The legal structure you choose for your business is one of the most important decisions you will make in the startup process. Each business entity has its own pros and cons, and it's important to sort through it all before settling on one. Your choice can greatly affect the way you run your business, impacting everything from liability and taxes, to control over the company.
The key is to figure out which type of entity gives your business the most advantages when it comes to helping you to achieve your organizational and personal financial goals. Here's everything you need to know when choosing your business's legal structure.
Types of business entities
1. Sole proprietorship
This is the simplest form of business entity. With sole proprietorship, one person is responsible for all of 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, CEO of MyCorporation.com. "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."
This entity is owned by two or more individuals. There are two types: general partnerships, where all is shared equally; and limited partnerships, where only one partner has control of its operation, while the other person or persons simply contribute to and receive only part of the profit. Partnerships carry a dual status as a sole proprietorship or limited liability partnership (LLP), 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," said Sweeney. "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."
3. Limited liability company (LLC)
A limited liability company is a hybrid structure that allows owners, partners or shareholders to limit their personal liabilities while enjoying the tax and flexibility benefits of a partnership. Under an LLC, members are protected from personal liability for the debts of the business, as long as it cannot be proven that they have acted in an illegal, unethical or irresponsible manner in carrying out the activities of the business.
"A limited liability company offers more protections and separations to businesses than sole proprietorships and is a combination of a corporation and partnership," said RaShea Drake, B2B analyst with Verizon Business. "Your personal assets and company assets are separated in most cases, and your profits and losses are not taxed at the corporate level."
The law regards a corporation as an entity that is separate from its owners. It has its own 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.
- C corporations, owned by shareholders, are taxed as separate entities.
- S corporations avoid this double taxation, much like partnerships or LLCs. Owners also have limited liability protection.
- B corporations, otherwise known as benefit corporations, are for-profit entities structured to make a positive impact on society.
- Close corporations, typically run by a few shareholders, are not publicly traded and benefit from limited liability protection.
- Nonprofit corporations exist to help others in some way, and are rewarded by tax-exemption.
A cooperative is owned by the same people it serves. Its offerings benefit the company's members, who vote on the organization's mission and direction.
Factors to consider
For new businesses that could fall into two or more of these categories, it's not always easy to decide which one to choose. You need to consider your startup's financial needs, risk and ability to grow. It can be difficult to switch your legal structure after you've registered your business, so choosing correctly at the start is crucial.
You'll want to ask yourself where your company is headed, and if your structure allows for it. Turn to your business plan to align your goals with the proper structure. Your entity should support the possibility for growth and change, not hold it back from its potential.
When it comes to startup and operational complexity, there is nothing simpler than a sole proprietorship. You simply 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 roles and percentages of profits. Corporations and LLCs have various reporting requirements with the state and federal governments.
A corporation carries the least amount of personal liability, since the law holds that it is its own entity. This means that creditors and customers can sue the corporation, but they cannot 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 will pay taxes, just as a sole proprietor does — all profit is considered personal income and is 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, chief marketing expert at Expertly.com. "The LLC structure prevents that, and makes sure you're not taxed as a company and as an individual."
Partners 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 end effect on your return.
A corporation files its own tax return each year, paying tax on profits after expenses, including payroll. If you pay yourself from the corporation, you will pay personal taxes — such as Social Security and Medicare — on your personal return for what you were paid throughout the year.
If it is important for you to have sole or primary control of the business and its activities, a sole proprietorship or an LLC might be the best choice for you. 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 to 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 as a small corporation, the rules intended for larger organizations — such as keeping board-of-directors notes of every major decision that affects the company — still apply.
If you need to obtain outside funding sources — like investor or venture capital, bank loans and other avenues for money — you may be better off establishing a corporation, which has an easier time of obtaining outside funding than does a sole proprietorship. Corporations can sell shares of stock, securing additional funding for growth, while sole proprietors can only obtain funds through their personal accounts, using their personal credit or taking on partners. An LLC can face similar struggles, although, as its own entity, it is not always necessary for the owner to use his or her personal credit or assets.
Licenses, permits and regulations
In addition to getting your business entity legally registered, 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 a 'one size fits all,' and businesses may not be aware of what's applicable to them."
It's important to note that the structures discussed here only apply to for-profit businesses. If you've done your research and you're still unsure about which business structure is right for you, Friedman advised speaking with a specialist in business law.
For more information on the types of business structures you can choose, visit the Small Business Administration website.
Additional reporting by Marci Martin and Nicole Fallon. Some source interviews were conducted for a previous version of this article.