Business Structures Explained

Businesses can range from those having almost no structure to complex organizations that are tightly regulated. As someone who wants to start a new business, you are probably wondering, “What type of business is right for me?” Businesses have to deal with customers, money, rules, permits, and liability. You have to ask yourself what you do well and match the business structure to your abilities. Some questions that can help you decide are discussed below.

Which Business Entity Structure is Right for You?

Starting your own business can feel scary, especially if this is the first time or you are planning to form one on your own. One of the most important decisions you need to make before officially opening up shop is your choice of business entity. The best fit for your situation depends on a number of different factors, including what kind of goods and services your business will provide, tax concerns, flexibility of decision making, and personal liability protections amongst others. Here are some of the questions an entrepreneur or small business owner should explore before picking a business entity structure.

Start-Up Costs

Costs for registering your business’s name, formation, renting commercial office space, preparing initial inventory, and other necessities can be substantial. On the other hand, some businesses might only require you and your computer. Entities like LLCs are fairly simple and inexpensive to set up, but if you are looking to grow and expand your business in the future, a more structured entity like a corporation may be the better choice. How much are you willing to pay?

Administration

For some business structures like LLCs and partnerships, only minimal administration is required. For bigger businesses, it’s not quite as simple. You may need to hire someone to take care of keeping records and oversee daily operations. The big question here is how involved do you want to be in the business’s daily operations? Businesses with more formal structures like corporations set up a lot of decision-making structure upon formation, meaning that you as the founder can take a more hands-off approach to company operations down the road.

Earning Power and Growth Potential

If your business is just you or you and a few friends and you’re not looking to make any big changes in the near future, simpler business strictures like LLCs or partnerships might serve your needs best. On the other hand, if you are looking to grow, hire employees, or even go public, the corporate structure might be a better fit.

Liability

How much personal liability do you want to assume? Many formal business entities offer some degree of personal liability protection for their owners/founders/members. But many common law entities (sometimes called informal entities) like partnerships and sole proprietorships do not, and thus the owner/partners are jointly liable for business debts on a personal level. If you have employees, the company will be responsible for the losses and accidents that happen on the job. Choosing a formal entity is an important step to reducing your personal liability.

Stress

When you work for yourself, you’re in control. A formal business structure takes more time and effort to set up, but if done properly allows you to step back from daily operations if need be. On the other hand, smaller less formal businesses give you more control and direct more of the decision-making powers towards its owners/members. How much stress do you want to take on, and where is the stress coming from?

Formalities

Working for yourself leaves you with few restrictions, which makes informal entities like partnerships and sole proprietorships an easier and less expensive way to get your business up and running. In other entities like corporations, there are more restrictions that include state, federal, and local government regulations. The trade-off, as mentioned above, means greater personal liability protection in exchange for following stricter guidelines. Are you good at working within a structured system?

Taxes

The business structure you choose can have a major effect on your taxes. You may have to pay personal income tax on the income from the business or the business could pay its own taxes, or both. From S and C corporation elections to pass-through entities and much more, having a basic grasp on how your entity will be taxed at the federal, state, and local level can make a huge impact. How comfortable are you with complicated tax planning?

Before you decide what type of business is right for you, you have to think about why you’re starting a business. You have to look at the details of what it means to register a business and incorporate it. Examine the implications of the different business forms, and set goals. Then you can make a decision and start the process.

What Are the Types of Business Structure?

Business structures differ in how their revenue is treated, in business ownership, and in the separation of business and personal activities. Some corporate structures have additional special features. The Small Business Administration (SBA) has a published review of business structures on their website. The most common types of businesses include the following:

• Sole proprietorships: You work for yourself with little formal structure and no liability protection.
• General partnership: Similar lack of liability protection and structure as a sole proprietorship, but with multiple owners. Not sure what a partnership is in business? We define business partnerships here.
• Limited liability company (LLC): Flexible structure that protects your personal assets from business liability. Compare LLCs and LLPs.
• C corporation: Tax election in which the corporation is a separate entity and pays its own income taxes in addition to the owners (shareholders) paying taxes on their individual tax returns on their share of the profits. This is called “double taxation.”
• S corporation: Tax election where business is also separate from your personal activities, but you avoid double taxation and are only taxed at the personal level. S corps have far more restrictions than C corps do.
• Professional limited liability company (PLLC): A business structure that protects professionals from personal liability. Not sure if you should start a PLLC or LLC? Compare LLCs and PLLCs.
• Limited liability partnership: A flexible business structure governed by a partnership agreement.
• Nonprofit corporation: A business that’s incorporated at the state level and focuses on something that benefits an area of society without focusing on profit.

You can choose to start your business using any of these structures. They all have specific features, advantages, and benefits. When you look through the detailed features described in the next few sections, you can eliminate the business forms that don’t work for you. Then you can choose the best one for you.

Sole proprietorship: The simplest type of business

When you create a sole proprietorship or general partnership, it can be as simple as selling products or services in your own name. Check with your town hall to see if you can run your business out of your home. You may have to rent a place of business and/or get an inexpensive permit. Otherwise, you can work as you want.

Sole proprietorship advantages:

• Quick and simple to startup
• Low start-up costs
• Business losses deductible
• Few regulations
• Little mandatory record-keeping

Disadvantages:

• Personal liability
• Hard to raise money
• Difficult to sell

Business founders sometimes choose a sole proprietorship to start their business and see how it performs. This is especially attractive if the business is low risk so that you’re unlikely to be sued. Once the business grows, you can decide whether to transition to one of the other business types.

