Types Of Business Structures: The Complete Guide
If you’re starting your own business, one of the first steps is choosing a business structure. 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 personal liability for the debts and obligations of your business.
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.
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. In this article, we’ll break down different business structures and the benefits and drawbacks of each to help you make the most informed decision for your business.
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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. There is no need to formally register your business. However, depending on the type of business you own, you may still be required to get the state and local licenses and permits needed to legally operate your business.
Under a sole proprietorship, you may operate under your own name or a fictitious name — also known as a trade name. This trade name does not create a legal entity separate from the owner.
The owner of the sole proprietorship records the income and losses of the business on their personal tax return by filing a Schedule C form. Sole proprietors also file a Schedule SE for paying self-employment tax. These forms are filed with the standard Form 1040.
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.
One of the biggest downsides is that a sole proprietorship is not a separate legal entity. In fact, it is indistinguishable from its owner. This means that the business owner can be held personally liable for the debts and obligations of the business. If your business is sued for negligence, for example, your personal assets — such as your bank account and personal real estate — could be at risk. If you default on a business loan, your personal assets could be seized to repay the debt.
Sole proprietorships are best for low-risk businesses. Some entrepreneurs start off 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.
Pros & Cons Of Sole Proprietorships
Is a sole proprietorship right for your business? Consider these pros and cons before deciding.
- Easy & Inexpensive: There are no costly fees associated with setting up a sole proprietorship. In fact, you don’t even have to register at all. Simply buying and selling goods or performing other business activities classifies your business as a sole proprietorship.
- No Ongoing Requirements: Unlike other business structures, a sole proprietorship does not have requirements such as meetings or voting.
- Simplified Taxes: You do not have to file a separate tax return for your sole proprietorship. Instead, you simply attach your Schedule C and Schedule SE to your personal income tax return. You will also have your earnings taxed just once, and you can write off your business losses on your personal return.
- Unlimited Personal Liability: As a sole proprietor, you would be responsible for the debts, obligations, and liabilities of your business. Your personal assets could be put at risk, and lawsuits can be filed against you.
- Financing Difficulties: Getting extra capital when you need it can be difficult as a sole proprietor. Banks, credit unions, and even some alternative lenders are hesitant to loan money to sole proprietors. You also will be unable to sell stock to raise money.
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.
When it’s tax time, a Form 1065 is filed with the IRS to report income, losses, gains, deductions, and credits. The partnership does not directly pay income taxes, but instead, “passes through” profits and losses to each partner, who report this information on their personal tax returns. Profits or losses are recorded on a Schedule K-1, which is filed with personal tax returns. All partners are also required to pay self-employment tax based on their share of the company’s profits.
Before establishing a partnership, it’s always important to ensure the right partners are selected. Disagreements between partners can hinder business growth and even be the downfall of a business.
While any business with two or more owners can form a partnership, this business structure is best for low-risk businesses and professional groups. Like sole proprietorships, this structure is also a good way to test out a new business idea. If the business is successful, owners may take the next step to growth by reorganizing as a corporation.
Types Of Partnerships
We’ve established the basic definition of a partnership. However, there are three different kinds of partnership to consider. The primary difference between the three lies in the personal liability of each partner.
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.
With a limited partnership (LP), there is one general partner that 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.
Pros & Cons Of Business Partnerships
With the right people, a partnership can be very successful. There are several benefits to forming a partnership. Before you get started, though, it’s also important to understand the risks and drawbacks associated with this business entity.
- Minimum Requirements For GPs: General partnerships have minimum requirements and do not require filing with the state. Partnerships are also not subject to the same requirements as corporations, such as holding meetings, recording meeting minutes, and establishing bylaws.
- Tax Requirements: Partnerships are not required to pay taxes on income, and partners can report their share of profits or losses on their personal income tax returns. Business losses can also be deducted on personal tax returns.
- Raising Capital For LPs & LLPs: Businesses that choose to form an LP or LLP may be able to raise capital from their investors.
- Personal Liability: General partners are personally liable for the debts, obligations, and liabilities of the business. Each partner may also be held accountable for the actions of other partners.
- Financing Challenges For GPs: General partnerships may have difficulties getting loans or other types of business financing if the business is not a registered entity.
- Costs: While forming a general partnership is easy and inexpensive, forming a limited partnership or limited liability partnership may be more expensive and requires filing with the state.
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 personal tax returns. Many corporations enlist an accountant and/or tax preparer to ensure returns are filed correctly, which adds an additional 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.
A C-corporation, or C-corp, is your basic corporation. This business entity is completely independent of its owners. With a C-corp, owners have the best protection from personal liability. 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.
An S-corporation, or S-corp, is different from a C-corp because it is used to avoid double taxation. Profits and losses of the business can be passed through to the personal tax returns of the owners without being subject to corporate tax rates. To form an S-corp, a filing with the IRS is required.
Another way that an S-corp differs from a C-corp is that there is a limit on the number of shareholders. An S-corp may only have up to 100 shareholders, which could limit the amount of capital raised by the business.
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.
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.
Pros & Cons Of Corporations
There are big benefits that come along with forming a corporation, but like other entities, there are also negative aspects to consider before choosing a corporation as your business structure.
- Ability To Raise Capital: Corporations give you the biggest opportunities for raising large amounts of capital through the sale of stock.
- Limited Personal Liability: Corporations offer the most protection against personal liability for shareholders.
