The choice of business structure for a new enterprise is hardly one of the most exciting decisions a business owner has to make. However, it is one of the most important. How you decide to legally structure your business has long lasting implications for you and your company. It determines your financial risks and legal responsibilities as a business owner, and will directly effect how the IRS taxes your business’ profits. It may not be an exciting decision to make, but it is definitely not one to be taken lightly.
Understanding Your Options
Unfortunately, choosing the right business structure for your new venture isn’t as easy as picking out a website design or settling on your new shop’s décor. There’s a lot to consider before you make your final decision, and it helps if you understand the basic differences between the types of structures that are available to you.
For our purposes there are 4 basic business structures from which you might choose. Each model offers its own advantages and disadvantages, and it’s down to each business owner to decide is the best fit for their new enterprise.
Our basic business structure models can be broken down into the following categories:
- Sole Proprietorship
- Limited Liability Corporation (LLC)
While it is possible to change your business structure after your business is established, it is generally best to decide early on how you want to structure your venture. Changing your company’s business structure can get complicated and, more importantly, expensive after the fact.
A sole proprietorship applies to any unincorporated business that is owned by a single individual who reports their business’ profits on their personal tax returns. A sole proprietorship is the simplest type of business to form, and is beast suited to ventures with limited budgets and minimal debt profiles.
The advantages of registering as a sole proprietorship include:
- Minimal Expense – It is relatively inexpensive to form a sole proprietorship. The most significant associated costs will be your business license fees and the expense of setting up your DBA (Doing Business As).
- Simplified Tax Returns – A sole proprietorship is considered a “pass-through” tax entity. This means that all profits and losses flow through the business owner and must be reported on their tax returns. Sole proprietors are also required to file and pay quarterly tax estimates.
Operating as a sole proprietor keeps the business owner’s taxes fairly simple and straightforward. However, it can bring added complications when the business expands and begins hiring on employees.
While forming a sole proprietorship is relatively simple and inexpensive there are some downsides to consider. For example:
- Increased Liability – As sole proprietor the business owner is responsible for all of the company’s legal and financial obligations. If the business fails or is sued the owner’s personal assets are at risk.
- Lending Limits – Banks are typically hesitant to approve small business loans for sole proprietorships, as they see them as a greater risk. This can make it difficult for small business owner to grow and expand their businesses.
Any unincorporated business that is owned by two or more people qualifies as a partnership. In general, the partners share in all of the profits and report that income on their personal tax returns.
There are three basic forms of partnerships to consider:
- General Partnership – A general partnership assumes that all profits, liabilities and business responsibilities are equally shared among the partners. In some instances one partner may accept a greater portion of the profits in exchange for a greater portion of operational duties, however this must be clearly spelled out in a legal and binding partnership agreement.
- Limited Partnership – Sometimes referred to as a limited liability or silent partnership, this model applies to partnerships where one or more of the parties are acting only as an investor. This can be an overly complicated business structure, and is rarely used by small businesses.
- Joint Venture – This is similar to a general partnership, but with a limited life span. For example, if two people are joining together complete a specific business project they might form a joint venture.
Forming a partnership is similar to a sole proprietorship. It is relatively inexpensive, with the only major costs being license fees and the optional DBA. However, there are some important points to consider before launching into either a general or limited partnership:
- Tax Obligations – Partnerships are considered “pass-through” entities and all profits and losses must flow through the partners. Before entering into a general or limited partnership all parties should familiarize themselves with the IRS’ partnership tax Like sole proprietorships, partnerships are required to file and pay quarterly tax estimates.
- Partnership Agreements – A partnership agreement is not necessarily required to start a multi-owner business, but it is highly recommended. A legally binding partnership agreement will outline each partner’s risks and responsibilities, and will ultimately protect all parties. The added expense of hiring a lawyer will pay off in the long run should any of the partners fail in their responsibilities or decide to sever the relationship.
Business partnerships can get complicated, so it is always important to only partner with people you can trust. Remember, any bad business dealings or debts are the responsibility of all of the partners. Choose your partners wisely and don’t neglect a legally binding partnership agreement.
