How to choose a business structure
Before registering your business with the state, you'll have to decide what type of business structure you want to establish. In some cases, you'll have to clarify your business structure before you can obtain an employee identification number (EIN) or apply for specific licenses and permits.
This is more than a legal formality. Your business structure can impact everything from your day-to-day operations to how you pay taxes. That's why we're here to explain the difference between the various business structures. This guide will show you how to choose a business structure that suits your needs.
What is a business structure?
What exactly is a business structure, anyway? When we talk about business structures, we're speaking about the legal structure of a particular company or organization. This legal structure will influence the way you perform many key tasks, such as:
- Earning revenue and raising capital
- Fulfilling your business debts and obligations
- Obtaining a business license or permit
- Meeting tax obligations
Business structures have a great deal of influence over the regular operation of a given business. Your business structure needs to reflect the nature of your company, as well as the way you intend to operate as a business owner.
Types of business structures
There are four common types of business structures in use today. You can structure your business as a:
Sole proprietorships are the simplest business structure. However, specific business structures offer advantages and features that may be necessary for managing your company.
Some of these other business structures have sub-categories that are important to understand. Below, we'll give you a little bit of insight into each one.
The sole proprietorship business structure is arguably the simplest and least formal. You'll register as a sole proprietorship if you conduct business activities but can't classify your business using any of the other business structures.
Sole proprietorships provide business owners complete control over the way their businesses are run. This is great for solo entrepreneurs who manage their own small businesses.
A sole proprietorship operates through something called pass-through taxation. This means that your company is not considered a taxable business entity by the Internal Revenue Service (IRS). Instead, all revenue from your business passes on to you, the owner. You'll report the profit and loss from your company when you file your personal tax returns each year.
The downside is that sole proprietors have unlimited personal liability for their business debts, liabilities, and losses. This means that a sole proprietor can risk losing their personal assets if a business should fail. This may not concern low-risk business ventures, but some small business owners may wish to consider other business structures that provide greater personal liability protection.
Partnerships are designed for businesses that have more than one owner. In some cases, this can be a pair of business partners. In others, a partnership might extend to a business group (like a group of attorneys leading a firm).
Partnership business structures come in three forms. General partnerships allow two or more people to serve as co-owners of their business. Partners will create and sign a partnership agreement to designate what shares go to each business partner.
In a general partnership, all the revenue from the business goes to each partner (as per the agreement). Like a sole proprietorship, each partner will report the earnings from the company on their personal tax return.
General partnerships offer no liability protection for any of the partners involved in the business. This means that each partner could find themselves personally liable for the decisions of their business associates.
Limited partnerships are designed for partnerships that need some degree of liability protection. Unlike a general partnership, limited partnerships divide their owners into general partners and limited partners. General partners retain full control over the company, though they also bear the burden of personal liability if something should go wrong.
Limited partners are shielded from personal liability, though in exchange, they do not have any decision-making rights in the company. Limited partners serve in a capacity that is similar to shareholders. They have a financial stake in the company without risk or responsibility.
Limited liability partnership (LLP)
A limited liability partnership takes the advantages of the limited partnership one step further. Rather than dividing the owners into general and limited partners, every owner of an LLP is afforded limited liability protection. This means that no partner will be held personally responsible for the decisions of the other owners.
Limited liability company (LLC)
Limited liability companies combine the best features of a corporation, partnership, and sole proprietorship. Most importantly, they offer their members limited liability, which means if the business faces financial hardship or a lawsuit, personal assets are not in jeopardy.
However, members will have to ensure that they never use their personal assets for the business (a practice known as "piercing the corporate veil"). Otherwise, they could become personally liable in the event of bankruptcy or a lawsuit.
LLCs are considered to be pass-through business entities for tax purposes. This means that each LLC member will report their earnings on a personal tax return. This also means that an LLC can be taxed in the same way as a sole proprietorship (known as a single-owner LLC) or given the same tax treatment as a partnership.
The defining feature of any corporation is that it exists as a separate business entity. Corporations provide the best protection against personal liability, though they also represent the most complex business structure in use today.
Operating a corporation requires due diligence in bookkeeping, management, and planning taxes.