- Some Tax Benefits: C-corporations offer more tax deductions than other business entities, as well as lower self-employment taxes. S-corporations also offer the additional benefit of no corporate tax rates or double taxation.
- Higher Cost To Form: It is more expensive to form a corporation than any other business structure.
- More Requirements: Corporations have more ongoing requirements, including holding meetings, recording meeting minutes, and establishing bylaws.
- Shareholder Restrictions: The number of shareholders is restricted to 100 or less if you create an S-corp.
- Higher Taxes: C-corps face double taxation. Business losses also can’t be deducted on personal income tax returns.
Limited Liability Company (LLC)
Business owners that want the best of both worlds may consider forming a limited liability company, also known as an LLC. An LLC 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. All members of the LLC can fully participate in the operations of the business.
LLCs must be registered with the secretary of state in the state where the business will operate. In some states, an operating agreement will also need to be filed.
In an LLC, owners have limited liability, in most cases protecting their personal assets from being taken to pay off business debts and obligations, just like a corporation. Personal assets will also be protected in the event that the business files for bankruptcy.
Owners can select how an LLC is taxed by the Internal Revenue Service. LLCs can be taxed like a corporation, or the profits and losses can be passed through to the LLC members and filed on personal tax returns. Members must file a Form SE to pay self-employment taxes.
An LLC is best for any business that wants to protect the personal assets of its members. It’s also a good choice for businesses that want the benefits of a corporation without paying corporate tax rates.
Pros & Cons Of LLCs
Will forming an LLC best meet the needs of your business? Only you can answer this question, but make sure to fully evaluate the pros and cons of forming an LLC before making your decision.
- Limited Liability: One of the biggest benefits of an LLC is that all members have limited liability, meaning personal assets aren’t at risk in most cases.
- Tax Benefits: With an LLC, you have the option to choose how your business is taxed.
- Fewer Requirements: There is less paperwork and fewer ongoing requirements for an LLC when compared to a corporation.
- No Shareholder Limits: An LLC has no limits to its number of shareholders.
- Expensive & Time-Consuming To Set Up: Because you will have to register with the state where you conduct operations, setting up an LLC is more expensive and time-consuming than forming an entity like a general partnership or sole proprietorship. You may also need to hire an accountant to help ensure you’re complying with the rules and regulations of your state — adding an additional expense to your list.
- Limited Life: If a member quits, dies, or retires, the LLC may be dissolved. Some states even have laws in place that require an LLC to dissolve after a set number of years.
Most businesses have one primary goal: to make a profit. One business structure is the exception: nonprofits. A nonprofit — or 501(c)(3) — is a business that is beneficial to the public.
Nonprofit corporations follow a set of rules and regulations similar to other types of corporations. However, nonprofits also have additional rules governing how profits are used. For example, profits can’t be distributed to members of the corporation.
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 IRS to receive this exemption, in addition to registering with the state.
Religious, educational, literary, and scientific organizations may be eligible for nonprofit status. Charities are also businesses that are formed as nonprofits.
Pros & Cons Of Nonprofits
If the goal of your business is to benefit the public, a nonprofit structure may be the right choice for you. However, if your goal is to make a profit, consider choosing another business structure. Before you make your decision, weigh out these pros and cons:
- Tax Exemption: Qualifying organizations may be exempt from paying corporate income tax, as well as state and local taxes.
- Tax Deductions: Charitable contributions by a nonprofit may be tax-deductible.
- Limited Liability: All founders, directors, employees, and members of the nonprofit are not liable for the debts and obligations of the nonprofits … in most cases. There are, however, some exceptions, such as when the organization is engaged in illegal activity.
- Grant Opportunities: Nonprofits may be eligible for public and private grants not available to for-profit businesses.
- Paperwork Requirements: Nonprofits must submit annual reports to state agencies and the IRS in order to maintain tax-exempt status.
- Costs: Starting a nonprofit can be expensive in terms of time and money. Nonprofits must pay fees, and most organizations opt to hire attorneys, accountants, and/or consultants to make sure records are kept up-to-date and all regulations are followed.
- Stricter Policies: In addition to following state laws and regulations, nonprofits are also required to follow their own bylaws and articles of incorporation.
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.
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.
Pros & Cons Of Cooperatives
If you’ve thought about your goals and you think a cooperative may work for your business, read through these pros and cons before you make your final decision.
- Everyone Has A Voice: Member-owners get to weigh in on key issues and decisions of the business. Regardless of how many shares a member-owner holds, all votes are weighed equally.
- Member Investments: Member-owners buy into a cooperative, providing a source of capital that can be used for operational expenses or expanding the business.
- Funding Challenges: Finding startup loans and other types of funding through traditional lenders may be difficult. Cooperatives have to get creative with other funding sources, such as launching a crowdfunding campaign or applying for small business grants.
- Slow Decision-Making: Voting and making decisions can be a lengthy process. This can put the cooperative at a disadvantage if a critical decision must be made immediately.
Ultimately, the type of business structure you select is based on the current and future goals of your business. You should consider the long term plan before choosing your business structure. While you can always reorganize if needed, this process can be lengthy and expensive. If you’re still having difficulties choosing the right business structure, consider consulting with an accountant, business consultant, and/or attorney to weigh out the pros and cons of each and make the decision that’s best for your business. Once you’re ready to your business off the ground, check out our beginner guides for business to get started on the right track.