Starting your own business is a goal for many people. However, there are factors that go into the creation of a business, and you need to think about these before you even open your doors. One of the most important determinations is choosing the right business structure.
This may seem like a straightforward step, but there’s a lot to consider and each option has its own pros and cons.
You’ll want to give this step some serious thought because choosing the right business structure can make the difference between success and struggle. The way you organize your business will affect numerous aspects of your operations, including many that you may not even think of at first.
Your business structure will impact your day-to-day activities, how you raise funds, the taxes you will pay, the paperwork and record-keeping that will be required, your personal liability, the continuity of the business, and more.
Changing to a different structure later is possible, but will likely be costly and complex. So, it’s a good idea to try and get it right at the beginning.
Since this decision is so important for your business both now and in the future, you’ll want to make sure you understand all the key details about each major type of business structure. Knowing this information will help you make the right choice for your company.
Four Major Types of Business Structures
Generally, there are four major types of business structures: sole proprietorships, partnerships, limited liability companies, and corporations. Understanding each of these, the different versions of each, and their potential benefits and drawbacks will help get your business started on the right foot and give you a stronger chance of success going forward.
A sole proprietorship is the simplest and most straightforward type of business. In a sole proprietorship, a single individual is the owner of the entire business. Creating a separate business or trade name isn’t necessary and, unless you register as another type of business, any business run by an individual will typically be automatically considered a sole proprietorship. For this reason, many businesses that are just starting out often organize themselves as sole proprietorships.
One of the major factors that stands out about a sole proprietorship is that it’s not legally a separate entity from the individual. This aspect has both positives and negatives.
A positive is that you won’t need to file separate business taxes. All income generated through the business is included in your personal income tax returns. It’s the same with your business expenses.This can save you a lot of time and hassle when filing taxes. Plus, there will only be a single layer of tax to pay.
You also don’t need to open a business bank account. All your business expenses and income can go through your personal account. Additionally, you are not required to file annual reports with state or federal governments.
Depending on your industry and where you live, however, you may be required to have a license or permit.
Of course, with a sole proprietorship, you have full control over the business. There isn’t anyone else to answer to and all decisions can be made by you. This can make the business more agile and you’ll be able to adapt your work to your own personal lifestyle. For this reason, many self-employed persons, freelancers, and contract workers often choose to start out as sole proprietorships.
Because the business is not a separate legal entity from the individual, there are risks and downsides as well. The most crucial is that sole proprietorship provides no liability protection to the owner. In fact, the unlimited liability of a sole proprietorship means that you can be held personally liable for the obligations and debts of the business. Your assets are not separate. This can potentially cause serious issues if there are any debts that the business is unable to pay or if someone takes legal action against your business.
Since there is no differentiation between your own finances and the business, you could potentially have your personal assets seized to cover money owed by the company or be held personally responsible for legal fees or other costs.
Another potential issue is that it tends to be more difficult for sole proprietorships to raise money. Lenders are typically unwilling to give business loans to sole proprietorships and you will probably have a tougher time getting government funding or investors as well.
A partnership is formed when two or more people go into business together. A general partnership (GP) is a type of business structure where all partners share responsibilities, profits, and liabilities equally. It is possible for partners to have unequal shares, but these must be set out in a legal document in case of disputes. This is often the easiest type of partnership to create, but it also carries more risk since there is no legal separation between the business and its partners.
A limited partnership (LP) is sometimes called an investment partnership. In this organizational structure, at least one of the owners is considered the general partner, while the others invest money into the business. General partners make business decisions and are personally liable for the business and its debts. Investment partners have minimal control and are not responsible for any business debts besides their initial investment.
In a limited liability partnership (LLP), all partners have management responsibilities and all have limited personal liability. This means that if the business fails, creditors are usually not able to go after the personal assets or income of any partners.
All types of partnerships are taxed the same. While the partnership must file annual information to the Internal Revenue Service, it does not pay income tax. Instead, each partner is responsible for reporting their share of the partnership’s profit or loss on their personal income taxes.
Partnerships are used by many different types of businesses, but limited liability partnerships are most commonly used by professional services companies, such as legal and accounting firms.
Limited Liability Company
A limited liability company (LLC) has some of the characteristics of a sole proprietorship or a partnership and some of a corporation. It is a type of business structure that aims to protect the business owners from personal liability.
When you form an LLC, you are not personally responsible for the company’s debts. If the business is sued or goes bankrupt, creditors or other parties are generally not able to go after your personal assets or income.
LLCs are not taxed at the entity level. Like a partnership, all income, losses, and deductions pass through the LLC and are reported by individual members on their personal income taxes. This straightforward taxation process is one of the reasons why an LLC business structure is quite common.
A drawback of the LLC structure is that if one of the members leaves the entity or dies, there could potentially be an issue. In some states, you may be required to dissolve the LLC and reestablish it in these circumstances. However, a business continuation agreement can often be used to allow for a transfer of interests in these situations.
LLCs are very common and used by a variety of businesses of all sizes. In fact, the LLC is the most common type of business entity in the United States.
C Corporation and S Corporation
A C corporation (C corp) is the default type of corporation in the United States. It is separate from an S corporation (S corp), which is a special designation in the U.S. tax code typically used by smaller businesses.
Both C corps and S corps offer liability protection. This means the individuals who make up the corporation cannot be held responsible for the debts of the business. The main differences between a C corp and an S corp relate to ownership restrictions and taxes.
An S corp cannot have more than 100 shareholders and none can own another for-profit business. A C corp does not have these restrictions.
When it comes to taxation, an S corp is not separately taxed. All income is passed through to the business owners and is declared on personal income tax returns.
A C corp, on the other hand, is taxed as a corporation. This means you will pay corporate taxes at corporate tax rates on company profits. If you distribute dividends to shareholders or if you pay salaries to owners, you will be taxed separately on this income. This can result in a “double taxation” scenario.
However, if a significant portion of the profits remain in the corporation by reinvesting them into the business, it could be an advantageous situation, since corporate tax rates tend to be lower than personal income tax rates.
It is important to consider your specific situation in terms of income and profit when choosing the right business structure.
In addition to taxes, corporations tend to be more complex to set up than most other business structures and require compliance with ongoing government requirements. Your business may be subject to more government regulation and oversight, more complex tax rules, in addition to other requirements. For example, depending on your state, you will likely be required to have a board of directors, hold annual shareholder meetings, and file annual reports.
Still, it tends to be much easier to raise capital when running a corporation. And, because a C corp is not restricted to less than 100 shareholders, the business can raise funds by selling shares and even going public.
Another benefit is that a corporation is a separate legal entity that can exist indefinitely. This has many benefits:
- It is easy to transfer shares to beneficiaries, which helps in estate planning, for instance.
- Since the corporation will continue to exist even as shareholders, officers, and directors come and go, it is a safer and more stable place for investors to trust.
- Management is also able to make long-term plans, since they know the business will continue long into the future.
Of course, a corporation can go bankrupt or can be dissolved for other reasons.
There are advantages and disadvantages to each type of business structure. These include the amount of liability for the owners, the ease of creation and operation, tax considerations, and funding aspects.
When it comes to choosing the right business structure, all of these factors are important, but the weight that each of them holds will depend on your individual circumstances. Your business will be unique from any other, so the business structure should be decided based on your situation, not anyone else’s.
It is important to seek advice from experienced and knowledgeable business counselors, attorneys, and accountants before making a decision. They will help you understand how the specifics of each structure apply to your situation.
While it is possible to change structures later, doing so can be time-consuming and complex. Choosing the right business structure from the start allows you to hit the ground running with a business that works for you and your needs.
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