An LLC has a formal structure with a flexible business model

When you start an LLC, you can combine a formal business structure with some of the flexibility of a sole proprietorship. Different states have specific requirements for the operation of an LLC, but the founders own the company. The operation of the company is governed by the operating agreement, which details how the owners plan to run the business. The owners can write the operating agreement and organize the company the way they want as long as it’s legal.

An LLC keeps the business activities of the company separate from the personal lives of the owners, who are called members. Members aren’t personally liable for the debts of the company. The company generates income that is distributed to the members according to the operating agreement. The members themselves pay the resulting income tax at their personal rate.

Some states make it difficult for a simple LLC to change its members. Unless the operating agreement details how memberships are sold, it can be difficult to change ownership. This makes it complicated to sell the company and difficult to raise money.

LLC advantages:

• Flexible and easy to set up
• Moderate start-up costs
• No double taxation
• Little personal liability
• Few restrictions
• Moderate recordkeeping required

Disadvantages:

• Complex operating agreements may need legal input
• Hard to obtain financing
• Hard to sell the company

An LLC is a great starting point for a group of people who want to go into business together. If the business is successful, it can outgrow the LLC structure. The members can then dissolve the LLC and create a corporation or use Business Divisions for the LLC.

Compare LLCs and sole proprietorships.

C corporations: an IRS tax structure designed to accommodate growth

Most large corporations are C corporations, although the structure works for some small businesses as well. You have to look at the C corporation advantages and see if there are any features you need that simpler business structures don’t have. Registering and operating a C corporation can be expensive and it can be difficult to stay compliant with the regulations.

A corporation is a separate entity from its owners, and it assumes liability for its own operations and debts. The shareholders of the corporation are the owners, and shares can be bought and sold. The income of the corporation is taxed at the business tax rate. Dividends are taxed again as the personal income of the shareholder in a kind of double taxation.

A key benefit of a C corporation is the ability to go public and sell shares on the stock markets. An initial public offering (IPO) can be profitable for the original shareholders. It can raise a lot of money for growth, purchasing other businesses, and expansion. Business structures that don’t provide for the ability to issue shares to the public can’t take advantage of this feature.

Advantages:

• Strong liability protection for owners
• Easier to raise money
• Ability to issue shares to the public
• Transparent ownership structure

Disadvantages:

• More costly to set up
• More expensive to operate
• Double taxation
• Tight regulations
• Extensive record-keeping

If you have a good business concept and want to grow into a big corporation, the C corporation structure is a good choice. For other businesses, the ability to issue shares might be important. You have to look at whether other business types are adequate for your needs if the C corporation is too expensive.

S corporation: avoids double taxation but is subject to more restriction

An S corporation is actually a tax designation, not a business entity itself. Consequently, a C corporation or an LLC can apply to be taxed as an S corporation. When you register a corporation in a state, it’s automatically a C corporation. To change to an S corporation, you have to apply to the IRS and fulfill the S corporation requirements. States vary in their treatment of S corporations, but generally, the S corporation designation makes it a pass-through business for taxes, avoiding the double taxation experienced by C corporations.

LLC members can sometimes find the S corporation status advantageous because it can save them money on self-employment taxes. It allows the members to instead be paid a salary. A certified public accountant can help you determine if this will ultimately save you more money at tax time.

The S corporation status comes with restrictions limiting the number of shareholders to 100, all of whom have to be United States citizens. In addition, there can be only one class of stock.

Advantages of an S corporation:

• LLC members can save on self-employment taxes
• Owners are not liable
• No double taxation

Disadvantages:

• Restrictions on shareholders
• Harder to raise money
• Tightly regulated
• Expensive to set up and operate

Before applying to form an S corporation, it may be worthwhile to talk with a financial advisor who’s familiar with the latest rules.

Professional limited liability companies (PLLCs)

A PLLC is a special purpose company formed by a licensed professional such as a doctor, engineer, or accountant. Some states require professionals to form a PLLC while others allow PLLCs but don’t let professionals form an LLC. Professionals use the PLLC to avoid liability for company debts or lawsuits. Professionals are still liable for their own practices.

In general, the advantages and disadvantages of the PLLC are the same as for the LLC. For professionals, the main aim is to limit personal liability; PLLC members are not held personally liable for the malpractice of another member. Disadvantages such as the difficulty in raising money for the business are less important.

Limited liability partnerships (LLPs)

An LLP is similar to an LLC but has partners rather than members. Like an LLC, it creates a limited liability for the partners. A managing partner assumes liability for the company operations and the individual partners aren’t liable for the actions of the other partners. As with an LLC, the company organization is flexible and taxes are paid by the partners at their personal income tax rates.

An LLP is often the preferred business structure for a professional services company such as a law partnership. The advantages and disadvantages are similar to those of an LLC. Check how your state regulates this type of business structure because it varies.

Nonprofit corporation

A nonprofit corporation is a business that focuses on something that benefits an area of society without focusing on profit. The benefits could be educational, scientific, or humanitarian — but there are many other areas of focus that could qualify. A nonprofit corporation can apply to the IRS to be exempt from federal income tax. Some states will also exempt such organizations from state income and sales tax.

Conclusion

The right structure for your business depends on risk, income level, complexity, and your plans for the future. The owners of risky businesses need liability protection, so you may need to look for that feature. If your business is likely to make a lot of money, the tax treatment becomes important. Complex businesses need a lot of organization and recordkeeping. When you examine the advantages and disadvantages of each type of business, you can see how they match your plans. This way you’ll be able to make an informed choice.