As you put together your business plan, it is crucial that you decide what type of legal business structure you will have.
Setting up your legal business structure will dictate the different benefits you will be eligible for, your taxation, the liability of you as an individual and the safety of your personal assets.
Choosing a business structure will depend on the following aspects:
- Business size
- Need for capital
- Risk of liability
- Tax implications
- Future goals
There are four main types of business structures covered in this article:
Each different type of business structure will provide different benefits and its structure will facilitate different aspects of a business such as your eligibility to raise capital. All these will require different procedures and documents.
A sole proprietorship is a structure where one business owner oversees all operations and makes every decision. The individual is therefore directly responsible and liable for the business. Legally, there is no separation between the business owner and the business itself. Simultaneously, the business owner receives profits from the business and its debts.
The registration process of a sole proprietorship is simple and inexpensive since there is no legal distinction between the business and its owner. Because of this, the business is not recognized as a separate entity. The registration process requires that the owner selects a business name and files as a DBA or “doing business as” for sales and tax purposes. The DBA filing can be done at a clerk’s office or state agency depending on what state you live in. However, the business owner must still apply for any licenses and permits depending on the type of business. They must also apply for an EIN number with the IRS if they plan on hiring full time employees.
Examples of sole proprietorship businesses are usually home based businesses such as bookkeeping or any kind of freelancing services.
Pros of a Sole Proprietorship:
- Sole ownership and total rights to the business and brand
- Total control of the business
- Easy, inexpensive registration
- Fast to set up
- Can hire employees as independent contractors
Cons of a Sole Proprietorship
- Owner has unlimited liability for the business
- Full responsibility for debts and losses
- There is no separation between business and personal assets
- Difficult to finance
A partnership is an easy way for two or more people to own a business together. There are different types of partnerships that distribute responsibilities and profits differently.
A general partnership is the easiest and most inexpensive type of partnership to set up. In this type of partnership, responsibilities are divided among partners. Consequently, profits and costs are shared equally among partners; however, an unequal distribution is not uncommon. Usually, percentages of ownership are stated in an agreement. For example, one partner can own 60% while the other owns 40%. Profits and costs are distributed according to the agreement.
Another type of partnership is a limited partnership. This distributes the liability differently depending on who the controlling partner is. The general partner in this structure would have the most of the liability while giving investors and other partners limited liability in the business.
Limited Liability Partnership (LLP)
Lastly, there is a limited liability partnership (LLP) not to be confused with a limited partnership. This type of partnership is where all partners have limited liability. The difference between an LLP and a limited partnership is that in a limited partnership, one partener must have unlimited liability, and the others who have limited liability cannot be in management. In an LLP, all partners have limited liability and can have managing roles. Common examples of this type of partnership are law firms and accounting firms, where partners are not responsible or liable for the other partners in the business.
Forming a Partnership
To form a partnership, the business must be registered with the state. In order to do so, the business must have an official name. Once registered, research what permits and licenses your business will need to operate in your state. Check out more tax information from the IRS.
Pros of a Partnership:
- Easy to form
- Shared Liability or Limited Liability
- Shared financial responsibility
- Partners bring different skills and specialities
Cons of a Partnership:
- Still a large amount of liability depending on the type of partnership
- Shared profits
- Disagreements arise between partners
Limited Liability Company (LLC)
Most people are fairly familiar with the acronym “LLC”, otherwise known as Limited Liability Company. An LLC is a marriage between a partnership and a corporation. A business that is registered as an LLC is owned by “members” rather than partners. In this type of structure, there is a legal distinction between the members and the business, which means personal assets and business assets are legally separated. This means that members of an LLC can protect their personal assets from a lawsuit. Much like a partnership, an LLC must also be registered in accordance with the laws of the state in which it operates.
A particular aspect of an LLC is that it can have an “expiration date” depending on state laws and the articles of organization. Its members may decide the duration of the LLC varying with time, or other events such as bankruptcy, the exit or death of a member. LLCs can also be set up perpetually if they remain compliant with the law.
Pro’s of an LLC
- Tax flexibility
- Personal protection from lawsuits and limited liability
- Can legally operate on its own
- Less paperwork and formalities
- Managers do not have to be members of the LLC
Cons of an LLC
- Newer type of structure that has little case law precedence
- Less understanding as to how LLCs operate
- More expensive to operate
- Getting investments could be more difficult
There are different types of corporations, but the main types are S Corporations and C corporations.
