Guide to Choosing a Business Structure

Starting a business is exciting. After deciding to open your business, you face a critical decision: selecting your business structure or entity. This choice will shape many aspects of your operation, so it's essential to understand your options.

Your business structure influences several key factors:

• Taxes
• Legal liability
• Day-to-day operations
• Reporting requirements
• Long-term growth potential
• Management structure

In this guide, we'll explore these factors in depth to help you make an informed decision.

Understanding Business Structures

Business structures and entities are authorized by state law and are, in most cases, created by filing specific documents with a state agency called The Secretary of State. The business structure you choose at the state level will be used by the Internal Revenue Service (IRS) to classify how your business is taxed at both the Federal and State level. Your chosen structure defines how you establish and maintain your company. It affects not only your tax obligations but also potential liabilities for you and any partners or owners in your state.

Setting up a separate business entity is often necessary for:

• Opening business bank accounts
• Obtaining business credit cards
• Applying for loans and financing

Your business structure impacts various elements of your daily activities, including:

• Administrative requirements: The paperwork and record-keeping you must maintain
• Banking procedures: How you manage business finances
• Funding opportunities: Your ability to attract investors or secure loans
• Legal liability: Your personal responsibility for business debts and legal issues
• Taxation: How and how much you pay in taxes

Overview of Business Structure Options

Choosing the right business structure is one of the most important decisions when forming your business. The type of entity you register as will directly impact your business, including taxation, liability, growth, and dissolution, as well as the type of reporting you’re obligated to perform for the IRS.

Limited Liability Company (LLC)

A limited liability company (LLC) offers flexibility, agility, and liability protection for its owners. It can be a single-member LLC (SMLLC) with one owner or a multi-member LLC (MMLC) with two or more owners. Employees can be hired in both cases.

Pros of LLCs

• Personal asset protection: LLCs create a separation between your personal property and business dealings. This means your personal assets are generally protected if your business faces legal issues or debts.
• Flexible tax options: LLCs offer a choice between pass-through taxation (where business income is reported on your personal tax return) and corporate taxation. This flexibility allows you to select the most advantageous tax treatment for your situation
• Fewer formalities: LLCs have less stringent reporting requirements compared to corporations. This reduces administrative burden and allows you to focus more on running your business.

Cons of LLCs

• Self-employment taxes: LLC members must pay self-employment taxes on their share of business profits that are considered income from a “trade or business.” This can result in a higher tax bill compared to some other business structures.
• Varying state laws: LLC reporting and filing regulations differ from state to state. It's crucial to check with your state's Secretary of State office to understand the specific requirements in your area.

Best For: LLCs are best suited for small to medium-sized businesses seeking liability protection while maintaining the utmost flexibility and lightest required reporting obligations.

Sole Proprietorship

A sole proprietorship is the most straightforward way to start a business. It doesn't require any formal registration—you become a sole proprietor simply by deciding to start a business. If you don't choose another business structure, your business automatically defaults to a sole proprietorship.

In this structure, you and your business are considered the same entity for legal and tax purposes. This means:

• All business income, gains, losses, and deductions are reported on your personal tax return.
• You use your Social Security Number (SSN) for tax reporting.
• If you earn $400 or more from self-employment in a year, you must file Schedule SE along with your IRS Form 1040.

Pros of Sole Proprietorship:

• Easy Setup: You don't need to file any formal business formation documents. This means minimal paperwork and regulations to deal with.
• Low Costs: The only initial costs are typically license fees and business taxes. There are no incorporation fees or complex tax structures to navigate.
• Tax Benefits: As a sole proprietor, you're eligible for several tax deductions. These include:
  • Health insurance premiums
  • The Small Business Health Care Tax Credit
  • Self-employment tax deduction
• Complete Control: As the sole owner, you have full authority over all business decisions. There's no need to consult with partners or shareholders.
• Easy to Terminate: If you decide to close your business, the process is relatively simple. You'll need to notify state and local tax authorities and any relevant licensing entities, but there's no complex dissolution process.

Cons Sole Proprietorship:

• Unlimited Personal Liability: This is the biggest drawback. As a sole proprietor, you're personally responsible for all business debts and legal issues. Your personal assets could be at risk if your business faces financial troubles or lawsuits.
• Limited Growth Potential: As your business expands, you may find that the sole proprietorship structure becomes limiting. Significant growth often requires transitioning to a different business structure.
• Difficulty Raising Capital: Without a separate business entity, it can be challenging to secure business credit or loans. Many lenders prefer to work with formally established business entities.

Best For: Sole proprietorships are perfect for freelancers, consultants, and newly formed, small-scale operations.

