Business Structures are the first step to consider if you’re starting your startup or a small business. The legal structure of your business determines how much you pay in taxes, paperwork requirements for your business, your ability to raise money, and your liability for the debts and obligations of your business. Before you make your choice, the first thing on your to-do list should be to have an understanding of the characteristics of each business structure.
Every business is different, so the legal structure you choose should be based on the specific needs and goals of your business. The best option for one business may not be best for you, even if you’re in the same industry.
Types Of Business Structures
1. Sole Proprietorship
A sole proprietorship is easy to form and gives you complete control of your business. You’re automatically considered to be a sole proprietor if you do business activities but don’t register as any other kind of business. A sole proprietorship is the most basic business structure. A sole proprietorship is an unincorporated business that is owned and operated by one person. If you engage in business activities, you are legally considered a sole proprietor.
In sole proprietorships, business liabilities are not separate from your assets. You can be held personally liable for the debts of your business. Though sole proprietors are still able to get a trade name, they can’t sell stock, because most sole proprietors do not formally register their business.
Sole proprietorships can be a good choice for low-risk businesses and owners who want to test their business idea before forming a more formal business. Many small business owners choose to operate as sole proprietors because of how quick, easy, and inexpensive it is to get started. However, this type of legal structure isn’t without its drawbacks. Sole proprietorships are best for low-risk businesses. Some entrepreneurs start as a sole proprietorship when testing out a business idea before reorganizing under another business structure. Most commonly, sole proprietorships are selected by service professionals, freelancers, and consultants.
2. Partnership
Partnerships are the simplest structure for two or more people to own a business together. There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP). Businesses that have two or more owners may consider forming a partnership because it is quick, easy, and inexpensive. A partnership is the simplest business structure for businesses that have multiple owners. Like a sole proprietorship, you are not required to register your partnership. Simply coming to an agreement with other owners and engaging in business activities is enough to establish a partnership. However, you may still be required to obtain the appropriate licenses and permits required to legally operate your business. You may also be required to register your partnership with your state depending on the type of partnership you form. Limited liability partnerships protect each partner from debts against the partnership, they are not responsible for the actions of other partners.
Types Of Partnerships
We’ve established the basic definition of a partnership. However, there are three different kinds of partnerships to consider. The primary difference between the three lies in the personal liability of each partner.
General Partnership: In a general partnership (GP), all owners are considered general partners. Each partner manages the business and is an active participant in day-to-day operations. Each partner is also personally liable for the debts, obligations, and liabilities of the partnership.
Limited Partnership: With a limited partnership (LP), there is one general partner who is responsible for managing the business and overseeing day-to-day operations. The remaining partners are limited partners that do not participate in managing the business and have limited control. These partners are investors only and are commonly known as “silent partners.” In this type of partnership, only the general partner can be held personally liable for the debts, obligations, and liabilities of the business.
Limited Liability Partnership: A limited liability partnership (LLP) is made up of limited partners. Partners are not personally liable for the debts, obligations, and liabilities of the business. Partners will also not be held personally responsible for the actions of another partner.
3. Corporation
A corporation is the most expensive and complicated business structure. If you plan to raise capital through the sale of common or preferred stock, your business will need to be set up as a corporation. There are no limitations on how long a corporation can exist. If an owner dies or retires, the corporation does not have to be dissolved.
Corporations are independent legal entities and are separate from their owners. The good news is that this provides the owners with the best liability protection. The bad news is that there are more regulations and tax requirements for this type of legal structure. Most corporations hire an attorney to ensure the corporation is set up and maintained according to state regulations. Depending on the type of corporation, double taxation may also be a concern. This means that corporations pay federal and state corporate income tax, while shareholders also report dividends on their tax returns. Many corporations enlist an accountant and/or tax preparer to ensure returns are filed correctly, which adds business expense.
Types Of Corporations
If you plan to grow your business in the future and want to raise large amounts of capital to fund that growth, a corporation could be the best legal structure for your business. Before you make that decision, though, there are a few different types of corporations. Let’s explore the differences between each type.
C-corporation: A C-corporation offers the strongest protection to its owners from personal liability, but the cost to form a corporation is higher than other structures. Corporations also require more extensive record-keeping, operational processes, and reporting. Unlike sole proprietors, partnerships, and LLCs, corporations pay income tax on their profits. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and again when dividends are paid to shareholders on their tax returns. C-corps can raise capital through the sale of stock and make profits, but double taxation, higher costs associated with formation, and more legal requirements are drawbacks of this business structure.
Corporations can be a good choice for medium- or higher-risk businesses, those that need to raise money, and businesses that plan to “go public” or eventually be sold. Corporations have a completely independent life separate from their shareholders. If a shareholder leaves the company or sells his or her shares, the C corp can continue doing business relatively undisturbed. This business entity is completely independent of its owners. With a C-corp, owners have the best protection from personal liability. Corporations have an advantage when it comes to raising capital because they can raise funds through the sale of stock, which can also be a benefit in attracting employees.
S-corporation: An S-corporation is a special type of corporation that’s designed to avoid double taxation because it allows profits, and losses, to be passed directly to owners’ income without ever being subject to corporate tax rates. There is a limit on the number of shareholders in most countries’ laws. Check the FIRS website for eligibility requirements. You’ll still have to follow the strict filing and operational processes of a C corp.
B-corporation: A B-corporation, or B-corp, is similar to a C-corp in how it is taxed. However, a B-corp must offer a benefit to the public in addition to making a profit. In some states, an annual report must be filed to prove that the company is providing a benefit to the public.
Close Corporation: Close corporations resemble B corps but have a less traditional corporate structure. These shed many formalities that typically govern corporations and apply to smaller companies. A close corporation is similar to a B-corp but is a structure typically used by smaller businesses. Close corporations are generally prohibited from public trading. Shareholders run this type of corporation, and a board of directors is not required. State rules vary, but shares are usually barred from public trading. Close corporations can be run by a small group of shareholders without a board of directors.
4. Limited Liability Company (LLC)
A limited liability company combines the benefits of other business entities to keep taxes and business requirements lower than corporations while also offering personal liability protection for its owners. Profits and losses can get passed through to your income without facing corporate taxes. However, members of an LLC are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security. All members of the LLC can fully participate in the operations of the business. Owners can select how an LLC is taxed by the Federal Internal Revenue Service.
5. Nonprofit
Nonprofit corporations are organized to do charity, education, religious, literary, or scientific work. Because their work benefits the public, nonprofits can receive tax-exempt status, meaning they don’t pay state or federal income taxes on any profits they make. Most businesses have one primary goal: to make a profit.
Another difference between nonprofits and other corporations is that this type of business entity may be exempt from state and federal income taxes. However, nonprofits must register with the FIRS to receive this exemption, in addition to registering with the state. Charities, Religious, educational, literary, and scientific organizations may be eligible for nonprofit status.
6. Cooperative
Any type of business can become a cooperative if the goal of the business is to benefit the user-owners. Businesses that aim to sell their products or services to consumers for a profit would be better suited to form another type of business entity. A cooperative is a business or organization owned by and operated for the benefit of those using its services. Profits and earnings generated by the cooperative are distributed among the members, also known as user-owners. Typically, an elected board of directors and officers run the cooperative while regular members have voting power to control the direction of the cooperative. Members can become part of the cooperative by purchasing shares, though the amount of shares they hold does not affect the weight of their vote.
A cooperative, or co-op, is a type of business that operates for the benefit of its members. Members of a co-op are known as user-owners and have the right to vote on important decisions surrounding the growth and direction of the business. Officers and a board of directors are responsible for running the co-op.
