Perhaps the most important step one needs to take when starting your own business, is choosing a business structure – or the form of entity you plan to establish. This will help you determine your liabilities as a company owner, how you’ll raise money for the organization, pay taxes, and file your paperwork. There are multiple structure options to choose from, so making this decision may be overwhelming, especially if you don’t know much on the subject.
In this article, we’ll break down the most common business structures in the U.S., noting advantages and setbacks associated with each. It’s important that entrepreneurs fully understand these options so they can determine which structure best meets their business’ needs and goals.
What is Business Structure?
A business structure refers to the category of a company’s organization as recognized legally within the jurisdiction in which it operates. A business’ structure helps the business determine what types of activities it can undertake relating to raising funds for the company, paying taxes, and the liabilities the company’s owner/s face.
Before deciding what business structure to use for your company, it’s imperative to consider your objectives and the level of liability you or your partners are willing to shoulder.
4 Types of Business Structures
The most commonly used structures in the United States are: sole proprietorships, partnerships, limited liability companies (LLC’s), and corporations. Here’s an overview of each, including the advantages and disadvantages they present:
The most common and simple type of business structure used in the U.S. is a sole proprietorship. Within this structure, only one person owns and operates the business. He or she makes all the decisions (management and financial) and has complete control of the entire company. In a sole proprietorship, the owner won’t have to file the business as a separate legal entity.
As for the tax perspective, a sole proprietorship is considered as a “pass-through” business. This means that the business taxes that are due for the company are filed along with the owner’s taxable income. Unlike other business structures, the business doesn’t pay its taxes separately.
Bookkeepers, freelance writers, tutors, fitness trainers, and cleaning professionals are some examples of individuals who will typically choose a sole proprietorship to set up their businesses.
Benefits of a Sole Proprietorship
- Easy to Set-Up. With sole proprietorship businesses, there isn’t a lot of paperwork to deal with. You won’t have to set-up an agreement between any partners because you’re the only one who has full control of your business. Unlike other business structures, like limited liability companies, you won’t have to register with the state government to do business. You become a sole proprietor by merely providing services or your expertise to the public.
- Filing Taxes is Easier. With sole proprietorships, you won’t have to file your business’ taxes separately. Instead, your business and personal taxes are filed as one in your 1040 form. Sole proprietors can also deduct 20% of their business income from their taxes based on the Tax Cuts and Jobs Act of 2017.
- Less Expensive. Sole proprietorship business structures are generally less expensive compared to others. Essentially, the only fees you have to pay are licensing and business taxes. This advantage appeals more to start-ups who are operating on a tight budget.
Drawbacks of a Sole Proprietorship
- No Protection for Personal Assets. Again, since your business and personal assets aren’t legally separated, a sole proprietorship could put your personal assets at risk in times of trouble, like if a business loan defaults. This would mean that creditors could tap into your personal assets to pay for your debts.
- Harder to Improve your Business’ Credit History. Since the business in its entirety relies on only one person – the owner – its credit will also depend on the owner’s personal credit history. This makes it harder for the business itself to establish a substantial credit history.
- Harder to Secure Business Loans. Since the business itself doesn’t have a good credit history to show banks, it will also be harder for the company to qualify for business loans. Banks and other financing companies tend to base the company’s credit approval on their credit history.
The second most common type of business structure in the U.S. is a partnership. In this arrangement, two or more owners will come together to create and run a business in which each has something unique to contribute. For instance, in a restaurant business, one owner could be a manager who is charge of overseeing the business operations, and the other owner could be a chef who oversees everything in the kitchen. Both individuals are bringing their expertise to the table to run the business together.
Partnerships can come in two different forms: general partnerships and limited partnerships. In a general partnership, all the profits, losses, and decisions in the company are shared equally between the owners. A limited partnership gives greater control and share of the company to one person while the other person contributes and receives a lesser percentage of the profits. The one who has a more significant share and control of the company likely gave more considerable seed capital.
When planning to form a partnership with another person, drafting a partnership agreement is always a smart step. This contract should include whether the partnership is a general partnership or a limited partnership. Have lawyers review the agreement to ensure that the partnership will result in a win-win situation for both parties.
As for the taxes, the profit and losses are passed through the owners of the company. The IRS requires the owners to report this information in their 1065 form. Furthermore, partners should also pay a self-employed tax based on the profit they receive from the partnership.
Benefits of Partnerships
- Easy to Set-up. In a partnership business structure, there’s also fewer papers to file. Some states require partnerships to operate under a specific name. In this case, you would need to file a Certificate of Conducting Business as Partners to secure a business license. Additionally, you would have to obtain a draft of your partnership agreement to consolidate the partnership.
- It’s Flexible. Unlike corporations, partnership companies are relatively easy to manage. The company owners do not have to answer to or get the approval of a board of directors, executives, shareholders, and other officers. The partners can talk and easily make the decisions together without the need to hold formal meetings.
