- Your business’s legal structure determines your tax rates, management and paperwork requirements, fundraising abilities, and more.
- Sole proprietorships and partnerships are relatively easy to start, but they lack liability protection.
- Corporations may take more work to start, but they offer liability protection and, in some cases, more favorable tax rates.
- This article is for business owners looking to learn more about the different small business legal structures.
Your business’s legal structure has many ramifications. It can determine how much liability your company faces during lawsuits. It can put up a barrier between your personal and business taxes – or ensure this barrier doesn’t exist. It can also determine how often your board of directors must file paperwork – or if you even need a board. [Related article: What to Do if Your Business Gets Sued]
We’ll explore business legal structures and how to choose the right structure for your organization.
What is a business legal structure?
A business legal structure, also known as a business entity, is a government classification that regulates certain aspects of your business. On a federal level, your business legal structure determines your tax burden. On a state level, it can have liability ramifications.
Why is a business legal structure important?
Choosing the right business structure from the start is among the most crucial decisions you can make. Here are some factors to consider:
- Taxes: Sole proprietors, partnership owners and S corporation owners categorize their business income as personal income. C corporation income is business income separate from an owner’s personal income. Given the different tax rates for business and personal incomes, your structure choice can significantly impact your tax burden.
- Liability: Limited liability company (LLC) structures can protect your personal assets in the event of a lawsuit. That said, the federal government does not recognize LLC structures; they exist only on a state level. C corporations are a federal business structure that includes the liability protection of LLCs.
- Paperwork: Each business legal structure has unique tax forms. Additionally, if you structure your company as a corporation, you’ll need to submit articles of incorporation and regularly file certain government reports. If you start a business partnership and do business under a fictitious name, you’ll need to file special paperwork for that as well.
- Hierarchy: Corporations must have a board of directors. In certain states, this board must meet a certain number of times per year. Corporate hierarchies also prevent business closure if an owner transfers shares or exits the company, or when a founder dies. Other structures lack this closure protection.
- Registration: A business legal structure is also a prerequisite for registering your business in your state. You can’t apply for an employer identification number (EIN) or all your necessary licenses and permits without a business structure.
- Fundraising: Your structure can also block you from raising funds in certain ways. For example, sole proprietorships generally can’t offer stocks. That right is primarily reserved for corporations.
- Potential consequences for choosing the wrong structure: Your initial choice of business structure is crucial, although you can change your business structure in the future. However, changing your business structure can be a disorganized, confusing process that can lead to tax consequences and the unintended dissolution of your business.
Did you know?: If you have to expand your business to another state, you won’t have to create a new company or structure, but you may have to register it as a “foreign entity.”
Types of business structures
The most common business entity types are sole proprietorships, partnerships, limited liability companies, corporations and cooperatives. Here’s more about each type of legal structure.
A sole proprietorship is the simplest business entity. When you set up a sole proprietorship, one person is responsible for all a company’s profits and debts.
“If you want to be your own boss and run a business from home without a physical storefront, a sole proprietorship allows you to be in complete control,” said Deborah Sweeney, vice president and general manager of business acquisitions at Deluxe Corp. “This entity does not offer the separation or protection of personal and professional assets, which could prove to become an issue later on as your business grows and more aspects hold you liable.”
Proprietorship costs vary by market. Generally, early expenses will include state and federal fees, taxes, business equipment leases, office space, banking fees, and any professional services your business contracts. Some examples of these businesses are freelance writers, tutors, bookkeepers, cleaning service providers and babysitters.
A sole proprietorship business structure has several advantages.
- Easy setup: A sole proprietorship is the simplest legal structure to set up. If you – and only you – own your business, this might be the best structure. There is very little paperwork since you have no partners or executive boards.
- Low cost: Costs vary by state, but generally, license fees and business taxes are the only fees associated with a proprietorship.
- Tax deduction: Since you and your business are a single entity, you may be eligible for specific business sole proprietor tax deductions, such as a health insurance deduction.
