Business Structures: How to Choose the Right One

Deciding on a business structure is a big step when starting a new business. It will affect your taxes, personal liability, how you raise capital, day-to-day operations and more. It’s an important decision, but it can be hard to know which is the right option.

Luckily, with the right information you can be more confident in determining a business structure. Keep in mind, it’s also a good idea to consult with professionals, like accountants and attorneys, who can offer personalized guidance and advice.

What is a business structure?

A business structure is the way your business is organized. It determines many aspects of your business, including:

• Legal liability
• Taxation
• Operational flexibility
• Ownership and roles

The Internal Revenue Service (IRS) requires most businesses to classify their structure when registering with their secretary of state. Keep in mind that your choice isn’t always permanent, and this could likely change as your business grows and evolves.

What are some of the different types of business structures?

Let’s break down some common types of business structures. You should also keep in mind that the laws, regulations and requirements for these common business structures may differ from state to state. Research your state’s laws or consult a professional before making a decision.

Sole proprietorship

A sole proprietorship is a business that is owned and operated by one person. It is an extremely simple business structure. Legally, the small business owner and the business are the same — meaning the business is not a separate legal entity. This means the owner is personally responsible for any debts the business may incur. It’s relatively easy to establish and manage a sole proprietorship — making it a popular option for those just starting out.

Pros

Easy to set up. Setting up a sole proprietorship often requires very little paperwork and is typically low cost.

Total control. As a sole proprietor, you are the sole decision maker.

Simple taxes. With a sole proprietorship, business income is reported on your personal tax return — this is called “pass-through” taxation.

Cons

No liability protection. Because your company is not considered a separate business entity, you are liable for any debts incurred. This means your personal assets could be at risk.

Accessing credit can be difficult. Banks and other lenders may be hesitant to lend to sole proprietors. Additionally, you cannot sell shares of your business to raise money.

Limited growth flexibility. Since raising working capital is difficult, it may be more difficult to grow as a sole proprietorship. To take advantage of some of these opportunities, you may have to consider changing your business structure later on.

Partnership

A general partnership is one of the simpler ways for two or more people to own and operate a business together. However, there are different ways this can happen. In a limited partnership, there are general partners. These owners manage the business and assume full liability. Then there are limited partners. These owners have contributed capital but have limited liability and less control over business decisions. On the other hand, in a limited liability partnership (LLP), all owners have protection from personal liability and they share the responsibility of managing the business.

Pros

Shared responsibility. In a partnership, you don’t have to shoulder all the responsibilities alone. Your partners can help manage the business.

Minimal costs. Partnership agreements are fairly simple to establish and they’re often low cost.

Pass-through taxation. Profits are distributed to the owners and taxed as personal income.

Cons

Liability. Depending on the type of partnership you establish, you may still be personally liable.

Potential conflicts. Just like any relationship, personal conflicts between business partners can happen — especially during challenging or stressful times.

Exit challenges. Leaving a partnership can be complicated. There are often legal agreements in place that you’ll need to work through. Plus, there are financial considerations and any departure will impact other partners.

Limited liability company (LLC)

An LLC combines the simplicity of sole proprietorships and partnerships with the liability protection offered by a corporation. An LLC can be owned by one or more people, and it protects their assets from business debts and other liabilities. LLCs are a popular option for many small business owners. Though they seem similar to an LLP, there are a few differences. For example, with an LLC you don’t have to manage the business yourself and you can hire someone else to run the business.

Pros

Limited liability. With an LLC, your personal assets are protected. In most cases, you will not be liable for any business debts.

Tax flexibility. LLCs can choose to be taxed as a corporation, partnership or sole proprietorship. In most cases, pass-through taxation will be the default. Consulting with a CPA can help you make informed decisions about your business’s taxes.

Flexibility. An LLC does not have as many strict legal and compliance requirements as a corporation.

Cons

Extra paperwork. Registering as an LLC requires a formal registration and annual filings.

