When you’re starting a new business, you have many important decisions to make. From deciding what kind of products to sell to what pricing strategy to use, there are key choices that affect the success of your venture. One of the most important decisions new entrepreneurs make is what type of business structure to use. This affects everything from how much legal liability, tax liability and tax rates.
What Is a Business Structure?
A business structure is the organization of the company in terms of its legal status. It is one of the most important aspects of the company, as it affects everything from day-to-day operations to long-term success. There are several different business structures from which to choose. It’s critical to understand the advantages and disadvantages of each one so you pick the one that provides you with the right balance of legal protection and benefits.
Choosing a business structure involves looking at many factors, such as taxes, legal liability, flexibility and risk tolerance. What works for one kind of business may not work for another. Plus, some businesses may need to change their legal structure as they evolve and grow. However, it’s important to keep your future goals in mind when selecting your business structure.
Five Structures to Choose From
The five key types of common business structures include:
- Sole proprietorship: This is one of the simplest business structures. In this case, one person owns the unincorporated business and reports the profits on his personal tax return.
- Partnership: This unincorporated business is owned by two or more people or businesses. The profits of the company are divided among the owners and reported on their tax returns. There are several categories of partnerships.
- Corporation: This kind of business is a legal entity that is separate from its founders and owners, which means that the business is taxed, held accountable for its actions and can make a profit. Often called C corporations, these business entities have multiple classes of stocks and unlimited shareholders. A variance of the C corporation, the S corporation, can only have one class of stock and up to 100 shareholders. Unlike the C corporation, the S corporation does not face double taxation. There are multiple subcategories of corporations, and they are all generally subject to corporate tax per the IRS.
- Limited liability company: The limited liability company (LLC) is a hybrid business structure between a corporation and a partnership. In this situation, the liability of the business owners is limited, but they are able to have the profits of the business taxed on a member level.
- Cooperative: This business is owned and operated by its users. The profits of the cooperative are distributed among each of the members.
How to Choose Your Business Structure
With many options, it’s difficult to know which direction to go when it comes to selecting the right business structure. Keep in mind that it depends on a number of factors and your situation, not just the kind of business you run. For example, a local flower shop could be a C corporation or an LLC. The right form of business structure will depend on criteria such as:
- Risk tolerance: If you run a business, you are at a greater risk of a lawsuit. If that happens, your personal assets may be at risk depending on the kind of business structure you have.
- Taxes: Do you want to pay taxes on your business profits as an individual or as a separate legal entity?
- Capital investment: If you need funding from investors to start your business, you may have to consider starting a corporation rather than going about it as a sole proprietor.
- Growth: Where do you see your company in five or 10 years? The legal structure you choose should help you meet those goals, not hinder them.
- Control: Do you want to have unilateral control over business decisions, or are you open to sharing that responsibility with others?
- Record keeping: The more complicated your business structure, the more paperwork you have to complete. You may also need to hire an accountant or attorney on an ongoing basis.
Becoming a Sole Proprietor
This is the easiest business structure with which to start, and it is best for one person who wants to work alone now and in the future. With a sole proprietorship, the business owner is responsible for everything within the company, including debts and profits. This business structure is ideal for business owners who are starting a business from home without a separate physical location or those who are testing out their business idea before forming a formal business. For example, a freelance web designer or freelance copywriter would be ideal candidates to set up a sole proprietorship.
There are a number of key advantages of a sole proprietorship:
- Low startup costs: While the initial costs will vary from business to business, sole proprietorships are often less costly to start. Expenses usually include state and federal fees, taxes, computer equipment and professional services like bookkeepers.
- Taxes: Any income or expenses from the business are included on the owner’s personal tax return. Plus, any losses your business suffers can offset income you have earned from other sources, like a part-time job. However, sole proprietors do have to pay self-employment taxes and make quarterly tax payments on their income.
- Full control: The owner of a sole proprietorship has full control over all decisions in the business and does not have to answer to a partner or board.
- Flexibility: If you want to dissolve a sole proprietorship, the process is simple and does not require any formal paperwork. In most cases, it’s as easy as halting operations.
The major disadvantage of a sole proprietorship is that in terms of liability, there is no separation between the business and the business owner. This means that you are personally liable for all of the business’s liabilities. If you face a lawsuit, then your personal assets may be seized. In addition, if you want to raise capital, you may need to use a different business structure since lenders and investors prefer to not work with sole proprietors.