- Easy exit: Forming a proprietorship is easy, and so is ending one. As a single owner, you can dissolve your business at any time with no formal paperwork required. For example, if you start a day care center and wish to fold the business, refrain from operating the day care and advertising your services.
The sole proprietorship is also one of the most common small business legal structures. Many famous companies started as sole proprietorships and eventually grew into multimillion-dollar businesses. These are a few examples:
- Marriott Hotels
A partnership is owned by two or more individuals. There are two types: a general partnership, where all is shared equally, and a limited partnership, where only one partner has control of operations and the other person (or persons) contributes to and receives part of the profits. Partnerships can operate as sole proprietorships, where there’s no separation between the partners and the business, or limited liability partnerships (LLPs), depending on the entity’s funding and liability structure.
“This entity is ideal for anyone who wants to go into business with a family member, friend or business partner – like running a restaurant or agency together,” Sweeney said. “A partnership allows the partners to share profits and losses and make decisions together within the business structure. Remember that you will be held liable for the decisions made as well as those actions made by your business partner.”
General partnership costs vary, but this structure is more expensive than a sole proprietorship because an attorney should review your partnership agreement. The attorney’s experience and location can affect the cost.
A business partnership agreement must be a win-win for both sides to succeed. Google is an excellent example of this. In 1995, co-founders Larry Page and Sergey Brin created a small search engine and turned it into the leading global search engine. The co-founders met at Stanford University while pursuing their doctorates and later left to develop a beta version of their search engine. Soon after, they raised $1 million in funding from investors, and Google began receiving thousands of visitors a day. Having a combined ownership of 11.4% of Google provides them with a total net worth of nearly $226.4 billion.
Business partnerships have many advantages.
- Easy formation: As with a sole proprietorship, there is little paperwork to file for a business partnership. If your state requires you to operate under a fictitious name (“doing business as,” or DBA), you’ll need to file a Certificate of Conducting Business as Partners and draft an Articles of Partnership agreement, both of which have additional fees. You’ll usually need a business license as well.
- Growth potential: You’re more likely to obtain a business loan with more than one owner. Bankers can consider two credit histories rather than one, which can be helpful if you have a less-than-stellar credit score.
- Special taxation: General partnerships must file federal tax Form 1065 and state returns, but they do not usually pay income tax. Both partners report their shared income or loss on their individual income tax returns. For example, if you opened a bakery with a friend and structured the business as a general partnership, you and your friend are co-owners. Each owner brings a certain level of experience and working capital to the business, affecting each partner’s business share and contribution. If you brought the most seed capital for the business, you and your partner may agree that you’ll retain a higher share percentage, making you the majority owner.
Partnerships are one of the most common business structures. These are some examples of successful partnerships:
- Warner Bros.
- Ben & Jerry’s
Limited liability company
A limited liability company (LLC) is a hybrid structure that allows owners, partners or shareholders to limit their personal liabilities while enjoying a partnership’s tax and flexibility benefits. Under an LLC, members are shielded from personal liability for the business’s debts if it can’t be proven that they acted in a negligent or wrongful manner that results in injury to another in carrying out the activities of the business.
“Limited liability companies were created to provide business owners with the liability protection that corporations enjoy while allowing earnings and losses to pass through to the owners as income on their personal tax returns,” said Brian Cairns, CEO of ProStrategix Consulting. “LLCs can have one or more members, and profits and losses do not have to be divided equally among members.”
According to TRUiC, the cost of forming an LLC comprises the state filing fee and can range from $40 to $500, depending on your state. For example, if you file an LLC in New York, you must pay a $200 filing fee and a $9 biennial fee, according to LLC University, and file a biennial statement with the New York Department of State.
Although small businesses can be LLCs, some large businesses choose this legal structure. The structure is typical among accounting, tax, and law firms, but other types of companies also file as LLCs. One example of an LLC is Anheuser-Busch, one of the leaders in the U.S. beer industry. Headquartered in St. Louis, Anheuser-Busch is a wholly owned subsidiary of Anheuser-Busch InBev, a multinational brewing company based in Leuven, Belgium.
