Small Business Basics: Choose a Business Structure

A wall with many doors represents the options business owners have as they choose a business structure

As you work through the steps of starting your business, you’ll need to choose a business structure. The choice you make will affect the protocols you’ll follow in your daily operations, the taxes you’ll pay, and how much of your personal assets are at stake in the event of default. Because so much is riding on this choice, it’s imperative that you take time to examine your options and find one that best suits your needs.

 

What are my choices?

You may choose a business structure from the following list of options:

  1. Sole proprietorship
  2. General partnership
  3. Limited partnership
  4. Limited liability company (LLC)
  5. C corporation (C corp)
  6. S corporation (S corp)
  7. Nonprofit
  8. Cooperative (co-op)

 

Which one is right for my business?

Most business owners choose either an LLC or an S corp business structure. However, you should consider all of your options before making a selection. The structures differ in their ownership rules, liabilities, taxes, filing requirements, and other critical factors, including how the business can raise money.

 

What are the key differences?

The following chart provides a high-level overview of the key differences. Be sure to speak with an attorney and a representative from your state’s Secretary of State office or their Department of Taxation to learn how the rules could vary in your state.

 

Structure Who can own it? How much personal liability will I have for
the business’s debts
and obligations?
What are my tax obligations?

Sole proprietorship

One person Unlimited Personal taxes

General partnership

Two or more people Unlimited Personal taxes

 

Self-employment taxes, except for limited partners

Limited partnership

Two or more people Unlimited for general partners

 

Minimal for the limited partner

Personal taxes

 

Self-employment taxes
for the general partners

Limited liability company (LLC)

One or more people Minimal Personal tax

 

Self-employment tax

C corporation

One or more people Minimal Corporate tax

S corporation

One to 100 U.S. citizens Minimal Personal tax

Nonprofit

One or more people Minimal Tax-exempt

Cooperative

One or more people Limited Corporate tax

 

Information on each of the structures is provided below:

Sole proprietorship
A sole proprietorship is a business that’s owned and operated by one person. The owner/operator has full control of the business and full discretion over the decisions that are made.

 

How it’s formed:

  • Sole proprietorships are the default form of organization. Unless you register as another form of business, your state will recognize your business as a sole proprietorship when you file your state’s formation paperwork.

Advantages:

  • Sole proprietorships are the easiest structure to establish.
  • As the sole owner, you have full discretion over how you’ll run your business.
  • Sole proprietors can avoid the double taxation that impacts other ownership arrangements by reporting business profits and losses on their personal tax returns.

Disadvantages:

  • You will be personally responsible for the business’s taxes, debts, and claims against the business.
  • Creditors can seize your personal assets to reclaim debts.
  • You may struggle to raise the cash you need because banks are often hesitant to lend to sole proprietors.
  • You can’t raise cash by selling stock.
General partnership
A general partnership is a co-ownership arrangement between two or more people who share legal and financial responsibility for the business.

 

How it’s formed:

  • General partnerships are formed with a partnership agreement. This agreement should be drafted by an attorney and signed by every ownership partner.

Advantages:

  • Each partner shares in the responsibility of running the business.
  • The partners can pool their strengths, resources, and connections to benefit the business.
  • Partners may be able to attain loans with favorable terms because of the strength of their combined credit ratings.
  • Partnerships avoid the double taxation that impacts other ownership arrangements by reporting business profits and losses on the partners’ personal tax returns.
  • The ability to allocate losses to owner partners can increase the business’s internal rate of return on investment and may afford the partners some income tax benefits.

Disadvantages:

  • Each partner is personally responsible for the business’s taxes, debts, and claims against the partnership.
  • Each partner is liable for other partners’ debts.
  • Creditors can seize any partner’s personal assets to reclaim debts.
  • Each partner can commit the business and other owners to obligations without signed consent.
Limited partnership
A limited partnership is an arrangement that includes one or more general partners who have full legal and financial responsibility for the business and one or more partners whose liability is limited to the amount they invest in the business.

 

How it’s formed:

  • Like a general partnership, limited partnerships also require a partnership agreement. This agreement should be drafted by an attorney and signed by every ownership partner.

Advantages:

  • As a general partner, you can raise the capital you need for acquisition without giving others a say in its daily operations.
  • You can repay the investments your partners make in the business on terms you both agree to (such as when the business has a certain amount of excess profits) rather than at fixed intervals of time.
  • Partnerships avoid the double taxation that impacts other ownership arrangements by reporting business profits and losses on the partners’ personal tax returns.
  • The ability to allocate losses to owner partners can increase the business’s internal rate of return on investment and may afford the partners some income tax benefits.

