The United States is often called the land of opportunity, and nothing proves this more than the number of small businesses in the country. Each year, more than 600,000 new small businesses open across the country. While some of these businesses are individuals who work for themselves, just under half of the country is employed by a small business, representing a significant portion of the economy.
If you are one of the people considering becoming a business owner, it may feel overwhelming to take the first steps. In addition to worrying about your personal income and all the details of your business plan and operating agreement, there are steps you need to take to ensure your business is registered through the government.
The first decision you will have to make is what structure your business will take on. There are different types of businesses. Each business structure has benefits and drawbacks, so it will be important to choose the one that most closely aligns with your goals.
Why is it important to get the right business structure?
While business structures have much to do with paperwork and formalities, the decision has farther-reaching implications than what is listed on your files with the state. The business structure you choose can impact everything from day-to-day life as a business owner to your long-term obligations.
There are three primary areas that are impacted by the business structure you choose.
Each state is in charge of administering business formation applications, usually known as Articles of Organization or Articles of Incorporation, but the Internal Revenue Service uses that information when it is time to file federal taxes. For taxation purposes, some business structures are considered to be pass-through entities, meaning profits are passed directly to the business owners and reported on personal tax returns.
Other structures are taxed as completely separate entities with their own tax rate and structure. The type of business entity you choose will impact how and when you file, along with what kind of taxes you may pay.
As a business owner, you are responsible for what happens at your company, which sometimes comes at personal risk. When a person and their business are considered one legal structure, it means that anything the business is liable for, the person is also liable for potentially.
Some structures offer little protection in this area, and the owner may be responsible for debts, obligations, and legal consequences on behalf of the business. Other structures offer a buffer from this liability in varying degrees.
Certain business structures require the organization to have well-documented and thorough plans for running the business. This can include information like how to settle disputes, who makes decisions, how money is handled, and how this information is reported back to the state. Stricter requirements for operations often mean more mandatory reporting, including the administrative overhead to maintain that reporting.
Types of businesses to choose from
1. Sole proprietorship
The business and its owner are considered a single legal entity in a sole proprietorship. Anyone who operates a business is technically considered a sole proprietor, even if they haven’t formally filed for that status. This allows owners to claim all profits and losses on their personal tax return but also means they assume all liability for the business’s obligations.
Who is it good for
A sole proprietorship is a good option for anyone who wants complete control of their business and is willing to assume this liability.
- Easy to set up with little administrative costs and activities
- Taxes are done at the individual level, which avoids corporate tax rates and allows for special deductions
- Owners maintain total control of their business and its operations
- Owners have unlimited liability when it comes to debts, lawsuits, and other obligations the business may have
- It can be more difficult to raise funds for a sole proprietorship.
2. Limited liability company (LLC)
An LLC, or Limited Liability Company, offers a hybrid option between sole proprietorships and the more formal corporation. Like a corporation, an LLC has a formal management structure that includes members. These members have a fair amount of personal asset protection, meaning they are not liable for most obligations the business could face.
The members can also claim profits directly on their tax returns, rather than paying corporate taxes.
Who is it good for
LLCs are the choice of anyone who wants to maintain control over a business without assuming total liability.
- Simple to start up, with minimal annual reporting requirements
- Personal assets are protected from creditors and others who may be able to collect from the business
- Tax treatment is on a pass-through basis, using individual tax returns rather than corporate ones
- Members can manage the business without the need for a separate board of directors
- There is some liability taken on by members, especially if they are found to be practicing business unethically
- New business owners may be subject to additional self-employment taxes
- If any member leaves or dies, the LLC must be dissolved and reinstated without them
If you want to go into a business with another person or people, a business partnership can be a great option to ensure everyone is treated properly. Partnerships can be formed as general partnerships, limited partnerships, or limited liability partnerships (LLP), but the core idea will remain a division of ownership.
As a part of starting these businesses, you will typically be expected to create a formal partnership agreement on how disputes will be handled and how ownership, responsibilities, and profits will be shared.
Who is it good for
Partnerships are often a good choice when people bring disparate experience and business acumen and need to combine forces to make a business successful, and are often best when the people can manage the business without involving emotion or personal relationships
- A partner means you will have an extra set of hands for daily operations, as well as additional knowledge brought to the table
- Starting a partnership is simple and doesn’t require much paperwork or tax forms
- You and your partner can dictate management structure and operational terms
- All decisions have to be made jointly, and it is inevitable that you will disagree with your partner
- Profits will be shared, and you will each be taxed individually
- A partnership is not a separate legal entity, meaning you and your partner are legally and financially responsible for the business
4. C Corporation
When someone refers to a corporation, they are most likely talking about a C corporation. These legal entities offer total personal asset protection for owners and can have unlimited owners, along with multiple classes of stock.
Taxes are paid at a corporate level; therefore, a C corp needs to comply with many regulatory guidelines to maintain status.
Who is it good for
Companies planning to issue stock or who want complete legal separation from the owners will choose a C corp.
- The business is a completely separate legal entity from its owners, meaning they are not liable for legal and financial obligations
- There is no restriction on who can hold shares, and they can be easily transferred
- Multiple classes of stock can be offered, including stock options
- Venture capitalists and other investors are familiar with C corps and willing to back them
- The entity is separate from the owners, so if one leaves or dies, the business continues
- Corporations can be more complex to operate as formalities must be managed, annual reporting must be done, bylaws created, and there is regulatory compliance to monitor
- Taxes must be paid on the corporation’s profit and loss, while shareholders must also pay taxes on their dividends. This phenomenon is known as double taxation
5. B Corp
Certain corporations can apply for a B Corp status if they demonstrate a strict commitment to social causes. By volunteering to implement rigorous social and environmental standards, these businesses commit to accountability and transparency around their practices.