Partnership

A partnership is a business structure involving two or more owners who share management responsibilities and liability. The most basic form is a general partnership, which is ideal for scenarios where all partners want active involvement in the business.

Pros of Partnership:

• Easy Formation: Like sole proprietorships, general partnerships don't require formal registration or incorporation. You can start operating as soon as you and your partner(s) agree to do business together.
• Shared Resources: Multiple partners can bring diverse skills, experiences, and resources to the business. This can be particularly beneficial for startups or small businesses.
• Simple Compliance: Partnerships have fewer regulatory requirements compared to corporations. There's typically no need for annual reports or regular formal reporting.
• Pass-Through Taxation: The business itself doesn't pay taxes. Instead, each partner reports their share of business income and losses on their personal tax returns.

Cons of Partnership:

• Joint Liability: In a general partnership, all partners are personally liable for the business's debts and legal issues. This means your personal assets could be at risk.
• Potential for Disputes: Without a formal agreement, partnerships can face challenges in decision-making and conflict resolution. Disagreements between partners can significantly impact the business.
• Complex Dissolution: Ending a partnership can be complicated, involving sensitive discussions and potentially complex paperwork, especially if partners disagree on the terms of dissolution.

Best For: General partnerships are perfect for small businesses with multiple owners but, if the company experiences significant growth, it may wear out its usefulness.

Limited Partnership (LP)

A Limited Partnership (LP) is a more complex business structure that includes at least one general partner and one or more limited partners. This structure offers a unique blend of management and investment opportunities.

Key Features of LPs:

• General Partners:These individuals manage the business and bear unlimited liability for the partnership's debts and obligations.
• Limited Partners: These are typically investors who contribute capital but don't participate in day-to-day management. Their liability is limited to their investment in the business.

Pros of LP:

• Attracting Investors: The mixed structure of LPs makes it easier to attract investors who want to contribute capital without taking on full liability or management responsibilities.
• Limited Liability for Some Partners:Limited partners' personal assets are protected from the business's debts and legal issues, making it an attractive option for passive investors.
• Pass-Through Taxation: Like other partnerships, LPs benefit from pass-through taxation. Additionally, limited partners can avoid self-employment taxes on their share of the profits.

Cons of LOP:

• Complex Formation: Setting up an LP requires multiple documents and filings, making the process more complicated than forming a general partnership.
• Higher Risk for General Partners: General partners bear unlimited liability for the partnership's debts and obligations, which can be a significant personal risk.

Limited Liability Partnership (LLP)

A Limited Liability Partnership (LLP) combines elements of partnerships and corporations. In an LLP, all partners actively participate in company management while enjoying liability protection.

Key Features of LLPs:

• Shared Management: All partners can take part in running the business.
• Liability Protection: Partners are shielded from personal liability for the actions of other partners or employees.

Pros of LLP:

• Protection from Liabilities: Partners are protected from personal liability for the negligence or malpractice of other partners. This is particularly beneficial for professional service firms.
• Flexible Management: LLPs don't require mandatory articles of association. Partners have the freedom to define their operational structure and profit distribution methods.

Cons of LLP:

• Disclosure Requirements: LLPs often must publicly file financial accounts, which can be a disadvantage for businesses preferring financial privacy.
• Administrative Obligations: LLPs typically have more complex management requirements, including scheduled filings and reports.
• Limited Availability: LLPs are not recognized in all states, and regulations can vary significantly between states that do allow them.
• Professional Restrictions: In many states, LLPs are limited to certain professions, typically those with potential malpractice claims.

Best For: Limited Liability Partnerships are ideal for professional groups that could experience malpractice or negligence claims like law firms, accounting firms. architecture firms, and more.

Corporation (C Corp)

A C Corporation, commonly known as a C Corp, is a separate legal entity owned by shareholders. It's recognized as distinct from its owners by the IRS and state law.

Key Features of C Corps:

• Separate Legal Entity: The corporation exists independently of its owners.
• Shareholder Ownership: The company is owned by shareholders who buy stock in the corporation.

Pros of C Corp:

• Limited Liability: Shareholders' personal assets are protected from the corporation's debts and legal issues.
• Easy Ownership Transfer: Shares can be bought and sold freely, making it simple to transfer ownership or bring in new investors.
• Better Funding Options: The C Corp structure is attractive to many investors and can make it easier to raise capital through stock sales.

Cons of C Corp:

• Double Taxation: C Corps face potential double taxation—the corporation pays taxes on its profits, and shareholders pay taxes on dividends they receive.
• Stringent Regulations: C Corps must comply with more regulations, including having a board of directors, holding annual meetings, and regular filings.
• Higher Costs: The complex structure and regulatory requirements of C Corps often result in higher operational and tax-related costs.