Disadvantages:

  • You, as the general partner, are responsible for the entirety of managing the business.
  • You bear full responsibility for the business’s debts, taxes, and claims.
  • Creditors can seize your personal assets to reclaim the business’s debts.
Limited liability company
A limited liability company (LLC) combines elements of a partnership and a corporation. Similar to a partnership, the LLC allows owners to avoid paying corporate-level income taxes because the owners report the business’s profits and losses on their personal income tax return. And, like a corporation, the LLC helps protect owners’ personal assets from the business’s debts and liabilities.

 

How it’s formed:

  • Owners file Articles of Organization with their state and pay a filing fee.

Advantages:

  • Unless you use your personal assets as collateral for business loans, creditors cannot seize those assets to reclaim business debts.
  • LLCs avoid the double taxation that impacts other ownership arrangements by reporting business profits and losses on the owners’ personal tax returns.
  • The ability to allocate losses to owner partners can increase the business’s internal rate of return on investment and may afford the owners some income tax benefits.

Disadvantages:

  • Your company cannot issue stock.
  • Some small businesses are ineligible to form an LLC. Certain states exclude banking or insurance businesses, accounting firms, architecture firms, and medical practices, among others.
C Corporation
A C Corporation (C corp) is a legal structure for businesses with multiple owners. Through this structure, owners’ personal assets are typically shielded from the business’s debts and financial obligations. Businesses that use this structure have an elected board of directors, adopt bylaws, issue stock, hold shareholder meetings, file annual reports, and pay annual fees related to their formation. They are taxed separately from their owners, and the owners also pay tax on the income they receive from the business.

 

How it’s formed:

  • Owners file Articles of Incorporation with their state and pay a filing fee.

Advantages:

  • Unless you use your personal assets as collateral for business loans, creditors cannot seize those assets to reclaim business debts.
  • You can offer multiple classes of stock to suit investor preferences.
  • You may offer shares to as many individuals or entities as you like, and they do not have to reside in the United States.
  • Your company’s shareholders can sell and transfer their shares freely.
  • You may be able to deduct all of your business’s charitable contributions and donations, provided they don’t exceed 10% of your company’s income, as well as some benefits, including health insurance.
  • Recent tax reform policies may allow you to pay a lower corporate tax rate than the maximum rate that’s currently in place for individuals.

Disadvantages:

  • Because the business must pay tax on its earnings and the shareholders must pay tax on their dividends, the corporation’s earnings are taxed twice.
  • The rules for corporations are strict and complicated.
  • The costs of running a business as a C corp are higher than in some of the other arrangements.
  • Extensive documentation is needed to establish this type of business.

If you plan to issue stock but won’t publicly trade shares, you may consider organizing as a close corporation. In this structure, you and a select group of individuals may own and operate the business without dealing with some cumbersome reporting requirements or outside shareholder pressures. Speak with an attorney to learn more about this structure.

If your business is a for-profit entity that serves a social good, you may wish to speak with an attorney about registering as a benefit corporation. There are some benefits (but no tax savings) to registering with this structure.

S corporation
An S Corporation (S corp) is a legal structure that shares many similarities with the C corp, but there are two key differences. First, a business organized as an S corp can issue only one class of stock to a limited number of U.S. resident shareholders (presently 100) rather than multiple classes of stock to an unlimited number of shareholders. Second, the S corp itself doesn’t pay tax. Instead, the owners report the business’s revenue as personal revenue.

 

How it’s formed:

  • Owners file Articles of Incorporation with their state and pay a filing fee, and they file Form 2553 with the IRS.

Advantages:

  • Unless you use your personal assets as collateral for business loans, creditors cannot seize those assets to reclaim business debts.
  • You and other shareholders don’t have to pay a corporate-level income tax.
  • Because of the Tax Cuts and Jobs Act (2017), you and other shareholders may be able to deduct up to 20% of your net qualified business income.
  • Your business’s losses will pass through to its shareholders, who may be able to use the losses to offset income.