A C-corp is a completely separate entity from its owners and members. Because of this, they offer the highest level of protection from personal liability. The daily operations of a corporation is usually more complex than the other types of business structures as it requires extensive record-keeping and bookkeeping. Corporations are unique in the sense that they pay income taxes off of their profits, and may be taxed twice when dividends are paid out and personal taxes are filed. Find the forms you need from the IRS to form a corporation.
C-corps function completely independently from the shareholders or owners, which is why large businesses with large amounts of cash inflows and outflows usually are a form of a corporation. Due to its structure, a corporation can easily attract investors compared to other business structures, which gives it a competitive advantage.
Pro’s of a C-corporation
- The highest amount of protection from liability
- Functions and exists on its own with or without the shareholders
- Separation from ownership and management
- Anyone can be a shareholder
- Established legal procedures and precedence
- Attracts investors and venture capitalists
Cons of a C-Corporation
- Complex record keeping and business operations
- Double taxation
- Expensive to start
- More regulations/ paperwork
- Cannot deduct losses on personal income taxes
S-Corps work a little differently than a C-corp. An S-corp is designed to avoid the double taxation that a C-corp has to go through. An S corp can not have more than 100 shareholders which all must be U.S citizens. In order to file as an S-corp, a business must meet these (and other) requirements with the IRS.
Pro’s of an S-Corporation
- The same amount of asset protection of a C-Corp
- Taxed once
- Overall has the same benefits of a C-Corp
- Can deduct Losses on personal income taxes
Cons of an S-Corporation
- Hard to qualify for
- More formalities/paperwork
How Do I Pick Which Structure is Best for My Business?
Now that you know what the main types of business structures are, it can seem overwhelming and confusing as all have great benefits and some drawbacks. You should pick which one is best for your business depending on business size, daily operations and your long term goals. The best thing about business structures is that they can be updated and changed as your business grows and develops.
When to be a Sole Proprietorship
A sole proprietorship is a good idea when a business is just starting up. It is the easiest type of structure to set up and requires little effort an money. It is also the most beneficial when the business is run by one person, has low risk and you are not worried about your personal assets or getting sued.
A one person startup or small local business is usually the most benefited by a sole proprietorship. A sole proprietorship is usually self financed because business loans are usually not given out to a sole proprietorship and venture capitalists usually do not invest in these types of structures. Any financing or capital would have to be achieved by a personal loan or credit cards.
If you are starting your own business as a sole proprietor and don’t initially need high amounts of capital, have little risk when it comes to liability, a sole proprietorship might be right for you. Once you start growing, acquiring clients and in need of scale-up capital, you can change the legal structure to best fit your needs.
When to be a Partnership
Similarly to sole proprietorship, a partnership is convenient when you are starting a small business with low risk. It is also beneficial if you need another person with a certain amount of skills or experience that could add value to your business.
It is possible to go from a sole proprietorship to a partnership. This often happens when business owners decide they need more support from another person with the right knowledge and experience to scale the business. Just like in a sole proprietorship, both partners would report profit and loss as part of their personal income.
Choosing a good business partner is essential to this particular business structure. When establishing a partnership, make sure you create a partnership agreement outlining the obligations and responsibilities of each person as well as the profit and loss split.
When to be an LLC
Starting an LLC should be considered when the business has a medium amount of risk or you are concerned about your personal assets and liabilities. An LLC does not necessarily have to be a larger business, as it has benefits for small business owners, sole proprietors and partners to have a limited liability. In fact, LLC’s are generally popular among new business and early stage businesses.
Much like a partnership or sole proprietorship, an LLC has its difficulties raising money through venture capital. A business that does not need a high amount of capital, but requires limited liability could be a good contender for an LLC.
When to be a Corporation
Forming a corporation is highly convenient if your top concern is your personal assets or liability. In other words, if there is a high risk of getting sued, you might want to look into a corporation structure. This type of business structure is also beneficial for those who need a high amount of capital and have more complex business operations, as investors are attracted to these kinds of organizations.
Join the CoLab INC community to grow your startup
About Raitchele Cornett
Raitchele (Hi-Chel-Ee) is from Curitba, Brazil, and grew up around entrepreneurs and business moguls.
Raitchele is a Boise State Alum and MBA Student with a passion for entrepreneurship.