A nonprofit called B Lab issues this certification, which requires strict adherence to their guidelines.
Who is it good for
Any type of business can become a B corporation if the organization is environmentally-minded. Only certain owners will be interested as this certification takes a lot of work and willingness to make adjustments that favor sustainability and people over profits.
- Becoming a B Corp means you are committed to doing good in the world
- Some clients, potential employees, and public relations vehicles will value the B corp status
- Becoming a B corp requires you to meet rigorous standards and uphold them throughout the life of your certification, which must be renewed
- Not every state recognizes B Corp as a business classification
- There are no tax or liability benefits
If a business has a purpose dedicated to social good and serving a need and is not designed to earn a profit, it can be eligible to be a nonprofit organization. Nonprofits are subject to separate state laws and may be able to obtain tax-exempt status. For tax purposes, some nonprofits are entirely exempt from business income tax altogether.
Who is it good for
Not just any business can be a nonprofit. If you plan to help others in some way, nonprofit status could be your best structure.
- A nonprofit seeks to help the larger community, which is personally and professionally rewarding
- Nonprofits enjoy lower tax burdens than other businesses and may even enjoy discounts on things like rent
- Founders and employees at nonprofits are protected from personal liability for things like fines and lawsuits
- It can be costly to start a nonprofit while not expecting to make a large amount of money
- Nonprofits must keep up with annual reporting and regulatory guidelines
- Securing funding for nonprofits is competitive and can be difficult
A business cooperative is a business that is owned by employees rather than separate owners. Each member has an equal voice in the business, regardless of the shares they own, and profits are divided equally between member-owners.
This differs from a partnership, which is still concentrated around designated owners. While each cooperative member is taxed individually, they enjoy some liability protection through the structure.
Who is it good for
A company that plans to give each employee a share and a say in the business.
- Employees at cooperatives tend to be very invested and dedicated to the company
- Equal distribution means the liability is evenly distributed amongst a large number of people
- Overhead costs are often low
- Owners are only taxed once, rather than being taxed as a business entity and then again through personal profit
- Not every state allows for businesses to be incorporated in this way
- Profits will be lessened for founders due to the equal distribution of funds
- It can be difficult to make decisions with a larger number of stakeholders
Things to consider when selecting a business type
The right business structure for your business will depend on your preferences in several areas. Consider which are most important to you when making this important decision.
1. Ease of setup
Business structures are managed by the state, which will have a defined process for the approval of any business. Some structures, like sole proprietorships or partnerships, require no paperwork and approval from the secretary of state. This means you can start working on your business immediately, without processing times and approvals holding you up. More complex structures like corporations will require more time, effort, and fees to get off the ground.
2. Liability protection
One of the core questions regarding the business structure is whether the owners and the business are considered legally separate entities. When they are not, liability is also shared, meaning that if a business owes money, is implicated in a lawsuit, is bankrupt, or is otherwise found liable, the owner can be forced to answer. Personal assets like cars, homes, and money can be seized in these cases. Choosing a business structure is, in part, deciding your risk tolerance when it comes to your personal assets. This may also vary based on your work and the potential for lawsuits and debts.
The IRS uses business structure to determine how businesses are taxed. Any time a corporation is taxed as its own entity, it is subject to higher corporate tax rates and potential other taxes, while members still must pay personal taxes on their earnings. This double taxation is a disadvantage for many people, who will opt for a pass-through style structure that skips corporate taxes and allows all profit and loss to be reflected on individual returns.
4. Number of owners
Some structures dictate the number of owners- a sole proprietorship can have only one, while a partnership must have at least two, for example. But depending on if you want to issue stocks and what kind, or if you are planning to go public one day, different structures will allow you to expand ownership.
Many businesses are intended to stay small for their lifetime and be successful on that scale. If you never plan to transfer ownership or bring in other owners, something like an LLC can be the best option. But if there is a potential for companies to be large, it may be easier to start out with a more complex structure like a corporation that allows for stocks to be issued, ownership to be transferred, and other moves that could facilitate the growth of a company.
6. Your commitment level
If you’re running a small company just for some extra cash, it may not be worth it for you to go through the tedious paperwork, reporting, and payments associated with something like a corporation. A simple sole proprietorship or LLC can be good for even the most casual of businesses. However, if you are entirely dedicated to a large business, it could be worth going for a more formal structure.
In a sole proprietorship, the owner and the business are the same legal entity, which means the owner assumes all liability for the business. In an LLC, the owners are separate from the business and afforded some asset protection. LLCs can also have more than one owner and a more complex structure overall.
Most freelancers choose a sole proprietorship, which allows them to completely control their work and business. The lack of applications and startup costs means there is no additional work to be a sole proprietor, and the focus can remain on the services provided through a contracting agreement.
Not every side hustle will need a business structure at all, but for freelancers or those starting small side businesses, a sole proprietorship is generally sufficient. This allows a business to exist without the time and effort it takes to maintain LLCs or corporations.
If you are unsure of the right business structure for you, a business attorney in your state can help you make the right choice. An attorney will offer guidance on liability, reporting, and compliance for each structure. You should also speak with an accountant regarding the tax implications of each structure.
No, S corps are not a separate business structure. Instead, it’s a tax liability structure. When this election is in place, the members assume complete tax liability for the business’s profit and losses.
This form of business has high standards. Only about 1 in 3 applicants are approved by the governing body.