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Types of Business Structures Explained
The choice you make about what type of business structure is appropriate for your company will affect how much you pay in taxes, the level of risk or liability to your personal assets (your house, your savings), and even your ability to raise money from angel investors or venture capitalists.
So, the structure you choose is significant.
This guide will explain the basics of common business structures, but we can’t tell you exactly which structure you should choose—if you need that kind of advice, you should consult a lawyer or an accountant.
The simplest business structure is the sole proprietorship. If you don’t create a separate legal entity, your business is a sole proprietorship.
The main advantage of the sole proprietorship is that it’s relatively simple and inexpensive. The disadvantage is that it doesn’t create a legal separation between you and your personal assets and business assets. If you’re sued or your business folds—your personal assets are fair game for creditors and in terms of legal liability.
Who is a sole proprietorship for?
A sole proprietorship is ideal for self-employed individuals like personal trainers offering individual coaching or artists selling unique items on platforms like Etsy.
- Cost-effective setup: The primary expense is usually the DBA (“doing business as”) registration. Some states may require public notice, like a newspaper ad. Generally, the total cost is below $100.
- Simplified taxation: Sole proprietorships are “pass-through” tax entities. Profits and losses are reported directly on the owner’s taxes, necessitating only a few additional tax forms if you’re the sole worker.
- Hiring employees is possible: Being a “sole” proprietor doesn’t restrict hiring. If you employ others, tax processes become slightly more intricate.
- Limited ways to raise funding: You can’t sell company stock, limiting fundraising avenues.
- Potential loan difficulties: Banks might hesitate to grant loans to sole proprietorships due to perceived credibility issues.
- Full personal liability: If the business faces debt or legal issues, your personal assets, including your home, car, and savings, are vulnerable.
Should you register as a sole proprietorship?
Explore the pros and cons of incorporating as a sole proprietorship.
Still a relatively simple business structure, a partnership involves two or more individuals sharing ownership of their new business. They’ll contribute to the business in some way and share in profits and losses.
Partnerships are harder to describe because they change so much. State laws govern them, but the Uniform Partnership Act has become the law in most states. That act, however, mainly sets the specific partnership agreement as the real legal core of the partnership so that the legal details can vary widely.
Usually, the income or loss from partnerships passes through to the partners without any partnership tax. The agreements can define different levels of risk, which is why you’ll read about some partnerships with general and limited partners, with different levels of risk for each. Your partnership agreement should clearly define what happens if a partner withdraws, buy and sell arrangements for partners and liquidation arrangements if necessary.
What are the types of partnerships?
- General partnership: Assumes equal involvement of all parties in profits, liabilities, and duties. Any intentional imbalance should be specified in the partnership agreement.
- Limited partnership: Suited for partners in an investor role with limited involvement in daily operations. This structure is more complex and less common.
- Joint venture: Designed for a single project or a limited duration, operating similarly to a general partnership.
Who is a partnership for?
A partnership is similar to an extended sole proprietorship and is ideal for two or more individuals wanting to start a business jointly.
To make the partnership more effective, you and your partners should have skillsets, connections, or other unique benefits that complement each other.
For example, a personal trainer and nutritionist building an online fitness program. One entrepreneur has experience building an exercise regiment with clients. The other understands how to create balanced meal and supplement recommendations.
They have unique but complementary knowledge that, when combined, creates a more valuable product/service.
- Partnership agreement: While not mandatory, it’s advisable to draft a partnership agreement, ideally reviewed by legal counsel, to clarify roles and responsibilities, ownership, and what will happen if a partner wants to leave the partnership.
- Tax implications: Partnerships are “pass-through” entities, meaning profits and losses are directly passed to the partners. Refer to the IRS for partnership tax details.
- Additional costs: Since it’s a good idea to have a lawyer look over your partnership agreement, don’t forget to factor in this added expense.
- Trust in partnership: Ensure your partner is trustworthy, as partners share responsibility for business decisions and debts. A well-drafted partnership agreement can prevent future conflicts.
How to create a business partnership agreement
Even if you’re not in an official partnership, you should consider drafting a partnership agreement. Doing so will clearly define rights and responsibilities and help you amicably resolve any disputes.
How partnerships are taxed
Understand how registering as a partnership impacts your taxes.
Plan for changes with a buy-sell agreement
What will you do if you or your partner quits, sells their portion of the business, or passes away?
How to find the right business partner
A partnership is more than a legal structure. It’s a relationship between entrepreneurs who share a passion for an idea and bring unique skill sets. So, how do you find the right person to make your partnership thrive?…
Traits to look for in a business partner
What makes a good business partner? If you’re considering someone with the following traits, you likely have a good fit.
How many partners should you have?
What’s the ideal number of business partners? The right mix of people and skillsets can lead to tremendous business growth. But too many may lead to disaster.
Limited liability company
Should your business fall on hard times, does the idea of being held personally responsible for all losses sound intimidating?
It’s understandable—plenty of would-be entrepreneurs shudder at the thought of the bank seizing their personal assets should the business go south.
A limited liability corporation (or LLC) is, in some ways, the best of both worlds. It allows for the flexibility of a partnership or sole proprietorship but, as the name suggests, limits the liability of those involved, similar to a corporation. An LLC is usually a lot like an S corporation. It offers a combination of some limitations on legal liability and some favorable tax treatment for profits and transfer of assets.
Who is a limited liability corporation for?
An LLC is ideal for those wary of personal liability in business. If you possess significant personal assets or operate in a lawsuit-prone industry—an LLC safeguards your personal finances.
- Complexity: While offering more protection, an LLC is harder to establish than a sole proprietorship or partnership.