Limited Liability Corporation (LLC)
Limited Liability Corporations, or LLCs, are perhaps the most common choice of business structure for small enterprises. They offer the flexibility of a sole proprietorship while providing some much-needed financial and legal protection for the business owner. If you want to protect your personal assets, and limit your legal liabilities in the event of a lawsuit or insurance claim, than an LLC might be right for you.
Forming an LLC is a bit more complicated than a sole proprietorship or general partnership. You have to choose a compliant business name, create an operating agreement, file articles of organization, and apply for the necessary licenses, permits and DBAs. It’s important to note here that LLCs tend to vary from state to state, so it’s always a good idea to work with a local attorney when setting up your limited liability corporation.
Some key points to consider when forming an LLC:
- LLCs are More Complicated to Form – With added protection comes additional costs and complications. Limited liability corporations are more difficult to form than sole proprietorships or general partnerships. Most business owners will require legal representation when forming an LLC, and that can add to a business’ start-up costs.
- Tax incentives – One of the attractions of an LLC is the availability of tax incentives for the business owner. An LLC is still classed as a “pass-through” entity, but owners are only taxed on their share of the profits. Having said that, incentives and exemptions can make for more complicated tax returns and business owners may require a dedicated accountant to keep on top of the obligations to the IRS.
- LLCs Vary from State to State – The laws governing LLCs are different in every state, so it is important to check with local governments when choosing a business structure.
A corporation is the most complex of the business structures we’ve looked at so far. Forming a corporation is rarely an option for smaller businesses and start-ups with limited resources and smaller employee rolls. As a general rule the corporate structure is best suited to larger, more established, businesses that intend to sell stock in their company.
There are 3 types of corporations to consider:
- C Corporations – With a C Corp all shareholders combine to fund the business and are assigned stock in return for their investment. C Corps are considered separate tax entities by the IRS, and can take advantage of valuable tax deductions and incentives. However, shareholders are subject to being taxed twice on the earnings as they relate to their business and personal tax returns.
- S Corporations – An S Corporation is structured similarly to a C Corp with one major difference. In an S Corp profits can “pass-through” the owner’s personal taxes. The S Corporation typically applies to family owned businesses and companies with smaller ownership groups (typically limited to 25 individuals). Only individuals can legally hold stock in an S corporation.
- B Corporations – A B Corporation is structurally similar to a C Corp. The major difference is that a B Corporation has a social mission at the heart of its business objectives. The ‘B’ stands for benefit, and businesses must be vetted before being given a B Corporation classification.
Unlike a proper nonprofit organization, a B Corp is still a profit making enterprise. While a B Corporation may become eligible for certain tax deductions and incentives due to their overriding mission statement, they still have shareholders that expect to be paid.
A corporation is the most difficult type of business structure to form, and there are some distinct advantages and disadvantages that deserve consideration:
- Greater Protection for Personal Assets – Forming a corporation offers greater protection for business owners and shareholders. If the business fails or is subjected to litigation the personal assets of its owners and investors are at a reduced risk.
- Easier to Raise Capital – Corporations have a greater potential to raise capital for expansion by selling shares in the company.
- Greater Tax Deductions – Corporate taxes are filed separately from personal taxes, with corporations often being able to qualify for tax deductions and incentives that are not available to other business models.
- Difficult and Costly to Form – While corporations have much to offer, they are extremely difficult and costly to form. As the most complicated of all business structures form any corporation requires a great deal of paperwork, fees and legal compensation.
- Double Taxation – Depending on the type of corporation double taxation could be an issue. For example, if you form a standard C Corporation you will be taxed on income earned from the corporation as well as any dividends. S Corporations, on the other hand, are not subject to double taxation as the shareholders are responsible for filing all of their own state and local taxes.
When in Doubt, Consult an Attorney
Choosing the right business structure for your new enterprise is critical to its long-term success. There are advantages and disadvantages inherent in each model, and careful consideration is needed before making your final decision. Legal advice is always beneficial when making such an important decision, and the cost of consulting a local business lawyer will pay for itself once you have the right business model in place.
Take your time, research your options, and take the advice of business advisors or legal experts in your area. Your choice of business structure sets the stage for your business’ future performance and it is important to make the right choice before you launch your new venture.