How to Choose a Business Structure
When starting a business, one of the decisions you’ll have to make is choosing a legal structure best fitting for your organization. Your choice will not only impact how you manage and make decisions for your business. It will also affect the amount of taxes you pay and whether you get personal liability protection or not.
Each business structure has its benefits and drawbacks that may or may not suit your business. Your goal should be to select the one that enables you to meet your present and future business needs.
All You Need to Know About Choosing a Business Structure
This post will go over the factors you need to know when choosing a business structure. You’re also going to learn the different types of business structures available and how they differ from each other.
Common Business structures
When deciding which structure best fits your business, your first action point should be to identify the characteristics of the ones available. There are five common business structures. They include:
Let’s explore the structures one by one:
Sole proprietorships are businesses owned and controlled by one individual. They are the most basic type of business structure. Sole proprietorships don’t require much financial investment or technical expertise to start and manage. They are an excellent choice for an entrepreneur who wants to try and test their idea before deciding whether to register a formal business. Here are the pros and cons of a sole proprietorship:
Ease of Starting and Dissolving
One notable advantage of sole proprietorships is they are easy to start. You don’t need to structure nor register a sole proprietorship with the state. You can, however, file for a DBA (Doing Business As) if you want to use a fictitious name for your business.
Sole proprietorships are also the easiest to dissolve. You, the sole proprietor, are the sole decision-maker. And thus, the resolution to end the business all boils down to you. Your choice won’t affect any other owner or investor but you.
The ease of forming and dissolving a sole proprietorship makes this structure ideal for someone who wants to try their hand on an idea. You can always change to another business structure if the business idea seems promising or dissolve the business if it doesn’t.
No Double Taxation
Another benefit of having a sole proprietorship is there’s no double taxation. The IRS perceives you and your business as one entity. They tax you at the personal income level.
The IRS considers your profits as personal income in a sole proprietorship. And thus, you’ll only pay taxes on the number of profits your business makes, but at the individual level. You also don’t need a federal EIN if you don’t have employees. You can report your taxes using your SSN.
Complete Ownership and Control
In a sole proprietorship, you, the sole proprietor, are the one who calls all the shots on how to manage your business. This business structure is the most flexible in that there’s no bureaucracy and no consultation or approval in decision-making. You have all the voting shares in the business and can dictate where you’d like it to go.
No Profit Sharing
One last benefit of a sole proprietorship is you get all the profit your business makes. You are not required to distribute them amongst other owners or stakeholders.
No Personal Liability Protection
Sole proprietorships are not separate entities from their owner. The sole proprietor has unlimited liability, meaning that they are fully responsible for the business’s debts. If you take a loan from a bank to finance your sole proprietorship, the bank can claim your personal assets if you default.
Limited Growth and Life Span
Sole proprietorships have limited growth opportunities. They can’t expand as quickly or as easily as other business structures. The sole proprietor, in most cases, lacks the financial capacity and expertise to grow their business into new territories, products, or ventures. Sole proprietorships are highly likely to collapse once the owner dies or leaves the organization.
Significant Time Commitment
In a sole proprietorship, there’s no shared responsibility and accountability. You manage everything alone or with one or two employees. This business structure may demand a lot of time commitment. You might have to play the role of manager, marketer, distributor, customer care, and so on.
Limited Funding Options
Sole proprietorships have limited funding options. Most investors and lenders may perceive this business structure as high risk and thus prefer not to invest in it. Sole proprietorships can’t sell stock to private investors.
A partnership is a business owned and controlled by more than one individual. In this business structure, partners share profits and losses equally. They may also share responsibilities if it is a general partnership.
There are many types of partnerships, each having one or two distinguishing characteristics.
Types of Partnerships
A general partnership is one where partners share day-to-day tasks in the business. They also share the burden of paying debts and liabilities.
General partnerships are the simplest business structure. Some states don’t require you to register this partnership structure. You and your partners can start the business using a partnership agreement.
In a general partnership, each partner has unlimited liability. They are all personally responsible for settling the business’s debts and liabilities. Like sole proprietorships, this partnership structure is more or less easy to start and dissolve.
A limited partnership is one where there’s at least one general partner and one or more limited partners. The general partners are responsible for the daily operations in the business. They have unlimited liability.
