Entrepreneur’s Guide to Choosing the Right Business Structure
Starting a new business is an exhilarating journey, filled with dreams of success and growth. But before you dive headfirst into your entrepreneurial adventure, it's essential to make a crucial decision that can significantly impact your business's future: selecting the right business structure.
With various options, each with its own pros and cons, finding the best fit can be overwhelming. Don’t stress over it! In this guide, we'll break down the main types of business structures and provide valuable insights into factors to consider to help you make an informed choice.
Exploring the Basics: Main Types of Business Structures
First, let's review the primary business structures and their pros and cons.
Sole Proprietorship
A sole proprietorship is a straightforward setup where you're the sole owner and operator of the business and don’t register as another type of entity. A sole proprietorship is easy to set up, has minimal compliance requirements, and gives you total control.
However, it leaves you with unlimited personal liability as your business and personal assets are not separated. And although you can create a business name, it can be challenging to secure funding because you can’t sell stock, and many banks don’t like lending to sole proprietorships.
Sole proprietorships are best suited for those with low-risk businesses and entrepreneurs who want to experiment with their endeavors before forming a more official business structure.
Partnership
A partnership occurs when two or more individuals share ownership, responsibilities, and profits of an unincorporated business. Owners report earnings on their individual tax returns. The most common types of partnerships are limited partnerships (LP) and limited liability partnerships (LLP).
Limited partnership snapshot:
One general partner with unlimited liability
Remaining partners have limited liability
Limited liability partners typically have limited business control (as documented in a partnership agreement)
Partners pay taxes on personal returns
General partner also pays self-employment taxes
Limited liability partnership snapshot:
Every owner has limited liability
Protects all partners from debts against the partnership
Partners are not responsible for the actions of other partners
Regardless of the type of partnership you choose, it's crucial to have a solid agreement, so always consult an attorney and accountant.
This business structure can work well for companies with multiple owners, professional groups (e.g., doctors or attorneys), and multi-owner businesses that want to test their venture before establishing a more formal entity.
Limited Liability Company (LLC)
An LLC offers personal liability protection while maintaining flexibility in management and taxation. It's a hybrid of a corporation and a partnership. You can decide if your LLC’s profits will be taxed to either the members or on the corporate level.
Remember, the IRS views LLC members as self-employed, meaning they are responsible for Medicare and Social Security self-employment taxes.
An LLC may be best if you have a medium- or high-risk business or significant assets to protect. In most cases, LLC owners also have a lower tax liability than corporations.
C Corporation
A C corporation is a separate legal entity from its owners and provides the strongest liability protection. Also known as a C corp, this type of business legal structure is taxed on both the business and personal levels.
Corporations can have an unlimited number of shareholders and multiple classes of stock. Since the entity is completely independent of its shareholders, business can continue even if a shareholder departs or sells their shares.
However, corporations must have a board of directors and have more complex legal and tax requirements—meaning more complex recordkeeping, operations, and reporting. And they’re more expensive to form than other business structures.
A C corp could work well if you have a medium- or high-risk company, need to raise funding, or plan to make the business public or sell it in the future.
S Corporation
An S corporation allows pass-through taxation, combining a corporation's liability protection with a partnership's tax benefits. Essentially, S corps can avoid the corporate tax rates that C corps are subject to.
S corps are similar to C corps but can only have one class of stock and a maximum of 100 shareholders with limited liability. A business must also meet strict IRS criteria to obtain S corp status. If you do, you must file and operate according to C corp requirements. Note that S corp rules vary by state.
An S corp can be an effective tax-saving business structure for companies that would be a C corp but meet the S corp criteria.
7 Key Factors to Consider When Choosing Your Business Structure
You may still be wondering, What business structure should I choose? Let’s take a closer look at the key factors you should consider.
1. Liability Protection
Regarding liability, your personal assets—including your property, vehicles, and bank accounts—are on the line with sole proprietorships and certain types of partnerships. They offer little separation between you and your business, potentially exposing you to unlimited personal liability in the case of a lawsuit or defaulted business loan.
On the other hand, LLCs and corporations provide a legal barrier, shielding your personal assets from business debts and liabilities. If minimizing personal risk is a priority, opting for an LLC or corporation might be the way to go.
2. Tax Implications
Business taxes can be complex, and your chosen business structure can impact how much you owe. Sole proprietors report business income and expenses on their individual tax returns.
Partnerships, LLCs, and S corps are "pass-through" entities, meaning profits and losses flow through to the owners' tax returns. This can lead to potential tax advantages, but it's crucial to understand the nuances and consult a tax professional.
C corps are taxed at the corporate and individual levels, which can lead to double taxation. For corporations that pay out dividends from their post-tax income, shareholders are also responsible for taxes on their proceeds. But C corps offer specific tax planning opportunities and benefits like deductible business expenses.
3. Complexity of Setup & Management
Consider the level of administrative work you're willing to undertake. Sole proprietorships and partnerships are relatively easy business structures to set up, requiring fewer formalities and mostly annual paperwork and fees (though again, we recommend consulting a lawyer and/or accountant for guidance).
Meanwhile, corporations and LLCs have more paperwork, including drafting articles of incorporation or organization, adopting bylaws or operating agreements, and holding regular meetings. The trade-off is enhanced credibility and potential tax benefits, but this complexity might not suit every entrepreneur.
So before you decide, ensure you’re up for the task—missed deadlines and filing errors can cause hefty penalties!
4. Ownership & Control
How your business is owned and managed can influence your ability to make decisions and shape the company's direction. Partnerships distribute control among partners with partnership agreements, while corporations have a more structured hierarchy of shareholders, directors, and officers.
If maintaining sole decision-making authority is vital, a sole proprietorship or LLC might better suit your needs. An LLC can be member-managed or run by a membership team of members and/or nonmembers. These roles would be dictated in an operating agreement.
5. Funding & Growth Plans
If you're seeking external funding or planning substantial growth, the type of business structure you choose can play a pivotal role. Corporations, for instance, can issue shares of stock to attract investors. That’s why they’re the best business structure for companies that intend to go public.
Not to mention, transitioning from one structure to another down the road can be complicated and costly, so choosing a structure that aligns with your long-term goals is wise.
Finally, what happens if you or another owner passes away, goes bankrupt, or leaves the business? In many cases, other types of entities dissolve unless defined ahead of time. But corporations can continue operating.
6. Location & Industry
Sometimes, your business's nature and location can influence the ideal structure. Certain professions required to have a license, like doctors and lawyers, have to form a Professional Corporation (PC) or Professional LLC (PLLC). A professional corporation owner is liable for their negligence or malpractice but not for that of other owners.
Most states have specific regulations for certain business types. Researching the legal and regulatory landscape in your area is essential.
7. Exit Strategy & Succession Planning
Consider how you envision the future of your business. If you plan to pass it down to family members or sell it, certain structures might be more suitable. Corporations can be more attractive to potential buyers due to their well-defined structure and transferable ownership.
Final Thoughts: Don’t Rush Your Business Structure Selection
Selecting the ideal business structure is like laying the foundation of a sturdy building. A strategic choice can provide the necessary support and protection for your business to thrive. Consider the unique factors that define your business, and don't hesitate to seek advice from professionals like your legal and accounting teams.
Do you need a savvy accountant to help you properly run your business from Day 1? JLS Accounting will take a holistic view of your business and goals to set you up for long-term success. Schedule an intro call to learn more about our robust accounting, tax, and payroll services today!