Here some other well-known examples of LLCs:
- Hertz Rent-a-Car
The law regards a corporation as separate from its owners, with legal rights independent of its owners. It can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks. Corporation filing fees vary by state and fee category.
There are several types of corporations, including C corporations, S corporations, B corporations, closed corporations, and nonprofit corporations.
- C corporations: C corporations, owned by shareholders, are taxed as separate entities. JPMorgan Chase & Co. is a multinational investment bank and financial services holding company listed as a C corporation. Since C corporations allow an unlimited number of investors, many larger companies – including Apple, Bank of America and Amazon – file for this tax status.
- S corporations: S corporations were designed for small businesses. They avoid double taxation, much like partnerships and LLCs. Owners also have limited liability protection. Widgets Inc. is an example of an S corporation that operates very simply: Employee salaries are subject to FICA tax (as are all employee salaries), while the distribution of additional profits from the S corporation does not incur further FICA tax liability. [Learn more about FICA taxes for small businesses.]
- B corporations: B corporations, otherwise known as benefit corporations, are for-profit entities committed to corporate social responsibility and structured to positively impact society. For example, skincare and cosmetics company The Body Shop has proven its long-term commitment to supporting environmental and social movements, resulting in an awarded B corporation status. The Body Shop uses its presence to advocate for permanent change on issues like human trafficking, domestic violence, climate change, deforestation and animal testing in the cosmetic industry.
- Closed corporations: Closed corporations, typically run by a few shareholders, are not publicly traded and benefit from limited liability protection. Closed corporations, sometimes referred to as privately held companies, have more flexibility than publicly traded companies. For example, Hobby Lobby is a closed corporation – a privately held, family-owned business. Stocks associated with Hobby Lobby are not publicly traded; instead, the stocks have been allocated to family members.
- Open corporations: Open corporations are available for trade on a public market. Many well-known companies, including Microsoft and Ford Motor Co., are open corporations. Each corporation has taken ownership of the company and allows anyone to invest.
- Nonprofit corporations: Nonprofit corporations exist to help others in some way and are rewarded by tax exemption. Some examples of nonprofits are the Salvation Army, American Heart Association and American Red Cross. These organizations all focus on something other than turning a profit.
Corporations enjoy several advantages.
- Limited liability: Stockholders are not personally liable for claims against your corporation; they are liable only for their personal investments.
- Continuity: Corporations are not affected by death or the transferring of shares by their owners. Your business continues to operate indefinitely, which investors, creditors and consumers prefer.
- Capital: It’s much easier to raise large amounts of capital from multiple investors when your business is incorporated.
This structure is ideal for businesses that are further along in their growth, rather than a startup based in a living room. For example, if you’ve started a shoe company and have already named your business, appointed directors and raised capital through shareholders, the next step is to become incorporated. You’re essentially conducting business at a riskier, yet more lucrative, rate. Additionally, your business could file as an S corporation for the tax benefits. Once your business grows to a certain level, it’s likely in your best interest to incorporate it.
These are some popular examples of corporations:
- General Motors
- Exxon Mobil Corp.
- Domino’s Pizza
- JPMorgan Chase
Learn more about how to become a corporation.
A cooperative (co-op) is owned by the same people it serves. Its offerings benefit the company’s members, also called user-owners, who vote on the organization’s mission and direction and share profits.
Cooperatives offer a couple main advantages.
- Increased funding: Cooperatives may be eligible for federal grants to help them get started.
- Discounts and better service: Cooperatives can leverage their business size, thus obtaining discounts on products and services for their members.
Forming a cooperative is complex and requires you to choose a business name that indicates whether the co-op is a corporation (e.g., Inc. or Ltd.). The filing fee associated with a co-op agreement varies by state.
