range of fringe benefits as business expenses, which helps to cut back on their tax liability. These fringe benefits include premiums on life, health and disability insurance; reimbursements for meals, transportation and moving expenses for employees; and the cost of medical expenses not covered by insurance.

C corps file Form 1120 with the IRS, and their tax returns tend to be extremely complicated. Unless you're a tax expert, don't try to prepare them yourself – get thee to a CPA or Enrolled Agent. The good news is that the fees you pay to get your business tax returns done professionally are deductible as a business expense.

The sole proprietorship is the simplest of all the business entities to set up. If you've started a business and you're the only owner, you're automatically running a sole proprietorship unless you go through the process of electing one of the other business entities.

Sole proprietors report their earnings on the form Schedule C, and unless it's a truly tiny business they have to file estimated quarterly taxes to the IRS. They also have to pay self-employment taxes on their income. Sole proprietors miss out on some of the tax breaks that owners of more complicated entities enjoy, but their tax setup is as simple as it gets for a business owner.

Businesses with more than one owner are automatically considered partnerships. Partnerships file an annual information return with the IRS (Form 1065), but like all pass-through entities they don't pay taxes themselves. The 1065 simply alerts the IRS to how much money they can expect the partners to report on their own tax returns.

Form 1065 is quite a bit more complicated than the sole proprietor's Schedule C, so if you elect this type of business you should seriously consider getting a tax professional to prepare the form for you. Like sole proprietors, partners pay self-employment taxes on all their income from the business and are generally required to pay estimated quarterly taxes.

The LLC (limited liability company) is a step up in complexity from a partnership. At a minimum, setting up an LLC requires you to file Articles of Organization with your state. Some states have steeper paperwork requirements, such as operating agreements and assorted permits, and a few states limit which types of businesses are allowed to set up LLCs (for instance, California doesn't permit certain professional partnerships, including those made up of doctors or lawyers, to become an LLC). By default, LLCs are taxed as partnerships and file Form 1065; however, you can file a request with the IRS to be taxed as an S Corporation, C Corporation or sole proprietor instead, in which case you'd use the tax forms and liability payment systems for that type of entity.

S Corporations are a type of corporation designed for small businesses. S corps are pass-through entities, so they avoid the double-taxation hit that C corps enjoy. And because S corp owners can choose to take money in the form of distributions, they can cut back on the self-employment taxes they have to pay. Mind, you can't take your entire payout as distributions; the IRS requires you to pay yourself a “reasonable” salary and you'll owe self-employment taxes on that money.

Some states don't recognize the S Corp structure and will require you to pay your state taxes as though you owned a C corp. S corps file an annual information return (Form 1120S) with the IRS, and you'll also have to pay estimated quarterly taxes.

So what's the best business structure for you?

Many business owners start out as sole proprietors and adopt a different structure once the business gets big enough to make it worthwhile (which would typically be when the business is making over $50,000 a year). This allows them to avoid the hassle and expense of setting up a more complicated structure while they wait to see if the business will turn a profit.

The LLC is often the preferred choice of a business owner who's outgrown his sole proprietorship, because it's highly flexible and somewhat simpler to set up and run than a corporation. If you're positive you'll be making more money than that right from the beginning or you have serious concerns about liability, then a more complex structure would be a good choice.

LLCs and the two types of corporation both offer some liability protection for owners – meaning that if someone sues your business or it goes bankrupt you'll have some legal protection over your personal assets.

Wendy is an Enrolled Agent and owner of Connick Financial Solutions, specializing in small business tax planning and preparation. I also write how-to information on business and finance matters.

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