- Tax benefits: LLCs maintain “pass-through” tax status, meaning you’re taxed only on your profit share, which is reported on personal taxes.
- Single-member LLCs: Most states allow single-person LLCs, making it a potential alternative to sole proprietorships.
How to form a limited liability company
Interested in forming an LLC? Here are the steps you’ll need to take.
How to create an LLC operating agreement
Set the rules for how your LLC will operate, including the management structure, individual responsibilities, ownership percentage, and other important information.
LLC costs and fees explained
Make sure you’re aware of all the costs and fees associated with forming an LLC.
Shareholders, a more complex legal structure, and more intricate tax requirements are all characteristics of a corporation.
Corporations are either the standard C corporation, the small business S corporation, or the benefit corporation or B corp. The C corporation is the classic legal entity of the vast majority of successful companies in the United States.
Corporations can switch from C to S and back again, but not often. The IRS has strict rules for when and how those switches are made. You’ll almost always want to have your CPA, and in some cases, your attorney, guide you through the legal requirements for switching.
Who is a corporation for?
Corporations are best suited for larger, established businesses with multiple employees, plans for rapid scaling, or intentions to trade or attract significant external investments publicly. A corporation might not be the right choice if you’re a small business owner or work with a small team.
What are the types of corporations?
What we typically think of when we refer to corporations, where all shareholders combine funds and are then given stock in the newly formed business.
A C corp is a separate tax entity, meaning your business can deduct taxes. It also means that earnings can be taxed twice, as they are concerning your business and your personal taxes if you take income as dividends. However, good tax planning can often minimize the impact of double taxation.
Most lawyers would agree (but verify this with your lawyer who is familiar with your unique business) that the C corporation is the structure that provides the best shielding from personal liability for owners, and provides the best non-tax benefits to owners. Many companies with ambitions of raising major investment capital and eventually going public consider the C corporation.
An S corp is similar to a traditional C corporation, with one major difference: Profits and losses can be “passed through” to your personal tax return without being taxed separately first.
In practical terms, the owners can take their profits home without first paying the corporation’s separate tax on profits. In most states, an S corporation is owned by a limited number of private owners (25 is a common maximum), and only individuals (not corporations) can hold stock in S corporations.
To become an S corp, you must first set your business up as a corporation within your state and then request S corp status. The IRS instructions for Form 2553 (which you’ll need to file to become an S corp) can help you determine if you qualify.
Does your company have a dedicated social mission, a good cause built into its foundation that you’d like to continue furthering as your company grows? If so, you might consider becoming a B corporation, which stands for “benefit corporation.”
However, the name is a bit misleading; a B corp isn’t an entirely different structure than a regular C corporation. It’s a C corp vetted and approved for B corp status. Some states give tax breaks to B corps, and it’s a great way to stand behind a cause.
So, why would you choose a B corp over a nonprofit? The biggest difference is in ownership—with a nonprofit, no owners or shareholders exist. A B corp, which is still a type of corporation, still has shareholders who own the company. So, a B corp has a social mission but is still a for-profit company (as opposed to a nonprofit) with an end goal of returning profits to the shareholders.
- Liability: Corporations offer the most protection for personal assets.
- Capital raising: The ability to sell stock enhances investment potential.
- Taxation: Corporate taxes are separate (except for S corps), but the structure can lead to double taxation, especially for C corporations.
- Complexity: Establishing a corporation is more intricate than other business structures, requiring more paperwork and formalities.
How to form a corporation
Follow these ten steps to incorporate as a C, S, or B corporation.
How are corporations taxed?
Understand how registering as a corporation impacts your taxes.
S corporation basics
Should you choose an S corp as the legal structure for your business? Learn the basics and what alternatives are available.
A nonprofit is a “not-for-profit” business structure, meaning the business does not exist to generate revenue for shareholders, but rather funnel business revenue into a social mission, cause, or purpose.
Who is a nonprofit for?
Nonprofits cater to those with missions centered on charitable, educational, scientific, or religious purposes. Examples include homeless shelters, conservation groups, arts centers, and educational institutions.
What’s the difference between a nonprofit and a cooperative?
Like a nonprofit, a cooperative is a business with a social mission that doesn’t divide income between shareholders but toward a cause or purpose. However, while some states view nonprofits and cooperatives as the same, a cooperative differs because the members own it, referred to as “user-owners.”
If you plan on organizing your business to be democratically owned, looking into the cooperative business structure might be a good idea to look into the cooperative business structure.
- Complex setup: Establishing a nonprofit requires steps similar to forming a corporation, including filing articles of incorporation, creating bylaws, and organizing board meetings.
- Fundraising will be your main priority: Nonprofits generally rely on fundraising and grants to keep a flow of income into their business.
What is a nonprofit corporation and how to start one
Learn the basics of setting up a nonprofit corporation.
Making your business legally compliant
Choosing a business structure is the first legal step you’ll take. Your choice will impact your taxes, fundraising, and personal liability.
Tim Berry, founder of Palo Alto Software (maker of Bplans) reminds small business and startup founders that choosing a business entity or structure is something to take seriously. He says:
“Make sure you know which legal steps you must take to be in business. I’m not an attorney, and I don’t give legal advice. I strongly recommend working with an attorney to review the details of your company’s legal establishment and licensing.
The trade-offs involved in incorporation versus partnership versus other structures are significant. Small problems developed at the early stages of a new business can become horrendous problems later on. In this regard, the cost of simple legal advice is almost always worth it. Don’t skimp on legal costs.”
TLDR: Take time, carefully weigh your options, and consult a legal professional.
Once you’ve chosen, check off the remaining legal requirements to start a business. While you can complete most of these in any order, here are a few suggestions.