Self-employment tax. Members of an LLC have to pay self-employment taxes.

Exit challenges. If there are multiple owners and one wants to leave, the LLC may have to be dissolved and reformed in some states. This can be costly as you have to go through the process of registering your business again.

Corporation

Corporations are a formal, more complex business structure. This option is often chosen by larger companies or those looking to attract investors. When you incorporate your business, it is officially established as a separate business entity. There are two common types of corporations — S corporations (or S corps) and C corporations (or C corps).

Both S corps and C corps share some similarities. They both must follow regulations set forth by the federal government, they offer limited liability protection and they have a formal structure. However, there are some key differences. S corps offer pass-through taxation, meaning profits are reported on the owners’ personal income tax returns. S corps also have some restrictions on ownership and the type of stocks they can sell. C corps do not have these types of restrictions, however they are not pass-through entities, meaning they face double taxation.

Pros

Limited liability. In most cases, your personal assets will be protected.

Access to capital. As a corporation, you can sell stock to raise capital and it may be easier to access credit.

Credibility. Corporations are often seen as more legitimate and stable structures.

Cons

Double taxation. Depending on how your business is incorporated, income may be taxed at the corporate level, and then again on shareholder dividends. There are also other tax obligations to consider such as payroll tax.

Complexity. Incorporating your business involves a lot of paperwork and time.

Strict regulations. As a corporation you are obligated to follow strict rules and regulations.

Non-Profit

A non-profit organization is created to serve charitable, educational, religious or social purposes. Unlike a for-profit business, non-profits focus on fulfilling a specific mission. Revenue earned is reinvested directly into the program and operations — ensuring the work benefits the public or a cause instead of an individual.

Pros

Tax-exempt. As a 501(c)(3) nonprofit organization, you are eligible for tax-exempt status.

Eligibility for grants. There are many grants available for non-profit businesses, and donations can help fund your operations.

Limited liability. Board members’ personal assets are protected in most cases.

Cons

Strict oversight. Non-profits must follow strict rules and reporting requirements.

Heavy scrutiny. Non-profits’ finances are often available to the public, meaning a high level of integrity and transparency is required.

Difficult setup. Establishing a 501(c)(3) can be a difficult process, requiring a lot of effort and documentation.

How do I choose the right business structure?

The right business structure for your company will depend on your goals and resources. Here are a few things to consider when choosing a business structure:

1. Personal liability protection. Consider if your business operations could put your personal assets at risk. Freelancers and other entrepreneurs who have fewer expenses may not be worried about this. However, if you’re starting a larger company and you have debt or other liabilities, you may want to consider a structure that offers you some protection.
2. Taxation. While sole proprietorships, partnerships and LLCs can help keep your taxes simple, corporations may offer long-term advantages. Consulting a CPA can help you determine what makes sense for you.
3. Ownership goals. Take into consideration how many owners will be involved.
4. Funding needs. Think about your funding needs now and in the future. Certain business structures can make it easier to access capital.
5. Future growth. What is your goal for this company? Consider what the future looks like so you can choose a scalable structure that can grow with you.

Before making a decision, it’s a good idea to consult with a CPA, lawyer or other professional.

How do I know it’s time to change my business structure?

The legal structure of your business isn’t set in stone. Here are a few signals to keep an eye on that may indicate it’s time to make a change:

Growth. Your business can grow in a lot of different ways. Maybe you need to hire an employee or maybe you want to open a dedicated office space. If your business is growing beyond its current structure, it may be time for a change.

Liability. Perhaps you’ve recently had to take on debt to run your business, or your industry has become more volatile. As the risk level changes, you may want to consider if limited liability could help protect you in the future.

New partners. If you want to bring on partners to help increase capital and help lighten the load of running a business, you may have to adopt a new business structure.

The Bottom Line

Choosing a business structure is a big decision that will affect your company’s future. It’s about aligning your structure with your vision, goals and needs. Take the time to weigh the pros and cons of each, and seek out professional advice to help set your business up for success.