- Easier to Obtain Financing. Since there are two owners, getting funds for the business will likely be easier. This is because there will be two credit lines for financing companies to consider. As long as one is good, that partner with the higher score can personally guarantee the business loan, increasing the chance of approval.
Drawbacks of Partnerships
- The Vulnerability of Personal Assets. Like with a sole proprietorship, the business is tied up to the owners through a partnership. When the company defaults on a loan, all the owners’ personal assets will be on the line. The bank can file a suit and confiscate the assets, including vehicles, properties, and even personal savings.
- Poorly Organized Partnerships Can Lead to Disputes. While there are certainly many benefits to a partnership, a poorly organized one – or entering into one with the wrong person – can quickly become a nightmare. Being in a partnership means giving up a certain amount of control of the business since decision making must be done jointly. Strong differences of opinion and disagreements could lead to the demise of the business. Especially if you’re entering into business with a good friend or family member, it could ruin that relationship. It’s always essential to put the partnership agreement on paper and outline how partners are to deal with such business-related decisions and disagreements.
Limited Liability Company (LLC)
A limited liability company (LLC) is a newer type of business structure. It’s a hybrid structure that combines the benefits of partnerships and corporations. Organizations running this type of business structure can enjoy the tax benefits that come with partnerships but also the personal asset protection that comes with a corporation. Taxes on an LLC business are passed through its owners, which they then report in their income tax statement. If the company ever gets into financial trouble, the business owners‘ personal assets won’t be used to pay for the company’s debts.
The LLC structure is a suitable business entity for small to medium-sized businesses. It doesn’t require extensive documentation like that of a corporation.
Benefits of LLC
- Protection of Assets. The company owners won’t have to worry about their personal assets if the company cannot afford to repay its debts. They’re shielded from personal liability as long as they carry out their business activities in a legal, ethical, and responsible manner.
- Simplicity. Unlike corporations with a range of formalities, like creating a board of directors and periodic meetings, an LLC doesn’t require owners to adopt the same practices. The owners of an LLC can operate as partners and don’t have to hold formal meetings to discuss company matters.
Drawbacks of LLC
- More expensive than Partnerships or Sole Proprietorships. With LLC, you’ll have to pay for the state filing fee, which can cost around $40 to $500 depending on what state you’re planning to operate in. You’ll also have to pay for biennial fees, which can go up to $300. These fees aren’t present in partnerships or sole proprietorships.
- Taxation. If a partner owns part of the business but is not active in physically running the company, that partner will not be able to receive the tax benefits of the LLC structure. They will, however, still have to pay for their individual taxes based on their share of the profits whether they received an income or not.
A corporation is a large body organization wherein shareholders hold a portion of a company and make decisions regarding the company’s operations. A corporation is a separate entity from the business owners. In other words, there is a separation of assets between the company and its owners. They are also taxed separately. Corporations should consider hiring an accountant to make sure that they file their taxes according to the state’s requirements and regulations.
Corporations are viable business structures for businesses that are planning on expansion. They can attract more investors and sell their company stocks to the public to help raise funds for their business. As a person buys a portion of a company, they will become a part-owner of the company and collect their profits according to how many shares they hold.
As for the taxes, corporations are double-taxed. Double taxation means that the owners must pay for the business entity’s taxes AND each of their share of profits.
Benefits of Corporations
- Shareholders are Not Liable for Company Debts. As mentioned, the corporation is a separate entity from the owners. In situations where the company cannot pay off its debts, the owners and shareholders aren’t responsible for paying it all off using their personal assets.
- Easier to Raise Funds. If the corporation requires more funding, they can sell some of its shares to the public or attract angel or venture investors into their company. It’s also easier for companies to apply for funding from financing institutions if they have good credit standing and no history of defaults.
Drawbacks of Corporations
- It’s Expensive. Forming a corporation is more expensive than the other types of business structures. In the early stages of incorporation, you have to secure a large amount upfront for the start-up costs as well as the operational costs to keep the business running. You also have to pay filing fees and your taxes will be higher.
- Longer Processes. Filing for incorporation is a long process. You’ll have to submit an extensive amount of paperwork, including a draft of your corporation by-laws. You’ll then have to conduct meetings with your shareholders to vote and elect officers who oversee the company’s operations. Furthermore, corporations also have to adhere to certain formalities like creating year-end reports to evaluate the company’s progress and success, reported during the shareholders’ meeting.
Business Structures: Final Thoughts
Deciding on the best business structure can be one of the most challenging decisions you’ll face as an entrepreneur. Choosing the best one requires a lot of research and consideration of the different factors that come into play. For one, you have to consider how you want to be taxed and whether or not you want full protection for your assets. Each structure type has its own share of upsides and downsides, so be sure to factor those in to your decision making.
Once you’ve decided on a business structure, be sure to consult with an attorney to help you set up the drafts and review the agreements. It will help strengthen your business structure and ensure that your business will run smoothly. You may want to consult an attorney, or an accountant, before choosing a business structure as they can inform you of the latest in regulations and requirements for the different types of structures.