Best For: C-corporations are the ideal business entity structure for companies aiming to go public or attract large investors.

S Corporation (S Corp)

An S Corporation, often referred to as an S Corp, is a special type of corporation that offers unique tax benefits and liability protection. It's named after Subchapter S of the Internal Revenue Code, which defines its regulations.

To qualify as an S Corp, your business must meet specific criteria:

• Domestic Corporation: The business must be incorporated in the United States.
• Eligible Shareholders: Shareholders can only be individuals, certain trusts, and estates. Other corporations, partnerships, or non-resident alien shareholders are not permitted.
• Shareholder Limit: The corporation can have no more than 100 shareholders.
• Single Class of Stock: The corporation must have only one class of stock. This means all shares must have the same rights to distribution and liquidation proceeds.

Pros of S Corp:

• Tax Benefits: S Corps enjoy pass-through taxation, similar to partnerships. This means the business itself doesn't pay corporate income tax. Instead, profits and losses "pass through" to shareholders' personal tax returns. This structure avoids the double taxation issue faced by C Corporations.
• Limited Liability: Like C Corps, S Corps provide personal asset protection for shareholders. This means your personal assets are generally shielded from business debts and liabilities.
• Reduced Self-Employment Taxes: S Corp owners who work in the business can receive both a salary and distributions. Only the salary is subject to self-employment taxes (Medicare and Social Security), potentially resulting in tax savings.

Cons of S Corp:

• Ownership Restrictions: The limit of 100 shareholders can restrict growth opportunities, especially for businesses seeking to expand rapidly or attract numerous investors.
• Complex Taxation Rules: While S Corps offer tax benefits, they also come with specific rules:
• Shareholders are taxed on their share of corporate income, whether or not it's distributed.
  • The corporation must pay reasonable salaries to shareholder-employees, which are subject to payroll taxes.
  • The company must comply with Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) requirements.
• Business Type Restrictions: Certain types of businesses are not eligible for S Corp status. These include most financial institutions, insurance companies, and domestic international sales corporations.
• Rigid Formalities: S Corps must adhere to corporate formalities, including:
  • Holding regular board meetings and keeping detailed minutes
  • Maintaining separate corporate bank accounts and records
  • Filing annual reports and paying necessary fees
  • Following other state-specific corporate governance rules

Best For: Because they can avoid double taxation, S-corps can be a great option for small businesses with limited shareholders.

Key Considerations When Choosing a Structure

Selecting the right business structure is a crucial decision that can significantly impact your company's future. Here are some key factors to consider:

Liability Protection

Personal liability protection is a crucial benefit of certain business structures. It safeguards your personal assets from being used to satisfy business debts or legal judgments.

Consider your need for liability protection based on:

• Your business's risk level: If your product or service could potentially lead to lawsuits, liability protection becomes more important.
• Growth expectations: If you anticipate rapid expansion, a structure with liability protection may be wise.
• Personal assets: The more personal assets you have, the more important liability protection becomes.

For sole entrepreneurs just starting out, liability protection might not seem necessary initially. However, as your business grows or if you operate in a high-risk industry, structures like LLCs or corporations that offer liability protection become more attractive.

Tax Implications

The tax treatment of your business can significantly impact your bottom line. There are two main types of tax treatments:

Pass-Through Taxation:

• Most U.S. businesses are taxed this way.
• Profits "pass through" the business to the owners and are taxed on personal tax returns.
• Applies to sole proprietorships, partnerships, most LLCs, and S corporations.
• Popular for side hustles and small businesses due to its simplicity.

Corporate Taxation:

• Applies to C corporations and some LLCs (if elected).
• Can result in "double taxation" - the company pays taxes on profits, and shareholders pay taxes on dividends.
• While this might seem disadvantageous, it can be beneficial for larger businesses or those planning to reinvest profits.

Consider consulting with a tax professional to understand which structure offers the most tax advantages for your specific situation.

Administrative Requirements

Each business structure comes with different levels of administrative responsibilities.

When considering which type of business structure is best for you, some questions to ask are:

1. Do we have time for the administrative tasks required?
2. Do we have the necessary knowledge to handle these tasks?
3. Can we afford additional resources (like a registered agent) to manage administrative requirements?
4. Can we cover the fees associated with this business structure?

Business structures from least to most administratively complex:

• Sole proprietorship
• General partnership
• Limited partnership (LP)
• Limited Liability Company (LLC)
• S corporation
• C corporation

Remember, while simpler structures require less administration, they may offer fewer protections or benefits.