Establishing a Partnership
If you’re considering starting a business with a friend, colleague or family member, then a partnership may be the right choice of business structure. There are two main types of partnerships: A general partnership is where everything is shared equally, and a limited partnership is where one partner has control and the other partner contributes to the business and receives part of the profits. Google, for example, was a partnership when it was started by two friends in 1995.
There are many advantages of using a partnership business structure:
- Low startup costs: While it may be more expensive than starting a sole proprietorship, a partnership is still easy to form. It’s advised that you use an attorney to make sure your partnership agreement is sound and beneficial to all partners.
- Simple setup: Other than a certificate of conducting business as partners, an articles of partnership agreement and a business license, there is little paperwork to complete.
- Investment opportunities: Unlike a sole proprietorship, you may be able to receive loans and investments since two credit lines are looked on more favorably than one.
- Tax benefits: Each partner reports the shared income or losses on her personal tax return. The partnership itself pays no income tax.
Similar to a sole proprietorship, legal liability is one of the major disadvantages of a partnership. Depending on the partnership agreement, each partner may be able to make decisions on behalf of the partnership that affect all of the partners, such as taking out loans.
Considering a Corporation
A corporation is one of the most complex business structures because it is a legal entity that is completely separate from its owners and shareholders. The stakeholders of the corporation have no legal liability for any claims against the business, which is one of the biggest advantages. In addition, having a corporation structure enables businesses to raise capital from angel investors, venture capitalists and lenders. A corporation also continues to operate regardless of the stakeholders, so it’s not affected by aspects such as death or departure of key personnel.
Within the corporation business structure, there are a number of different kinds of substructures:
- C corporation: This is a good choice for high-risk businesses that plan to go public. Corporations pay double taxes in some cases, where the corporation is taxed on its profits and then the dividends are taxed when paid to shareholders. Amazon is an example of a C corporation.
- S corporation: In this structure, the business can avoid double taxation, as the profits and losses are passed through to the owner’s personal income. All shareholders of an S corporation must be U.S. citizens. This is a good choice for small businesses that want to incorporate.
- B corporation: This is a for-profit entity where the mission is equally important. They are taxed the same as a C corporation, but they have different accountability and transparency. The Body Shop is an example of a B corporation.
- Closed corporations: This is a private company, often family owned, that benefits from liability protection.
- Open corporation: This business is available on the public market, so anyone can become an investor. Microsoft is an example of an open corporation.
Incorporating a business requires time and expertise. In addition to registering with state and federal authorities, every corporation needs to develop articles of incorporation, which is a legal document that outlines the details of your operation, including information on shares, directors and officers. A corporation also needs to draft bylaws that state how the business will be governed and how business decisions will be made.
Looking at Limited Liability Companies
An LLC is a hybrid structure that combines the advantages of a corporation with those of a partnership. It’s a good choice for small-business owners who want to limit their personal liability while taking advantage of the tax benefits of a partnership. All earnings and losses of the business get passed down to the owners as income on personal tax returns, so there is no corporate taxation.
Owners of an LLC are self-employed and must pay self-employment tax toward Medicare and Social Security. To register, they must submit an application and operating agreement to the secretary of state. If a member decides to join or leave an LLC, then the LLC may need to be dissolved and recreated depending on the laws of the state.
If you have a large amount of personal assets that you want to protect and are starting a medium-risk or high-risk business, then an LLC is a good option.
Benefiting From a Cooperative
If you’re interested in forming a business where the owners are also the customers, then a cooperative is a good choice. The user-owners share the profits of the business and vote on the direction of the company. Similar to an LLC, the owners are not taxed on the profits. One of the key advantages of a cooperative is the size of the business, which can be used to get bulk discounts on products and services.
In order to join a cooperative, the users must purchase shares of the business. The number of shares you own does not affect the weight of the vote. CHS Inc. is an example of a large cooperative that is owned by farmers, ranchers and other stock holders.
Choose from among these types of business structures to best lay out your business plan before doing business.
- NerdWallet: Business Structure: How to Choose the Right One for You
- Business News Daily: How to Choose the Best Legal Structure for Your Business
- Entrepreneur: Choose Your Business Structure
- U.S. Small Business Administration: Choose a Business Structure
- U.S. Small Business Administration: Register Your Business