Let’s be honest: You probably want to spend your time focusing on your passion. That’s what makes your business your business, but before you dive in too deeply, it’s important to think about how your business is actually structured. Choosing a business structure that works with your company is crucial to your long-term success. It will determine how you pay taxes (and how much you pay) along with who’s in charge, who’s liable in the event of an unfortunate circumstance and so much more.
The right business structure will adequately protect your personal assets, give you the best possible tax benefits and allow your company to grow beyond your wildest dreams.
About Sole Proprietorships
Sole proprietorships are the simplest type of business structure, which is why it’s extremely popular among small-business owners who run their businesses by themselves. For example, a freelance writer, piano teacher or someone selling goods on eBay or Etsy are excellent candidates for sole proprietorships. Even teens working as babysitters or tutors qualify as sole proprietors. This type of legal business entity is extra simple come tax time because business profits and expenses are run through the owner’s personal tax return.
Pros and Cons of Sole Proprietorships
The real draw to a sole proprietorship is that it’s easy. You don’t have to keep certain records, you can sign up with the IRS in less than five minutes and there are no special records you need to keep beyond business expenses and business income. Though sole proprietorships can have employees and hire contractors, you’ll only need to add a Schedule C, a Form 1050 and a Schedule SE to your personal tax return if you’re truly working alone.
Unfortunately, sole proprietorships can make growing as a company a bit difficult. It's notoriously hard to raise money because you can’t sell stock, and banks are hesitant to give loans to this type of business entity because they’re often seen as less credible. Assuming you don’t need funding, the main issue with a sole proprietorship is that you have no personal liability protection. If your business goes under or someone sues your company, your personal assets, like your car, house and personal savings, will be at risk.
How Do You Form a Sole Proprietorship?
You don’t really need to do anything if you want to own a sole proprietorship. You can use your Social Security number to file your income taxes, but for identity protection, you should probably get an employer identification number from the IRS. You can do this via the IRS website. If you plan to use a name other than your own for your business, you’ll also want to register for a DBA or “doing business as” via the IRS website.
Depending on the industry, sole proprietorships may require licensing and permits, so check with your secretary of state’s office before you begin.
Partnerships are similar to sole proprietorships, but they involve two or more people who share the business’s profits or losses. This is popular for any type of business with more than one owner. For example, two friends launching a brick-and-mortar retail store are excellent candidates for a partnership, and so are two songwriters performing together in a band or two pastry chefs starting a cupcake business.
Pros and Cons of Partnerships
Partnerships are popular because they’re so flexible. The way profits and losses are divided is dictated by whatever you choose to put in your partnership agreement, and typically, there’s not even any specific partnership tax. There are three types of partnerships that assume different levels of risk for the partners:
- General partnerships, where all parties are equally liable and equally involved unless otherwise noted in the partnership agreement
- Limited partnerships, where some partners have investor-only roles and are not involved in the day-to-day business
- Joint ventures, which are the same as a general partnership but for a limited amount of time — for example, teaming up with another person on a one-time project
Unfortunately, partnerships are also “pass-through” business entities, which means income and losses are passed through to the partners’ personal income tax. This means the partners do not have personal liability protection, and their personal assets are at risk in the event of unpaid debts, bankruptcy or lawsuits. They are also responsible for paying a self-employment tax, which is the employer's share of Social Security and Medicare taxes.
How Do You Form a Partnership?
Other than acquiring an EIN from the IRS, you don’t need to do anything special to register your partnership. However, you should write up an operating agreement that outlines each partner’s specific responsibilities and liabilities to prevent issues down the road. If you plan to use a name other than the names of the partners, file a DBA through the IRS website.
Like a sole proprietorship, some states and industries may require licenses and permits, so check with the secretary of state’s office beforehand.
About Limited Liability Corporations
Limited liability corporations are among the most popular types of business structures for small businesses. You’ll see it used for everything from grocery stores and hair salons to HVAC businesses, rock bands and restaurants. It’s essentially seen as the best of both worlds between a corporation and sole proprietorship or partnership because it offers favorable tax treatment and liability protection.
Pros and Cons of LLCs
The main draw of an LLC is the liability protection. Unlike a sole proprietorship or partnership, the owners of an LLC do not put their personal assets at risk in the event of unpaid debts, bankruptcy or lawsuits as long as the finances are properly managed. LLCs are also “pass-through” tax entities, so you’re only taxed on your share of the profits and don’t have to first pay corporate tax rates.
The downside of an LLC is that it does require maintenance. You’ll have to pay an initial fee to register and then renew your LLC every year. LLCs cannot sell shares of stock to investors or have an IPO, but you can always start your new business as an LLC and change the structure down the line.
How Do You Form an LLC?
You can form an LLC with one or many people, but you’ll have to:
- Choose a business name that isn’t already taken.
- File articles of organization with the secretary of state’s office.
- Pay a filing fee, typically between $30 and $200.