Funding

Your business structure can impact your ability to attract investors and raise capital. Consider:

• Future funding needs: If you plan to seek outside investment, some structures (like corporations) are more attractive to investors.
• Stock issuance: Corporations can easily issue stock, making it simpler to sell ownership shares.
• Self-funding ability: If you can self-fund and plan to keep your business small, funding flexibility may be less crucial.

Management and Control

As your business grows, decision-making processes become more complex. Your chosen structure will influence how your company is managed:

• Sole proprietorships and some partnerships offer complete control but can be stressful for a single decision-maker.
• Corporations typically have boards of directors, introducing more diverse perspectives but potentially slowing decision-making.
• LLCs offer flexibility, allowing you to choose a management structure that suits your needs.

Consider how much control you want to maintain and how you'd like decisions to be made as your company grows.

Long-term Goals

It's essential to think about your business's future from the start:

• Scalability: Some structures (like corporations) are better suited for rapid growth and expansion.
• Exit strategies: Consider how you might eventually want to leave the business. Options include:
  • Selling the business
  • Passing it on to family members
  • Closing down operations

Different structures offer varying levels of flexibility for these scenarios. For example:

• Sole proprietorships are easy to close but challenging to sell or pass on.
• Corporations and LLCs can be more easily sold or transferred to new owners.

By considering these factors carefully, you can choose a business structure that not only meets your current needs but also supports your long-term vision for your company. Remember, it's possible to change your business structure as your company evolves, but doing so can be complex and costly. It's often best to choose a structure that can accommodate your anticipated growth and changes.

6 Steps to Forming Your Business Structure

Once you've gathered information about different business structures, it's time to take action. While the specific steps may vary depending on the entity type you choose, here's a general guide to forming your business structure:

1. Determine the best structure for your business: Review the information about each business entity type and select the one that suits your specific needs
2. Consult with legal and financial advisors: While many of the steps to forming a business are straightforward, there are details that financial and legal advisors can guide you through to ensure that you submit the correct information and avoid common pitfalls
3. File necessary paperwork with state authorities: Depending on the structure you choose, you will need to file different forms of paperwork with the office of your Secretary of State
4. Draft essential documents (operating agreement, partnership agreement, bylaws): While these documents may not be necessary if you choose to run your business as a sole proprietorship, we strongly recommend them (or require them) for all other business entities
5. Register for state and federal taxes: In most cases, a business is required to pay both federal and state taxes, and needs to inform both the IRS and the Secretary of State office of their activity
6. Obtain necessary licenses and permits: Depending on your business and the state in which you function, you might be required to obtain various licenses and permits at local and state levels

Changing Business Structures

As your business evolves, you may need to change your business structure to better suit your needs. This process involves legal and financial implications, including:

• Filing Legal Forms:
  • Articles of Conversion or similar documents with your state
  • IRS forms to report the change in structure
• Creating New Legal Documents:
  • New operating agreements, bylaws, or partnership agreements
  • Updated contracts and agreements
• Filing with Your State:
  • Submit all required forms and pay associated fees
  • Update your business registration
• Transferring Assets and Liabilities:
  • Formally transfer all assets and liabilities to the new entity
  • Update property titles, contracts, and other legal documents
• Informing Involved Parties:
  • Notify employees, customers, vendors, and partners of the change
  • Update contracts and agreements as necessary
• Ending the Prior Business Entity:
  • File dissolution paperwork if required
  • Settle any outstanding debts or obligations

Additional Considerations When Changing Structures:

• New EIN: You may need to apply for a new Employer Identification Number from the IRS.
• Licenses and Permits: Reapply for necessary business licenses under the new structure.
• Banking: Open new business bank accounts reflecting the new entity information.
• Contracts: Address existing contracts that may not be transferable to the new entity.
• Taxes: Pay any taxes or fees associated with dissolving the current business structure.

While state offices often provide instructions for these processes, consulting with a lawyer and accountant about your specific circumstances can make the transition smoother and help you avoid potential pitfalls.

Choosing the Right Business Structure for your Company

Selecting the right business structure is a crucial decision that can significantly impact your company's future. From sole proprietorships to corporations, each structure offers unique advantages and challenges that affect your tax obligations, liability protection, and administrative responsibilities.

By carefully considering the pros and cons of each option, you can make an informed choice that aligns with your business goals and operational needs. Whether you prioritize flexibility, liability protection, or funding opportunities, the right structure will provide a solid foundation for your company's growth and success.

Remember, while it's possible to change your business structure later, choosing wisely from the start can save you time, money, and stress in the long run. If you're unsure about the best option for your situation, consider seeking professional advice to ensure your business is well-positioned for future success.