New companies are popping up every day. In 2016, there were 28.8 million small businesses in the United States alone. If you're ready to become an entrepreneur, make sure you understand the different kinds of business structures and their advantages. Each type of company is subject to different laws and tax regulations. Therefore, it's important to assess your options and choose a legal entity that best suits your needs.
Kinds of Business Organizations
Starting a business can be exciting. You'll be able to launch your own products and build your own brand, not to mention that you'll have full control over your schedule instead of working from nine to five. Like everything else, though, this professional path comes with its challenges and takes some planning.
About half of small businesses fail within five years. Roughly 20 percent close their doors in the first year. Lack of capital, pricing issues, poor marketing and low market demand are all common reasons why so many companies fail.
This may come as a surprise, but a staggering 17 percent of new organizations go out of business because they didn't have a business model in the first place. Another 8 percent cite legal challenges as the reason behind their failure.
One way to avoid these struggles is to choose the right legal structure for your startup. Do a web search for "type of business meaning" or "forms of business ownership," and you'll see that there are several types of business models. Sole proprietorships, limited liability companies, corporations, partnerships and nonprofit organizations are just a few examples. Each has distinctive advantages and drawbacks of which every entrepreneur should be aware.
What Are Sole Proprietorships?
As its name suggests, this type of business is owned by a single person. It's the easiest to set up and involves the lowest ownership costs compared to other business structures. Sole proprietors may hire employees and deal with less paperwork than those running an LLC or a corporation.
Sole proprietorships are among the most popular types of business categories. It's a perfect choice for freelancers, consultants, small stores and home-based businesses. Tax filing is easy, and there are no corporate formalities required.
Let's say you're a web designer working from home. In this case, it makes sense to start a sole proprietorship. You can set your schedule, work remotely and do your own taxes.
Why Start a Sole Proprietorship?
If you're looking for a type of business that's easy to form and operate, consider starting a sole proprietorship. You'll have greater flexibility, pay fewer taxes and deal with fewer legal regulations compared to an LLC or other business entities.
After setting up a sole proprietorship, you'll do business under your own name. It's not necessary to register a trade name and fill out extra paperwork. From a legal perspective, you're one and the same with your business.
Any profits or losses will flow through directly to your personal tax returns, making everything a lot easier. By comparison, other kinds of businesses are required to pay corporate tax and submit annual reports and tax filings. Since you don’t need to have a board or directors or stockholders, you're in complete control.
Are There Any Drawbacks?
The freedom you get with a sole proprietorship comes at a price. Since there's no distinction between you and your business, you're personally liable for all of its debts. If something goes wrong, you could lose everything, including your house and personal belongings.
Another drawback is that most banks and lenders may refuse to give you a loan. If you decide to expand your operations, you'll find it difficult to borrow the money you need. Raising capital can be a struggle. Any money you borrow counts as personal debt.
A potential downside of running this kind of business is the perceived lack of professionalism. Some clients prefer to work with LLCs or corporations, which are more formal business structures. However, this depends on your clientele and the services you provide.
What Is an LLC?
Along with sole proprietorships, LLCs are the most popular kinds of business structures in the U.S. This legal entity is formed by one or more individuals through a written agreement. It combines the characteristics of sole proprietorships or partnerships and corporations, offering a lot of flexibility to its owners.
This hybrid business structure offers the benefit of pass-through taxation and makes a clear distinction between the company and its owners. This means that you'll have limited personal liability. If you ever get into debt, you won't risk losing your personal assets.
Setting up an LLC is easier than starting a corporation. The initial fees are relatively low and vary among states, ranging between $40 and $500. California residents, for example, can start a limited liability company for as little as $70. If you live in Michigan or Arkansas, you'll only pay $50 plus some annual fees.
Advantages of Starting an LLC
A major advantage of LLCs over sole proprietorships is that the owners are not personally liable for any debts or business expenses. Additionally, this business structure is easy to form and maintain and can have any number of owners (members).
Furthermore, members can choose whether they want to be taxed as a partnership, sole proprietorship or corporation. They also have complete freedom when it comes to splitting the company's profits and losses. Corporations, on the other hand, must split their revenue and losses based on stock ownership.
If you start an LLC, you're not required to have a board of directors or hold annual meetings. Also, this business structure involves lower filing costs and less paperwork than a corporation.
Disadvantages of LLCs
Even though LLCs provide limited liability, you may still incur out-of-pocket expenses in certain situations. For example, if you commit fraud or use your personal funds to grow the business, you may be held personally liable.
Another disadvantage is that most states require LLCs to pay franchise tax and annual fees. Texas, New York, Delaware and Massachusetts are just a few to mention. Illinois, for instance, charges $250 to $300 annually.