- Create an operating agreement (which is sometimes required by law).
- Obtain any licenses or permits necessary in your state.
- Get a federal EIN from the IRS.
You’ll also need to follow certain laws to dissolve your LLC if you no longer wish to do business.
About S Corporations
An S corporation isn't exactly a type of legal business entity. Rather, it’s a designation that shows how a business wants to be taxed under the Internal Revenue Code. With this type of business, profits are taxed on a shareholder's personal tax return, and the shareholders have limited liability.
Pros and Cons of S Corporations
S corporations are popular because they allow for growth and offer personal liability protection to shareholders. They also aren’t subject to double taxation. Owners of traditional corporations are taxed twice on profits: They first pay a corporate tax on profits and then pay income taxes on dividends they have as a shareholder. S corps don’t have dividends, and owners are only taxed on business profits once.
In addition, owners of S corps give themselves a salary, which means they only have to pay Medicare and Social Security taxes on that salary instead of all business profits, like an LLC or sole proprietorship. S corporations can only have up to 100 shareholders and cannot involve foreign members, so growth is limited.
How Do You Form an S Corporation?
Deadlines and specific registration laws vary from state to state, so you’ll need to check with your secretary of state’s office before forming an S corporation. Generally, you’ll need to submit IRS Form 2553, Election by a Small Business Corporation, which is signed by all shareholders.
You’ll also have to follow all state corporation laws, which typically include things like choosing a business name, drafting your articles of incorporation, creating corporate bylaws, appointing directors, holding meetings with the board and issuing stock.
About C Corporations
C corporations are the most common type of corporation, and it’s a structure that’s generally used by the largest businesses in America. For example, Exxon Mobil, Intel and Walmart are all C corps. This is also a popular business structure for startups that are hoping to have an IPO or raise large amounts of capital. Unlike an LLC, C corps are viewed as stand-alone tax entities that can take their own deductions.
Pros and Cons of C Corporations
C corps are generally viewed as the type of business structure with the most personal liability protection because they’re viewed as separate entities from their owners. They also allow for major growth because C corps can have more than 100 shareholders. Almost 100% of publicly traded companies use this type of business structure, though many businesses prefer to start out as an S corp and switch to a C corp once they start turning a profit.
C corps attract venture capitalists and investors seeking equity, but this large opportunity for growth comes at a cost. There are strict laws dictating how a C corp must be governed, and they’re subject to double taxation. First, profits are taxed at a corporate level, and then, shareholders are taxed on the dividends they receive. It’s also a heck of a lot of paperwork and pretty complicated when it comes to tax time (i.e., your accountant fees will be significant, but at least it's a business expense).
How Do You Form a C Corporation?
In the case of filing a C corp, it’s probably best to get some help. There are websites like LegalZoom and BizFilings that offer this service, but it’s advisable to hire a business attorney or a CPA. To become a C corp, you’ll have to:
- Register your business name
- File your articles of incorporation (likely with the secretary of state’s office)
- Get an EIN from the IRS
- Draft corporate bylaws
- Choose a board of directors
- Hold a board meeting
What About Benefit Corporations?
If your business has a social mission, you can opt to register as a B corp (or “benefit corporation”) rather than a C corp. They’re essentially the same thing with the same processes, but B corps sometimes carry additional tax breaks. This is not to be confused with a nonprofit because B corps are still for-profit businesses.
About Nonprofit Corporations
If you’re in the business of doing good, you may want to register your business as a nonprofit. Nonprofits encompass a wide range of businesses, from charities and religious organizations to community clubs and political organizations. This is one of the few types of business structures that receives a federal tax-exempt status with the IRS.
Pros and Cons of Nonprofits
The main draws of a nonprofit are the federal tax-exempt status and the fact that you’re helping your community in some way. The latter is quite meaningful and almost certainly makes up for the fact that running a nonprofit can quickly spiral into a paperwork nightmare.
You can also risk losing your nonprofit status if you make too much money from unrelated income, and you won’t ever personally see the benefits of a particularly great year of growth. Profits must be reinvested back into the business or put toward the nonprofit’s cause in some way.
How Do I Form a Nonprofit?
To form a nonprofit, you’ll have to first follow all the steps to form a corporation (as long as you’re not already running a trust or association). This includes crafting bylaws, filing your articles of incorporation and appointing board members. You’ll also need to file a certain form to get federal tax-exempt status. Most nonprofits must fill out IRS Form 1023 or IRS Form 1024.
- Wall Street Journal: How to Form an LLC
- Nolo: How to Form an S Corporation
- IRS: S Corporations
- IRS: Have You Completed and Signed the Correct Application?
- Entrepreneur: Should You Structure Your Business as a Nonprofit?
- NerdWallet: Business Structure: How to Choose the Right One for You
- Bplans: The Complete Guide to Choosing Your Business Structure
- IRS: Business Structures
- Entrepreneur: Choose Your Business Structure