There are so many things to take care of when starting a business–budgeting, marketing, hiring, choosing a name.
In the midst of all the activity, one of the most important decisions can often get overlooked: choosing the right legal structure for your business.
While this might seem like a relatively trivial decision, the business structure you choose will affect your future taxes, your daily operations, the paperwork you need to file, your personal level of risk should your business be sued and your ability to raise funds from banks and investors if you decide to go that route.
You can normally change a business structure to a different one if you decide to in the future, but that will often entail costs and complications.
It’s far easier to make a thoughtful structure decision at the outset that has a good chance of working well for your business as long as its in existence.
Keep in mind that there’s no single right or best choice–different types of businesses will want different structures for different reasons. Here are the four most common business structures and what you should be thinking about when considering each.
(Please note that this article is intended to be informative and should not be treated as legal advice.)
Common Business Structures
A sole proprietorship is one of the most common types of small business structures and is easy to form.
In fact, if you just start doing business without setting up and registering any structure, the government will treat you as a sole proprietorship by default.
A sole proprietorship gives you full control over your business–and full liability. Your business assets are not separated or walled off from your personal assets. If your business hurts a customer or owes money to a vendor and he sues, that customer or vendor will get access to your personal assets if he wins that suit.
You’ll also find that banks and investors will not generally be willing to commit funds to sole proprietorships.
A sole proprietorship can be ideal for small businesses that involve one person–the owner. If you’re looking to turn your talent into a business (for instance, as an interior decorator or math tutor), a sole proprietorship can work well. Especially at the outset. If you choose in the future to expand, that might be the time to switch to a different structure.
Again, if you just start ‘doing’ your business without registering any structure, you’ll be treated as a sole proprietorship. There’s no paperwork to file. (However, if you’re going to use a name for your business, you might consider applying for a DBA, or ‘doing business as’ registration. You should also make sure that you have any licenses required for your conducting business in your particular industry.)
A sole proprietorship is a ‘pass-through’ entity for tax purposes. That means the business itself is not subject to federal income tax. All profits and losses will be treated as the owner’s income and she’ll pay the appropriate taxes on her personal income filing.
Keep in mind that a sole proprietorship does not mean you can’t have employees.
Partnerships are the simplest structures for setting up a business with two or more owners. There are three common types: general partnerships (GP), limited partnerships (LP) and limited liability partnerships (LLP).
All are pass-through entities for tax purposes.
Think of a general partnership as a sole proprietorship for multiple owners. It’s the simplest form of a partnership structure.
Like a sole proprietorship, if two or more people simply start doing business together the government will treat you as a general partnership by default.
There’s no paperwork required to register. A general partnership assumes that all partners are equal participants and all profits, losses and responsibilities are distributed evenly.
Having a written agreement that outlines how the partnership will be managed and how it will end is a good idea.
Limited partnerships have one general partner who has unlimited liability and all other partners have limited liability.
These limited partners (oftentimes investors in a business as opposed to active operators) usually have less control over the business as well–as spelled out in a written partnership agreement. The general partner will also be required to pay self-employment taxes.
Limited Liability Partnership
Limited liability partnerships offer limited liability to all partners.
All limited partners have limited liability against debts and aren’t legally responsible for the actions of the other partners. You’ll often see LLPs used in professional services firms, like an accounting or consulting firms.
Limited liability partnerships are similar to limited partnerships, but give limited liability to every owner. An LLP protects each partner from debts against the partnership, they won’t be responsible for the actions of other partners.
Keep in mind the possibility of a joint venture. If you’re going to partner for a limited amount of time (for instance, working on one deliverable for a single client), a joint venture is a partnership set up with a time limit.
Again, if you want to do business under a business name, consider filing for a DBA. And, of course, if you’re practicing accounting or doing legal work or performing in any regulated industry, you’ll need the appropriate licenses.
It’s a good idea to have a business lawyer review any partnership agreements. Disputes among partners are common in business and having a clear agreement that covers likely points of disagreements can save a lot of future headaches.
Limited Liability Company
A limited liability company is an attractive option for entrepreneurs who want to limit their own liability but avoid the costs and complexity of setting up a corporation.
An LLC is a business structure that combines the pass-through entity tax status of a sole proprietorship or partnership with the limited liability of a corporation (without actually establishing a corporation).
Profits and losses are passed through to your personal income without facing corporate taxes, but as a member of an LLC you’re considered self-employed and must pay self-employment taxes.
Setting up an LLC is a little more involved than forming a sole proprietorship or partnership. You’ll have to file a formal business name, articles of organization and create an operating agreement.
Also keep in mind that in many states, LLCs dissolve when new members are added or old members leave–unless there is specific language in the operating agreement to handle the transferring of ownership.
An LLC can be used as an alternative to a sole proprietorship. In almost all states, a single owner can form an LLC.
A corporation is the most complex business structure and requires the most effort to set up. It’s also the type of structure with the least liability for owners.
Unlike sole proprietors, partnerships, and LLCs, corporations pay income tax on their profits.
This structure is used by many larger companies and is also often preferred by businesses that are seeking lots of outside investment (such as venture capital). Corporations are also subject to what is call ‘double taxation.’
The business itself is taxed on its profits and the share of profits distributed to owners is also subject to taxation on their personal returns. For smaller businesses, double taxation can be a significant draw-back.
There are a few types of corporations.
A C corporation or ‘C corp’ is the most common type of corporation. All shareholders combine funds and are given stock in the business. A C corp is a separate entity and files its own taxes and owners face the prospect of double taxation of profits.
An S corporation or ‘S corp’ is like a C corp, but is a ‘pass-through’ tax entity. To establish an S corp, you first set up a corporation and then request S status.
A B corporation (which stands for ‘benefit corporation’) is appropriate for corporations that have social mission or public benefit as part of their mission.
Once you establish a C corp, you can apply for B corp status, which will provide some tax breaks to your business in certain states. (If you are considering a B corp, you may also want to look at a structure called a ‘Close corporation.)
Personal Service Corporations
Personal service corporations (or professional service corporations) are an option in most states for professionals such as dentists, engineers and architects. (Some states don’t allow these professionals to run LLCs.) Personal service corporations limit personal liability.
They are taxed similarly to C corps in that they don’t have pass-through taxation.
Nonprofit corporations are corporate entities organized for charitable, educational or religious purposes. Nonprofits have tax-exempt status that is granted by the IRS. These are often called 501(c)(3) corporations, in reference to the section of the federal internal revenue code that is used to grant tax-exempt status.
Combining Business Structures
Throughout this article you’ll have seen that business structures also serve to identify tax statuses. It is possible to have an LLC set-up to be taxed as a C corp, S corp or nonprofit. You’ll want to get advice from a business lawyer or accountant if you’re considering going this route.