While it's easier to secure funding as an LLC than as a sole proprietorship, you may still have a hard time raising capital. Investors often hesitate to put their money into limited liability companies because of their lack of a strict corporate structure.
How Does a Partnership Work?
Entrepreneurs may also opt for general or limited partnerships. This business structure is owned by two or more individuals who agree to contribute with labor, money or skills to the company in question. They make decisions together, sharing the profits and losses.
In a general partnership, all parties have unlimited liability and are equally responsible for the company's debts. If your partner goes into debt, you'll be held liable for his actions.
In a limited partnership, only one person has control over the company's operations. The other partner or partners have limited rights. They usually act as investors and receive a part of the profit. In a limited liability partnership, all parties have limited liabilities, so they cannot be held accountable for another partner's actions.
What Makes Partnerships Appealing?
Each type of partnership has its own perks. In general, this type of business entity is easier to form and requires less paperwork than an LLC. Partners can share responsibilities, pool together their skills and split the costs required for running the company.
With a partner on your side, you can expand your services and reach more customers. Your partner can bring skills and experience that you don't have. For example, if you're a web designer, you can team up with a friend who specializes in digital advertising and start a creative agency.
This legal structure appeals to those who want to go into business with a friend, family member or colleague. Since there are several people involved, it's easier to raise funds and grow your business.
The Drawbacks of Partnerships
The biggest risk of forming a partnership is that disagreements may be difficult to resolve. Decisions are shared, so you don't have full control over the business. Additionally, you may be held responsible for your partner's mistakes and actions.
Like sole proprietorships, partnerships often struggle to attract investors and secure funding. If the business fails, both parties will suffer.
Furthermore, you or your partner may not feel comfortable splitting the profits. Perhaps you're working harder than your business partner and believe that you're entitled to more money. This may lead to conflicts and affect the company's performance.
What Is a Corporation?
If you already have an established business with employees, you may consider forming a corporation. This complex business structure is owned by investors or shareholders and has specific legal requirements.
There are two main types of corporations, and each has distinctive characteristics. In a C corporation, the business is a separate entity from its owners, who are referred to as stockholders or shareholders. This type of company can have multiple classes of stock and unlimited stockholders, foreign or domestic.
C corporations pay corporate income tax, while their shareholders pay personal income tax on dividends. Therefore, this type of business is subject to double taxation. S corporations, by contrast, are taxed on the individual stockholders' tax forms.
Advantages of Forming a Corporation
Compared to other kinds of businesses, corporations find it easier to raise capital and attract investors. Shareholders have limited liability, so if the company encounters legal issues, they cannot be sued or held responsible for its actions.
All types of corporations have an unlimited lifespan. This means that they won't cease to exist if the stockholders leave the business or die.
Another advantage is that shareholders don't have to be actively involved in the company's operations. Instead, they can hire managers to handle day-to-day operations. Furthermore, corporations can sell stock to investors in order to raise the funds needed for business growth.
The Disadvantages of Incorporation
Double taxation can be a major turnoff for those who plan to start a C corporation. However, you can always opt for an S corporation to avoid this issue. A major drawback, though, is the extensive paperwork and strict regulations.
Corporations are legally required to file bylaws, articles of incorporation and annual documents. They must hold meetings regularly and form a board of directors. Fulfilling these requirements is nearly impossible without the expertise of a lawyer.
This type of business entity is more difficult and expensive to start and maintain compared to LLCs and partnerships. Plus, it's subject to local, state and federal regulations that may stall its growth. While it's true that S corporations seem more appealing from a tax perspective, they can only have one class of stock and a limited number of shareholders.
Now that you have this list of different types of businesses, analyze your options, speak to a professional and make an informed decision. Depending on your goals, you may also set up a cooperative, a franchise or a nonprofit organization. Consider your budget, plan for the future and determine how much flexibility you need.
- U.S. Small Business Administration: 2016 State Small Business Profiles Released with Fresh Design
- Fundera: What Percentage of Small Businesses Fail? (And Other Need-to-Know Stats)
- FitSmallBusiness: 5 Sole Proprietorship Pros and Cons
- How to Start an LLC: How Much Does It Cost to Form an LLC?
- Nolo: When You Might Be Personally Liable for LLC or Corporate Debt
- Investopedia: Sole Proprietorship
- Upcounsel: Pros and Cons of a Partnership: Everything You Need to Know
- AccountingTools: Characteristics of Corporations
- NerdWallet: LLC: Pros and Cons of a Limited Liability Company
- Fundera: S-Corp vs. C-Corp: How They Differ (and How to Decide)
- U.S. Small Business Administration: Choose a Business Structure