Disadvantages:

  • Because your business is limited to 100 shareholders, you may have difficulty raising large amounts of capital.
  • The shareholders of your business cannot be entities, so you won’t be able to raise capital from venture capitalists or private equity funds.
  • You will likely need to limit your shareholders’ ability to sell or transfer their shares to ensure shares aren’t given to an ineligible shareholder, a move that could terminate your S corp status.
  • Your shareholders will be taxed on the business’s profits, even if income isn’t distributed to them as cash.
Close corporation and benefit corporation structure are also available to entities electing S corp status. Speak with an attorney to learn more about these structures.
Nonprofit
Nonprofit corporations are organized to do work that benefits the public. Generally, their work involves charity, education, religion, literature, or science.

 

How it’s formed:

  • Owners must file articles of incorporation, apply for IRS and state tax exemptions, and follow state-specific procedures for registration.

Advantages:

  • Your business isn’t required to pay state or federal income taxes on profits.
  • Your business may not be required to pay real estate taxes or sales taxes.
  • Unless you use your personal assets as collateral for business loans, creditors cannot seize those assets to reclaim business debts.

Disadvantages:

  • This business structure isn’t for entities that aim to make a profit.
  • You can’t issue stock to raise capital.
  • It can be more difficult to attain lender financing.
Cooperative
A cooperative is an organization that’s owned and operated by the people who use its services. It isn’t a suitable arrangement for most businesses, but it offers advantages to certain groups.

 

How it’s formed:

  • Owners file Articles of Incorporation with their state, create bylaws, draft a membership application, and elect directors.

Advantages:

  • The arrangement prioritizes the collective good of the group rather than an owner.
  • You and other member-owners of the cooperative don’t have to pay a corporate-level income tax.

Disadvantages:

  • Decision-making isn’t centralized; rights are shared among the members of the co-op.
  • Profits and earnings are shared among member-owners.

Why would I choose a business structure with multiple owners?

By including other owners in your business, you may be able to access three forms of capital you need to succeed in your new venture:

Intellectual capital

Great partners often have knowledge, experiences, and skills that their counterparts don’t possess. As a team, they have a solid understanding of what needs to happen in every part of their business, and they excel at executing their plans.

Financial capital

Great partners have access to cash or ways to acquire funding. They have a good credit score (at least 650), which is necessary for taking out term loans, asset-backed loans, or SBA loans to cover startup costs, purchase inventory, or fund the business’s operations.

Human capital

Great partners are willing to put in the work that’s needed to make the business a success. Depending on the arrangement, partners may take a hands-on or hands-off approach, but in either instance, they’re willing to contribute when and precisely how they’re needed.

There are clear benefits to having access to more skills, knowledge, and support to start and run your business. There are benefits to accessing more financial capital, too: If you choose a partner who has cash on hand to invest in the business, you can avoid taking on costly loans or leveraging your assets, two options that introduce expense and risk.

There are some disadvantages to multiple-owner structures, too. Depending on your arrangement, you may not have the autonomy you want to make decisions and execute your ideas—at least, not without talking with your partner first. And while you and your partner may agree to share in the costs, you’ll also share the profits, which may be minimal in the first few years of operations.

If you decide to choose a multiple-owner business structure, you should commit to finding a partner who has the qualities you need to help you and your business thrive.

 

What should I look for in a partner?

The partner you choose should have skills, experiences, connections, or resources that will benefit your business. You should be confident in that person’s abilities to team well and execute plans to achieve important goals.

Some people avoid partnering with family members or close friends because of the potential for fallout if business decisions go awry. Still others prefer to partner with people in their closest circle of connections because they trust one another and know each other’s strengths, abilities, and limitations intimately. You should evaluate your comfort in working with friends and family, partnering with one or more of your professional contacts, or working with people with whom you have even less familiarity but who may have valuable skills, resources, and experiences.

 

When do I need to choose a business structure?

You’ll need to decide on the structure before registering your business with your state.

Read: How to Register Your Business in Your State

 

How do I formalize the arrangement I choose?

Your attorney can help you formalize the arrangement you choose and walk you through the state-specific steps you’ll need to take to register your preferred business structure.

Would you like to connect with an attorney? Click the Connect button below to get started:

 

What’s next?

Starting a business is a complicated process, but we have articles and advice that can help you with every action you need to take. Log into your owner’s portal for free, personalized guidance that will help you make your venture a success.

Share:

Share on facebook
Facebook
Share on twitter
Twitter
Share on pinterest
Pinterest
Share on linkedin
LinkedIn

Leave a Reply

Your email address will not be published. Required fields are marked *

Related Posts