How to Choose the Best Business Structure

Key Points

  • The business structure you choose impacts how you are taxed, how money is pulled out of your company, continuity options, and growth abilities.
  • Some structures provide more liability protection than others.
  • Your business goals will determine which structure is most favorable.

Table of Contents

  1. How Can Your Business Structure Affect You?
  2. What Should You Consider When Choosing Your Business Structure?
  3. Sole Proprietorship
  4. Partnership
  5. C Corporation
  6. S Corporation
  7. Limited Liability Company (LLC)
  8. Professional Corporation (PC)
  9. Conclusion

Choosing a business structure for your company is one of the most crucial first steps to starting a business. Your business entity type has legal, financial, and administrative implications, so it’s important you get started with the best entity for your situation.

1. How Can Your Business Structure Affect You?

Your choice of business structure will have an impact on these and other aspects of running your company:

  • Who qualifies to own your company
  • Whether you can—and what you must do to–transfer ownership of your company
  • Taxes your company is subject to
  • Your ability to get credit and funding
  • Your personal liability
  • The number of ongoing compliance requirements you need to satisfy

2. What Should You Consider When Choosing Your Business Structure?

Some of the factors that will influence which business entity type you select include:

  • Where do you plan to conduct your business
  • Wanting to have limited personal liability for your business activities
  • Whether you will have a partner or an investor
  • Your expected earnings and deductions
  • Desire to minimize your self-employment tax obligation
  • Your business goals
  • Your tolerance for compliance formalities
  • Registration and administrative costs to set up and maintain a business structure

To help you gain a basic understanding of the differences between entity types, below is a guide to the most common business structures entrepreneurs choose. Before selecting, though, you should talk with your accountant and attorney to determine which will best serve your needs.

3. Sole Proprietorship

In a Sole Proprietor, there is no legal separation between the business owner and the business. Property and liabilities are held in the owner’s name. Usually, the owner is an individual, but it could also be a married couple. Business taxes are filed as personal income using Schedule C (Profit or Loss from a Business), which is submitted with IRS Form 1040. Home businesses often select to operate as the Sole Proprietorship structure, because it is the most simple and inexpensive type of entity to establish and maintain.

The main drawback to operating a business as a sole proprietor is that the owner is personally liable legally and financially for the business. So, if someone files a lawsuit against your company or the business can’t pay its debts, your personal assets (bank accounts, home, car, retirement savings, etc.) are at risk. Another downside of the sole proprietorship is that business income is subject to self-employment taxes.

In most locations, starting a Sole Proprietorship may be as straightforward as filing a fictitious name, also called a DBA (Doing Business As). But even that might not be required if you decide to use your first and last name in the business name. Some licensing or permits might be required depending on the type and the location of the business. Otherwise, startup and ongoing compliance formalities are minimal.

Example 1 - when operating as a Sole Proprietorship is preferable:

  • Janet is a graphic designer who offers her services via Fiverr and Upwork
  • She is the only owner and does not have any employees
  • She converted one of her bedrooms into an office
  • The clients never enter her workspace
  • Her services have minimal legal risks associated with them
  • Janet’s income is less than $80,000 a year

4. Partnership

In its simplest form, the Partnership structure mirrors a Sole Proprietorship. It is used when there is more than one owner of the business.

In a General Partnership, owners share legal, financial, and management responsibilities for the business. In fact, the actions of one partner could impose liability on the personal assets of another partner.

If you have a partner, you should have a detailed partnership agreement to spell out the division of ownership and duties. As with a Sole Proprietorship, there is no separation between the business and its owners. Business tax obligations pass through to the individual owners. The income is reported on a separate income tax return (IRS Form 1065).

Other types of partnerships exist, as well, including:

  • Limited Liability Partnerships
  • Professional Partnerships
  • Limited Partnerships

These variations offer more flexibility and liability protection. They also come with more formation and ongoing compliance requirements.

Example 2 - when operating as a Partnerships is preferable:

  • They don’t have any employees.
  • Sofia and Natalie found their passion in sewing.
  • Sofia’s veranda was converted into a shop.
  • The partners do not intend to grow and reinvest money back into the business.
  • They don’t want to deal with compliance formalities.
  • Their products have minimal legal risks associated with them.
  • The company’s income is less than $100,000 a year.

5. C Corporation

C Corp is a confusing phrase to a lot of people. The IRS uses the term “C-Corp” for the purpose of distinguishing a for-profit Corporation from one that has elected to be taxed as an S Corporation.

The Corporation is a legal entity separate from its owners, and it provides a significant degree of personal liability protection for its owners (shareholders). Ownership is through holding stock in the company, which may be held privately or publicly. The ability to sell stock in the business offers an opportunity to raise capital to fund initiatives and fuel growth. Status as a Corporation often makes a business more attractive to outside investors, as well.

A Corporation must file its own income tax return (IRS Form 1120). The company receives deductions for business expenses, which reduces its tax liability when it earns revenue. It may not deducted as an expense money paid to shareholders as dividends, and the individual shareholders who receive dividends must pay income tax on that income. The term “double taxation” is often used to describe how the profit of a corporation is taxed, and then profits distributed as dividends (which are not deductible as expenses to the business) are taxed to shareholders.

Incorporating a business involves filing Articles of Incorporation with the state, and it comes with higher startup costs and more administrative complexity than running a business as a Sole Proprietorship, Partnership, or LLC. To maintain its status, a corporation must have bylaws and a board of directors, hold regular meetings, and abide by other regulations.