An example of a co-op is CHS Inc., a Fortune 100 business owned by U.S. agricultural cooperatives. As the nation’s leading agribusiness cooperative, CHS reported a net income of $422.4 million for fiscal year 2020. These are some other notable examples of co-ops:
- Land O’Lakes
- Navy Federal Credit Union
- Ace Hardware
Key takeaway: The five types of business structures are sole proprietorship, partnership, limited liability company, corporation and cooperative. The right structure depends mainly on your business type.
Factors to consider before choosing a business structure
For new businesses that could fall into two or more of these categories, it’s not always easy to decide which structure to choose. Consider your startup’s financial needs, risk and ability to grow. It can be challenging to switch your legal structure after registering your business, so give it careful analysis in the early stages of forming your business.
Here are some crucial factors to consider as you choose your business’s legal structure. You should also consult a CPA for advice.
Where is your company headed, and which type of legal structure allows for the growth you envision? Turn to your business plan to review your goals and see which structure best aligns with those objectives. Your entity should support the possibility for growth and change, not hold it back from its potential. [Learn how to write a business plan with this template.]
When it comes to startup and operational complexity, nothing is more straightforward than a sole proprietorship. Register your name, start doing business, report the profits and pay taxes on it as personal income. However, it can be difficult to procure outside funding. Partnerships, on the other hand, require a signed agreement to define the roles and percentages of profits. Corporations and LLCs have various reporting requirements with state governments and the federal government.
A corporation carries the least amount of personal liability since the law holds that it is its own entity. This means creditors and customers can sue the corporation, but they can’t gain access to any personal assets of the officers or shareholders. An LLC offers the same protection but with the tax benefits of a sole proprietorship. Partnerships share the liability between the partners as defined by their partnership agreement.
An owner of an LLC pays taxes just as a sole proprietor does: All profit is considered personal income and taxed accordingly at the end of the year.
“As a small business owner, you want to avoid double taxation in the early stages,” said Jennifer Friedman, principal at Rivetr. “The LLC structure prevents that and makes sure you’re not taxed as a company, but as an individual.”
Individuals in a partnership also claim their share of the profits as personal income. Your accountant may suggest quarterly or biannual advance payments to minimize the effect on your return.
A corporation files its own tax returns each year, paying taxes on profits after expenses, including payroll. If you pay yourself from the corporation, you will pay personal taxes, such as those for Social Security and Medicare, on your personal return.
Tip: To simplify payroll complexities and taxation issues, consider using a payroll service. Check out our reviews of the best payroll services to find a partner that fits your needs and budget.
If you want sole or primary control of the business and its activities, a sole proprietorship or an LLC might be the best choice. You can negotiate such control in a partnership agreement as well.
A corporation is constructed to have a board of directors that makes the major decisions that guide the company. A single person can control a corporation, especially at its inception, but as it grows, so does the need to operate it as a board-directed entity. Even for a small corporation, the rules intended for larger organizations – such as keeping notes of every major decision that affects the company – still apply.
If you need to obtain outside funding from an investor, venture capitalist or bank, you may be better off establishing a corporation. Corporations have an easier time obtaining outside funding than sole proprietorships.
Corporations can sell shares of stock and secure additional funding for growth, while sole proprietors can obtain funds only through their personal accounts, using their personal credit or taking on partners. An LLC can face similar struggles, although, as its own entity, it’s not always necessary for the owner to use their personal credit or assets.
Licenses, permits and regulations
In addition to legally registering your business entity, you may need specific licenses and permits to operate. Depending on the type of business and its activities, it may need to be licensed at the local, state and federal levels.
“States have different requirements for different business structures,” Friedman said. “Depending on where you set up, there could be different requirements at the municipal level as well. As you choose your structure, understand the state and industry you’re in. It’s not ‘one size fits all,’ and businesses may not be aware of what’s applicable to them.”
The structures discussed here apply only to for-profit businesses. If you’ve done your research and you’re still unsure which business structure is right for you, Friedman advises speaking with a specialist in business law.
Max Freedman and Matt D’Angelo contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.