The limited partners, by contrast, do not actively run the business. They are also not personally liable for the debts of the partnership. They do, however, get a share of the profits.
Limited Liability Partnerships
A limited liability partnership allows partners to share daily operations of the business while also limiting liability to their actions or those of other people under their supervision. In a limited liability partnership, every partner is a general partner but is only personally liable for his actions in the business.
Master Limited Partnerships
A master limited partnership is a type of partnership that can be publicly traded on the stock exchange yet taxed on the individual income level. This partnership structure combines the tax advantage in a general partnership with the ability to raise capital in a corporation. Master limited partnerships have two forms of partners, general and limited partners.
Advantages of Partnerships
Shared Roles and Responsibilities
In a partnership, owners share day-to-day responsibility, and thus no one feels overwhelmed with the time and task commitment. The partners also support and motivate each other to work, making running the business less stressful.
Ability to Pool Skills and Resources
Every owner in a partnership comes with their unique skill and experience. One partner might be good in business development. The other one may be skilled in technology and web design, while the third might be an expert in marketing and advertising. When solving a problem or making a decision, the partners bring different points of view to the table. Through brainstorming and debating, they can create better solutions for the business.
No Double Taxation
The IRS perceives a partnership as one entity with its owners. They, therefore, tax this business structure at the individual income level, not at the corporate level. There isn’t any double taxation.
Higher Chances of Survival
Partnerships have higher chances of survival compared to sole proprietorships. Once a partner dies or leaves the business, the other partners can pick up from where he left off.
Partnerships also have a better financial capacity than sole proprietorships. The partners can pool their funds together to grow or expand their business.
Disadvantages of Partnerships
Division of Profits
In a partnership, profits get distributed amongst all partners according to the partnership agreement. The Partnership Act of 1890 states that profits must be shared equally among all partners unless they amend a new partnership agreement to change this profit-sharing status.
Owners in a general partnership have unlimited liability. They are responsible for the debts of the business. In a limited liability partnership, each partner is only liable for their actions or those of people under their management.
Slow Decision-Making Process
Partnerships aren’t as flexible as sole proprietorships. The decision-making process in this business structure can be slow. Each general partner has a say in where the business should go. Before making a decision, the partners need to consult each other to approve or reject each decision that passes through them.
Harder to Terminate
Terminating a partnership will require a unanimous vote from a majority, if not all partners. It’s not as easy as ending a sole proprietorship.
A limited liability company, also known as an LLC, is a business structure that provides legal liability protection for its owners. The owners of an LLC are called members. In most states, the members can be an individual, corporation, another LLC, foreigner, even a foreign entity.
One notable benefit of an LLC is you select your choice of taxation. LLCs can get taxed on the individual income level like a sole proprietorship or corporate level like a corporation.
There are several types of LLCs:
- Single-member LLC – has one member/owner.
- Multimember LLC – has two or more members.
- Non-profit LLC – an LLC whose goals don’t include making a profit for the company.
- Professional LLC – an LLC that provides licensed professional services such as legal and medical.
- Series LLC – an LLC that consists of a mother or master LLC and other individual LLCs under it. In a series LLC, an individual LLC is not liable for the debts and liability of other individual LLCs in the series.
Advantages of an LLC
Legal Liability Protection
An LLC provides limited liability protection to its owners. Members are not personally liable for the debts of the company.
For example, when you take a bank loan for your LLC, the bank cannot claim your personal assets to pay the loan. They can only collect those of the LLC.
Choice of Taxation
As mentioned above, an LLC can get taxed as a sole proprietorship or a corporation. They can choose the pass-through taxation where the business’s profits get taxed at the owner’s tax return or the double taxation method of corporations.
Flexibility in Operations and Management
Another benefit of LLCs is anyone can form them, whether an individual, corporation, foreigner, or another LLC. There are no ownership restrictions, for example, the minimum or the maximum number of members. LLC can also be member-managed (meaning the members run and manage the company’s operations) or manager-managed, where the owners hire managers to run the business.
Disadvantages of an LLC
Costly to Form
LLCs are more expensive to set up and run. You may be subject to paying filing fees and filling in a good deal of paperwork.
A corporation is a business structure that’s a separate legal entity from its owners, also known as stockholders or shareholders. The owners of a corporation can be an individual or business entity. As a separate entity, a corporation can enter into litigation in its own right.