Example 3 - when operating as a C Corporation is preferable:

  • Jack and Jill started as beer enthusiasts making beer for their friends and community gatherings.
  • They have tested different flavors and ingredients, with several becoming neighborhood favorites.
  • They saw a great earning opportunity with something that started as a hobby and fun, but they had no funds to pursue it further.
  • Their friends and neighbors came to the rescue: some with funds, one offered to turn a barn into a mini plant, and one was a merchandiser and got their beer on shelves of every convenience and grocery store in the county.
  • They all agree that the profits will be reinvested, and when they are ready to take the business nationwide, the new company will seek venture capital and equity financing.

6. S Corporation

The S Corporation is a subtype of the corporation structure. It allows a S Corporation to elect to be taxed as a Partnership, with all business income taxed at the owner (shareholder) level at the tax rate for individuals. This avoids the double taxation that Corporations normally face (i.e., some income is taxed at the corporate rate and then again taxed at the individual rate when distributed to shareholders). One potential tax advantage for you as an owner is that instead of all their business income being subject to self-employment tax, only owners’ salaries are. Any profit is given to shareholders as distributions are not.

Some other advantages of C Corp, such as personal liability protection, are retained. On the other hand, a number of restrictions on ownership of stock apply in an S Corporation. For example, it may only issue one class of stock, it may only have up to 100 shareholders, and it cannot have shareholders who are nonresident aliens.

Today, the IRS allows multiple types of entities to elect to be taxed as an S Corporation. For example, an LLC, just like a Corporation, could elect to be taxed as an S Corp if it files for an S Corporation Election by the required deadline.

Example 4 - when operating as a S Corporation is preferable:

  • Steve is an architect.
  • He makes over $80,000 and wants to minimize their self-employment tax burden.
  • He also wants to make quarterly distributions and avoid double taxation on dividend income.
  • His company doesn’t have a need for issuing more than one class of stock.
  • Steve does not mind joining the efforts with a few other professionals in the same corporation, but the total number will never exceed more than 100 shareholders.

7. Limited Liability Company (LLC)

The LLC structure combines the advantages of a corporation and those of a partnership or Sole Proprietorship. It can be a single-member LLC or a multiple-member LLC. Forming your business as an LLC limits member (owner) liability while requiring less paperwork and fewer formalities than a corporation.

To start an LLC, Articles of Organization must be filed in the state(s) in which the business will operate, and other tasks must be completed so that the company follows all applicable rules and regulations. Taxes are handled as they are for a Partnership (or Sole Proprietorship), with all income flowing through to members and reported on their personal tax returns. An LLC may instead elect to be taxed as a corporation by filing IRS Form 8832 (Entity Classification Election).

The LLC structure also provides management flexibility. It can be member-managed, in which owners handle the day-in-day-out management responsibilities, or an LLC can designate a person (or persons) as a manager(s), which is called a manager-managed LLC. Most states will, by default, consider an LLC “member-managed” unless the formation paperwork specifies that it should be a “manager-managed” LLC. Learn more about Member-Managed LLC vs Manager-Managed LLC options.

An LLC can benefit from an LLC Operating Agreement, particularly when manager-managed or when it has multiple members, to describe the authority and responsibilities assigned to the individuals involved in the business. Learn more about Single Member LLC vs Multiple Member LLC options.

One disadvantage of the LLC is the inability to issue stock to raise capital. However, many LLCs can raise capital by issuing shares of membership, though this may be limited by the language in the LLC’s Operating Agreement.

Example 5 - when operating as an LLC is preferable:

  • Jeff and Adam are wealth advisors.
  • They want to limit personal liability but don’t want the compliance formalities of a Corporation.
  • They seek flexibility in how their company is owned and managed.
  • Their business doesn’t plan to seek venture capital and equity funding but is open to adding other members.

8. Professional Corporation (PC)

Some states require that business owners in certain professions form their companies as a Professional Corporation (also known as “Professional Service Corporation”). This is a limited liability type of corporation in which all owners (shareholders) hold a professional license.

Note that a Professional Corporation does not shield the professional who commits malpractice from personal liability. Therefore, a one-person PC offers no personal liability protection to its sole shareholder. In a multi-member PC, however, the personal assets of the other shareholders may be protected while the professional who committed the act which caused the liability to the PC may be held personally liable. By obtaining professional liability insurance, individual shareholders can help protect themselves.

In states where this structure exists, the Secretary of State office (or similar agency) will maintain a list of the occupations it applies to—typically doctors, veterinarians, lawyers, accountants, and other professions that run higher liability risks.

A professional corporation must usually identify a single purpose—to practice a specific profession—as explained in its Articles of Incorporation. A separate entity from its owners, a professional corporation is considered a C Corp for tax purposes unless it elects for treatment as an S Corporation.

Example 6 - when operating as a Professional Corporation is preferable:

  • Emily is a new emergency medicine physician in Florida
  • She has a Florida license
  • The state allows for Professional Corporations and Professional Service Limited Liability Companies, but by recommendation of an attorney and CPA, she chose a PC, electing to be taxed as an S Corporation.
  • Emily plans to invite her sister, Stacy, to join her, who has been working in a sports medicine care center.
  • Both professional services are considered a high liability risk.

9. Conclusion

When it comes to choosing your business structure, you want to weigh the pros and cons. Does it make sense to open a corporation if you never plan on offering public shares? How about limiting your business to a sole proprietorship if you have an innovative idea that can grow into a seven-figure business?

To find the right structure, you need to consider complexity, flexibility, liability shield, taxes, and growth opportunities. Additionally, do you want full control of the company? At the end of the day, choosing the right structure relies on your specific needs. The structure that works best for your startup won’t be the same as another business. This is why it’s important to take the time to conduct thorough due diligence before forming your business.

If you are still confused about which structure works best for your organization, reach out for expert guidance.

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