It's not uncommon for the terms "corporation" and "C corporation" to be used interchangeably, though here, we'll distinguish the features of a C corporation from other types of corporate structures.
In a C corporation, the business is owned by corporate shareholders. It is a good business structure for entrepreneurs hoping to expand their companies and attract investors.
C corporations are subject to something known as "double taxation." This means that the company itself will have to pay corporate income tax. Each shareholder will have to report earnings from the company on their individual income tax returns. This can get a bit confusing, as the corporate tax rates will differ from those of personal income taxes.
S corporations work a bit differently. Most significantly, an S corporation (or "S corp") avoids double taxation instead of passing revenue directly to the company's shareholders. The company must still report its profits to the federal government, but the actual revenue will be reflected on each member's personal income tax return.
An S corp faces a few more requirements than other corporate structures. An S corp must be owned by more than one person, but it cannot exceed 100 shareholders. Additionally, all shareholders must be legal U.S. citizens.
This can actually make an S corp a useful choice for small business owners looking to avoid the double taxation of other corporate structures. An S corporation is still fairly complex, however. This type of business structure requires careful attention and due diligence.
B corporations (also called "benefit corporations") are those devoted to environmental social governance (ESG) practices. In other words, B corporations are driven by mission as much as profit. They face additional requirements and accountability measures to maintain their status.
While an S corporation helps owners avoid double taxation, B corporations will follow the same tax structure as a C corporation. The main advantage of a B corporation is that it can highlight your company's ethical commitments, which has the added benefit of attracting clients who share your passions.
Nonprofit corporations are another business class entirely, often referred to as 501(c)(3) organizations, referring to a section of the Internal Revenue code that governs these entities.
Nonprofits are organized for the express purpose of providing charity, education, or other work that supports the public good.
Nonprofits must register with the government to obtain tax exemptions. This tax status is available only as long as the organization abides by the rules.
Violating these rules — perhaps by making a political financial contribution — can result in tax consequences and even the loss of key tax benefits.
How to choose a business structure
Which of these structures is best for your small business? As we noted, it's essential to choose the right legal structure, as this will have an enormous bearing on how you raise money, pay taxes, and more.
Here are some steps you can take to make your choice:
1. Do your research
Learn as much as you can about the various business structures. Our guide will serve as a helpful starting point.
Learning about the specific features of each structure might draw you toward one structure over another.
2. Define your purpose
What is the purpose of your organization? This might help you narrow the type of structure available to you.
For example, you might consider organizing a B corporation if your company's goals align with ESG criteria. Of course, if your purpose is simply to grow your business, you might be better off registering with an LLC structure or as a sole proprietorship.
3. Choose your leadership structure
Who's in charge? Entrepreneurs who want to be their own boss might consider registering as a sole proprietorship. If you have any business partners, you'll want to have an attorney assist you with creating a suitable partnership agreement for you and your colleagues.
4. Determine your level of risk
Remember, sole proprietors and general business partners are personally liable for any business debt or lawsuits their businesses incur. This means that your personal assets are at risk if the worst should happen.
If you're concerned about this level of liability, you might consider registering as a limited liability company or an S corporation, both of which provide some protection in the event of a downturn.
5. Plan ahead for tax season
Many of the business structures above are classified as pass-through entities, which means that the owners and shareholders pay personal income tax on the net income generated by the business.
However, you'll also have to determine whether you'll be able to pay income tax on the corporate profits of a C corporation. If you choose to register your business in this manner, you may need to make plans to file a corporate income tax return each year.
Help your small business go big
Running your own business takes a lot of responsibility, regardless of which business structure you choose. But with the right tools, you'll be better equipped to handle your administrative processes and manage your business assets.
Frequently asked questions
We hear a lot of questions about business structures. Here are some of the most common questions we hear:
A limited liability company is usually classified as a hybrid business structure, combining the liability protection of a corporation with the features of a partnership or sole proprietorship. Therefore, the two business structures are distinct, though they may share certain protective features.
Sole proprietorships and partnerships are considered to be pass-through entities, which means that owners report their business income on their personal income tax returns. There is no need to file a separate tax return for the business itself.
According to federal income tax guidelines, partners and LLC members must pay a self-employment tax. The exception to this rule is in limited partnerships. Limited partners only pay taxes using their personal tax returns.