Types of Corporations
There are various types of corporations, but the two that you are most likely to find in the United States include:
An S-corporation, better known as an S-corp, acts like a corporation but gets taxed like a partnership or sole proprietorship. This corporation type is attractive to small business owners because it enables them to avoid double taxation. S-corps are not separate taxpayers from the shareholders.
To achieve an S-corp status, you must first register as a corporation then file for S-corp with the IRS. The advantage that comes with this corporation structure include:
- No double taxation
- Can raise capital by transferring shares or stocks
- Limited liability
The disadvantages are:
- Only US citizens can register an S-corp
- Can only have a maximum of 100 shareholders
- The IRS scrutinizes S-corps closely
- The IRS can terminate your S-corp status if you fail to follow the formalities and regulations
C-corporations are the most common business structure in the United States since they provide limited liability and are a separate legal entity from the owners. The main difference between a C and S-corp is that a C-corp gets taxed twice. The IRS taxes them on the profits made and the dividends distributed to stockholders.
Here are the advantages you stand to gain by setting up a C-corp:
- Limited liability
- No stockholder limit – C-corps can have as many owners as they want
- Easy transfer of shares – can transfer stocks to raise money
- Long life span and unlimited growth
The disadvantages of a C-corp include:
- Double taxation
- Expensive to set up and manage
- Rigid management structures and formalities
- Difficulty in termination
A cooperative is a business structure owned and managed by the people who use the product or service. The owners of this legal structure can be producers, consumers, or employees who have similar needs. They combine resources to fulfill those needs.
Cooperatives are more community-focused than profits oriented. They are, in most cases, guided by a set of seven cooperative principles, and they focus on achieving a balance between profitability and fulfilling members’ needs. Cooperative should have at least 15 owners to start the business.
Factors to Consider When Choosing a Business Structure
Now that we’ve discussed the most common business structures, it’s time to help you choose the right one for your business. Here are the factors to consider when choosing a business structure for your organization.
How many owners do you want your business to have? If you’d like to be the exclusive owner, then a sole proprietorship or a single-member LLC would be an excellent choice. In the case of two or more owners, you can register a partnership, corporation, or cooperative.
Do you want your business to provide liability protection for its owners? If so, it’s better to register a limited partnership, LLC, or a corporation.
Cost of Formation
Sole proprietorships and unlimited partnerships are easier to form. Most states don’t require you to register these two. You only have to file for a DBA if you operate with a fictitious name.
LLCs and Corporations are the most costly to set up. They require you to pay filing fees, and you may have to submit tons of paperwork.
Ease of Dissolution
If you’d like to test a new idea in the market, you may want to register a business that’s easy to dissolve. This way, you’ll be able to dissolve if it doesn’t pan out the way you wanted.
Dissolving a sole proprietorship doesn’t require much thought or consultation. Your decision is the only one that matters. You can also register an unlimited partnership. It’s also not difficult to dissolve.
When choosing a form on business ownership, try not to overlook the tax implications that come with it. The IRS treats each business structure differently depending on whether it is a separate entity from its owners.
There’s no double taxation in a sole proprietorship, partnership, and S-corporation. A C-corporation, by contrast, is taxed at the corporate level and the individual level.
Management and Administration
Some business structures come with rigid management requirements. A corporation, for instance, may require you to have a board of directors that holds meetings annually. The process of making decisions or encouraging organizational change in such a structure will require careful consultation, and it may take time.
If you want your business to have a flexible ownership structure, go for a sole proprietorship, partnership, or LLC.
Ability to Raise Capital
It’s easier to raise money for a corporation than any other business structure. You just need to sell some of your shares to investors.
It might be challenging to attract investors in a sole proprietorship or partnership since there is no share structure. Most lenders also consider these two business structures as high-risk.
The legal structure you choose when starting your business may affect how you run the business. It might also affect the amount of taxes you pay.
The five common structures in the U.S include sole proprietorships, partnerships, cooperatives, LLCs, and corporations. It’s better to consult a CPA accountant to advise you on the advantages and disadvantages of each structure so that you pick the one best fitting for your organization.
The factors to consider when selecting a structure include setup cost, ownership structure, and personal liability protection. You may also want to think about the tax implication in the business structure, your ability to raise capital, and the ease of dissolution and administration.