Choosing a business structure might not be the first thing you think about when bringing your small business dream to life. But it's an essential step in setting up your business. The business structure you choose has implications down the line regarding tax status, fundraising, record-keeping, responsibilities and liability.
Why Business Structure Type Matters
Business structure refers to how your business is set up legally. While not all small businesses need to be registered with the state or federal government, if you expect your business to grow over time, you'll want to plan ahead and choose a business structure that accommodates future growth.
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How you set up your business determines your personal liability concerning the company. It affects the way you pay your taxes and how much you pay. It also impacts your ability to raise money to advance your business.
While you can change your business structure down the road, it is good to set things up right from the start, with an eye on how you expect your business to grow and evolve.
A good time to think about business structure is when you take care of the other paperwork, such as filing for a tax identification number and determining which licenses and permits you may need.
There is no one-size-fits-all structure for all business types and business owners. There are several common business structures to choose from, depending on the nature of your business, how much you plan to be involved in daily operations and your future plans and goals for the business.
How you set up your business determines your personal liability concerning the company.
A sole proprietorship is the easiest and least expensive business structure to set up. There is no formal process for this unincorporated structure, meaning no legal separation exists between a business owner and business entity. The owner and the business are the same and are treated that way by the IRS.
The IRS lists which forms and schedules you may have to file to submit taxes for a sole proprietorship, but often, a sole proprietor simply files business taxes on the same form as their personal income tax return.
As the name implies, this is a structure for sole owners who have complete control over the business, make all of the decisions and carry all responsibility.
The business name is often the same as the owner's name. However, sole proprietors can file for a DBA or "doing business as" name by filing paperwork with their state or county. Doing business under a DBA is not the same as incorporating. A DBA name does not separate an owner from the business.
When a business owner and business entity are not separated, that means the owner is legally liable for the actions of the business and its employees as well as any business debts or legal claims against the business. There are no protections for the business owner's non-business-related assets, and an owner can be personally sued for damages.
In terms of future growth, a sole proprietorship cannot raise business funds because there is no formal legal structure for this and no shares of the business to sell.
General Partnership and Other Partnerships
Setting up a business as a partnership requires at least two owners. A general partnership is like a sole proprietorship but with more than one owner. General partnerships are not legally required to register with the state to operate, and both owners have unlimited liability for business expenses, debts and legal actions.
A limited liability partnership (LLP) is like a general partnership in some ways but offers some liability protection for the business owners. An LLP provides flexibility in that owners can be added or removed from the business according to the partnership agreement drafted when the business structure is set up.
Partners of an LLP have limited liability, meaning their personal assets are protected from the business's debts and any legal action against the business entity.
LLP partners pay taxes like a sole partnership or general partnership by reporting business income on their share of the profits through individual tax returns.
A limited partnership (LP) is different from an LLP in that there is one general partner who is actively involved in the business, with financial backing from limited partners. The general partner has unlimited liability for the company, while limited partners are only liable up to the amount of their investment in the business.
Both LLPs and LPs must draft a partnership agreement signed by all parties and filed with the state. The income tax guidelines for partnerships will vary based on the type of partnership. Partnerships aren't designed for fundraising but have built-in flexibility to add new partners to the company.
When a business owner or group of owners wants to create a business entity that is entirely separate from their personal assets and finances, forming a corporation is the way this is accomplished.
A corporation is a separate legal entity. The business's income, assets and liabilities are legally distinct from that of the people involved in the business. A corporation can sell its stock, which can later be used to raise funds for the company.
This type of business structure involves more paperwork for the initial set-up with the secretary of state and the development of the corporate bylaws. Additional tax documents, payroll rules and record-keeping needs exist for this separate, tax-paying entity. There are unique tax benefits and regulations that apply to corporations.
Many corporation owners will also pay self-employment taxes on the portion of their income that is salary from the business to contribute to Social Security and Medicare.
Depending on the type of corporation, some incorporated businesses are subject to double taxation when a business pays corporate income taxes. Then individual shareholders are taxed on the dividends they receive from those same business profits.
There are different types of corporations, depending on the business.
C corporations or C corps are owned by a group of shareholders, and the business is governed by bylaws approved by those shareholders. The C corp structure allows for an unlimited number of investors so it positions the company for future growth. If a business owner plans to sell their business someday or go public with their stocks, a C corporation is a good choice.
A C corp is subject to double taxation because the business can raise funds by selling stock. Investors and shareholders pay taxes on the same business profits the company itself pays corporate taxes on.
An S corporation or S corp is a special designation that must be filed for with the IRS. S corps are similar to C corps in that the owners and business are separated. But the number of shareholders is limited to 100, and other requirements don't allow for as much growth as in a C corp.
For the most part, the business profits can pass through the owners' personal income taxes, so there is no double taxation on an S corp. Some states have specific rules for how much profit can be generated before the S corporation must pay corporate taxes.
A relative newcomer in business structure types, the B Corporation is a for-profit corporation driven by mission and profit. So, not quite a nonprofit, but not a C corporation.
According to the Small Business Association (SBA), B corps are taxed like a C corp, but they operate with a particular, socially-minded purpose, accountability and transparency. In this structure, the shareholders hold the company accountable for producing a social benefit in addition to their business profits.
A B corp designation is available by the state if specific legal requirements are met.
Nonprofit corporations meet certain requirements to gain tax-exempt status from the IRS. Nonprofits are organizations created to do work related to educational, charitable or religious missions. The IRS must grant nonprofit status, and nonprofits must meet federal tax obligations. The organizational and record-keeping rules of a nonprofit are similar to those of a C corp.
Limited Liability Company (LLC)
An LLC structure is a very common business structure with less paperwork than a corporation, but with similar protection for the business owner.
The company is a separate legal entity from the owner, and business income passes through owners' personal income taxes rather than being subject to corporate taxes. Most LLC owners are required to pay self-employment taxes to contribute to Social Security and Medicare.
An LLC structure is not available to all business types. Check with your state to learn the rules of organizing as an LLC. According to the IRS, an LLC can be treated as a corporation, partnership or part of the LLC owner's tax return unless the LLC files an Entity Classification Election form.
Choosing a Business Structure
Having an overview of the different business structure types and the pros and cons for you and your business are just the first steps. Every business is unique, and each of these structures has characteristics that will impact your set-up, operations and future.
Start by talking to your local SBA branch or SCORE office. Go over your business plan with experts and mentors to learn more about which business structure will help bring your business to life and grow with it into the future.
- Internal Revenue Service (IRS): Business Structures
- SCORE: Pros and Cons of the Popular Business Entities: Sole Proprietorship, LLC, S Corp and C Corp
- Small Business Association (SBA): Choose a Business Structure
- NYC.gov: Structuring Your Business
- SCORE: How to Structure Your Business: 9 Tips for Structuring New Businesses
- U.S. Chamber: When - and Why - to Consider Changing Your Business Structure