By creating a product or service to share with the market, you’ve taken the first step toward starting a business. Before moving forward, you need to choose a business structure. How you structure your company is an important decision that will affect all aspects of your business down the line.
Registering a business in your state allows you to correctly file taxes and in some cases, reduce your legal liability. Depending on the type of structure you choose, it could protect your personal assets. If you are seeking investment in your company, the right business structure is essential.
All business structures have their own set of features and benefits. By learning about the different types, you’ll be able to make the right choice for your company.
Types of Business Structures
An LLC is a Limited Liability Company. It’s separated as its own entity, but in terms of legal structuring is considered “pass through” on taxes, which means losses and gains are reported on personal income taxes. Lots of large businesses like Apple or Google started out as LLC’s when they were in their early stages.
Best For: small businesses seeking flexibility, who want to avoid double taxation.
How to form an LLC: State specifications vary, so be sure to check first. Most states require you to file what’s called articles of organization with the state’s corporate filing office. Find a registered agent–this is a company or individual that, if your organization is sued, agrees to accept legal papers on its behalf. (Most states will refer you to a list of agents who will do this for a fee.)
2. Sole Proprietorship
A Sole Proprietorship can also be called a sole trader. They can hire other people, but the organization is owned and run by a single person who is legally indistinct from the business itself. It offers full managerial control, but no personal protections against the company’s debts and obligations.
Best for: one person, very small businesses.
How to form a Sole Proprietorship: As the only owner, there are no formal steps to take. However, you’ll still need to apply for all the necessary licenses and permits for your specific industry. These will vary by state, industry, and locality, so do your research.
A Partnership is just what the name implies: two or more parties formally agree to operate and manage a business, while sharing its profits. There are several ways this can be managed, from sharing both profits and liabilities equally, to limited liability, and silent partnership (in which a partner does not take part in day-to-day operations).
Best for: legal and accounting firms, or other professionals who share a business.
How to form a Partnership: make sure to have a detailed partnership agreement that defines profit sharing, buy outs, and any other issue that might come up in the future.
A Corporation is a legally separate entity or “person”, created to make a distinction between a business and the person or people who own and run the company. It can be classified in a number of ways, so we’ll explore the various types of corporations and what makes them distinct from one another.
- S Corp takes its name from Subchapter S of the Internal Revenue code. These corporations do not typically pay income tax, instead their income and losses are divided and passed on to its shareholders.
- C Corp is a business that pays taxes on earnings, then distributes what remains to shareholders as dividends. Individuals must pay personal income taxes on dividends, but may also reinvest in the company at a lower corporate tax rate.
- B Corp (or benefit corporation) is a for-profit organization that is recognized for mission and public benefit as well as profit. They must meet requirements laid out for social mission and impact through a governing body called the B Lab.
- A Nonprofit Organization is a legal entity operated for public or social benefit. It receives special tax exempt status.
- A Cooperative is also known as a co-op, and is a business that is both owned and operated for the benefit of its members.
- Examples of Corporations:
- S Corp: Widgets Inc.
- C Corp: FedEx
- B Corp: Patagonia, Uncommon Goods, Bombas
- Nonprofit: American Heart Association
- Cooperative: Artisan Market, Farmers Market
The Advantages and Disadvantages of Each Business Structure
Now that you have an idea of what each entity looks like, and what type of company best fits each, let’s break down the pros and cons for the business structures. Keep in mind, many of these benefits or disadvantages will depend upon size, mission, or how you plan to run your business.
An LLC is a better choice for medium to high risk business ventures, owners who want to pay a lower tax rate, or want to protect personal assets.
Advantages of an LLC:
- Protects personal assets against liabilities such as bankruptcy or lawsuits
- You will not need to pay corporate taxes: rather, profits and losses are passed through to your personal income.
Disadvantages of an LLC:
- Under many state laws, if one member chooses to leave an LLC, the company will dissolve.
Sole proprietorship is a good format for new businesses. It gives you the opportunity to test ideas before adopting a more formal format.
Advantages of a Sole Proprietorship:
- Allows the owner complete control over the company
- No special registration required
Disadvantages of a Sole Proprietorship:
- Keeping business and personal finances separate can be a challenge without a separate legal structure.
- Banks and investors are less likely to be attracted to a sole proprietorship.
A partnership is a good option for a business with multiple owners (ie. friends who have created a product together), or a group of professionals like doctors or legal businesses.
Advantages of a Partnership:
- Simple to form
- Shared responsibility
Disadvantages of a Partnership:
- Disagreements between partnerships can be difficult to manage.
- Any time a partner leaves, it places a heavy burden on the remaining members.
An S Corp is often the choice of a corporation that was previously (or would otherwise be) a C Corp, but meets S Corp requirements.
Advantages of an S Corp:
- Bypasses corporate taxes
- Creates a more independent entity–loss of a shareholder does not create a large impact on the business
Disadvantages of an S Corp:
- Must meet eligibility requirements
- Must file through the IRS, rather than through the state
Corporations are a good option for businesses that need to raise money, or have plans to go public.
Advantages of a C Corp:
- Offer a high level of protection to owners
- Completely independent from shareholders
- It is far easier to raise capital with corporations
Disadvantages of a C Corp:
- May be subject to double taxation
Nonprofit organizations are specifically designed for corporations that directly benefit the public. This includes charitable or religious organizations, professional societies, educational or scientific entities.
Advantages of a Nonprofit Organization:
- Tax exempt status
Disadvantages of a Nonprofit Organization:
- Must meet specific requirements for 501(c)(3) corporations
- The legal structure of business plan is under greater scrutiny due to tax exempt status
- Rely on a board for decision-making in most cases
This type of business works best for a group of like-minded people, with similar goals and objectives.
Advantages of Cooperatives:
- Generally simple to run
- Profits are distributed among members, who are all considered co-owners
Disadvantages of Cooperatives:
- It only works for a very specific type of organization
Things to Consider
When choosing a business structure, consider the type of industry and your long term goals. Your state may have regulations which require you to pick one type over another, depending on what you do. Here’s some great questions to ask as you consider different business structures.
- Do I provide a service that is charitable or benefits the public good?
- Is it important to me that I have total control over my business, or am I willing to work with one or more partners?
- Does my venture require a lot of investors or a business loan to get off the ground?
- How much personal financial risk am I willing to absorb?
- Do I intend to sell my company or go public in the future?
After the initial idea that forms your business, deciding on your structure is the most important decision you can make. Take some time to weigh the pros and cons of each, and to evaluate your own needs. In all cases, remember to check the rules and filing requirements of your state. It’s also a best practice to consult with a business attorney or tax specialist to help you assess your character and criterion so that you can make the best choice.
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