- Your Guide to Choosing the Right Business Structure
- Choosing a Business Structure: Why It Matters
- Types of Business Structure
- Choosing the Right One for You
- Ready to Market Your Business?
Your Guide to Choosing the Right Business Structure
You’ve got an idea, the idea you’re sure will be the next big thing in business. You know what you want to accomplish and you’re pretty sure you know how you’re going to get there.
Starting a business is about more than just a great idea. It’s about knowing what your business needs and how to build a business that can sustain itself.
An essential part of the process is choosing a business structure. It sounds basic, but it’s actually a foundational component of your business’s future success. Here, we’re breaking why choosing the right structure is so important, a few types of business structures, and how to choose the right one for you.
Choosing a Business Structure: Why It Matters
Before we talk about your options, let’s talk about why it’s important to choose the right one.
Your business structure is about so much more than just titles and ownership. There are many reasons, but they can be boiled down to two key points:
- Organizational purpose
A business structure, in its simplest form, acts as an organizational guidebook for employees. It lets them know the hierarchy of relationships so that they know who they report to and what growth within the company will look like. It also makes it easier for you to add positions later.
This leads to the second point, clarity. If your employees know and understand the business structure, it’s easier to understand each individual’s responsibilities within the company. Because of this, each component of your company can function with much greater efficiency.
Types of Business Structure
With this in mind, let’s talk about the different types of business structures.
In the United States, there are five main types of businesses you’re likely to encounter:
- Sole proprietorship
- Limited liability company
How do you know which structure is right for your business? That depends on what your goals are and what matters most to you. Each individual structure has benefits depending on what you want to accomplish.
Let’s start with the simplest of the five: sole proprietorship.
A sole proprietorship is one of the most common types of business structures. It’s also, technically, not a business entity.
A sole proprietorship is an unincorporated business owned by one individual who reports business profits on their individual tax returns. In simple terms, your business isn’t viewed as its own legal entity, but rather as something tied to you as an individual.
Legally, this means that your business cannot assume liability–all legal and tax responsibilities fall squarely on you as the owner.
So if, for example, your business accrues a lot of debt, you’ll be the one responsible for paying it off.
Who It’s For
If you’re planning on running your small business on your own, including all the aspects involved in producing your products and services, then a sole proprietorship is the right choice.
Let’s say, for example, you want to start a business selling jewelry through Etsy. In this instance, you’re a great candidate for a sole proprietorship, since you handle all production yourself and all business transactions come through you alone.
It’s also one of the easiest business types to set up since there are no legal formalities like bylaws or agreements required. And since there is no legal separation between you and your business, it’s easy for you to transfer money back and forth between you and your business.
Oh, and if you dread Tax Day like the plague? Sole proprietorships are considered pass-through tax entities, which means that all profits and losses are reported directly on the owner’s taxes.
Now, let’s say you’re a personal trainer and your best friend is a nutritionist. You want to pair up and start the next great health and wellness empire.
You’re going to want to form a partnership.
A business partnership works a lot like a personal partnership. Essentially, two people are coming together and deciding to run a business together. This means that everything is shared jointly.
It’s easiest to think of a partnership as an expanded sole proprietorship. Profits are split between the two owners and reported on their individual tax returns. The business is still unincorporated and thus tied to the two partners.
There are three main types of partnerships:
- General partnership
- Limited partnership
- Limited liability partnership
The specific type of partnership you choose will depend on how long you plan to remain partners and how active each partner plans to be.
Who It’s For
Our personal trainer and nutritionist are a great example of a partnership. They each bring something different to the table, but their respective strengths complement each other as equal participants.
Regardless of how close you and your partner are, it’s a good idea to have a lawyer draw up a partnership agreement. This will legally formalize the terms of your partnership so that both sides can be held accountable for their end of the bargain.
Like a sole proprietorship, partnerships are relatively quick and easy to set up and don’t require many formalities beyond the initial partnership agreement.
That said, keep in mind that a partnership is still a pass-through tax entity, which means you’re liable for your business debts (and the responsibility for payment may depend on the structure of the partnership).
Partnerships also require a great deal of trust between both partners, since you have to take responsibility for each other’s actions.
Limited Liability Corporation
You’re probably noticing a trend at this point: in sole proprietorships and partnerships, you’re personally liable if your business falls on hard times.
That’s a scary notion to a lot of would-be business owners. It’s reasonable for you to feel uncomfortable at the thought of the bank seizing your assets if your business goes under.
This is where a limited liability corporation (LLC) can help cushion you against potential fallout.
In an LLC, as the name implies, members of a company are not personally liable for the company’s debts and liabilities if the company hits rough water. As such, they’re a sort of halfway point between corporations and partnerships.
That said, you still retain the relative flexibility granted to a sole proprietorship or partnership, which is a definite plus.
Who It’s For
The process of forming an LLC is more complicated than a sole proprietorship or partnership since you need to file articles of incorporation, create a business agreement, and file taxes as a corporation, as well as any industry-specific permits or licenses.
Because of this, LLCs come with added difficulty. You’re going to have to jump through more legal hoops on your own or get more people to agree to jump through legal hoops.
That said, there are significant tax benefits. While an LLC is still a pass-through entity, you’ll only be taxed on your share of the profits as part of your personal taxes.
A word of caution: LLCs do not scale well. If your business grows faster than expected, you’re going to have to convert to a corporation whether you want to or not.
Now you’re starting to deal with the big leagues.
A C-corporation is what people usually think of when they think of corporations. In this structure, the shareholders are taxed separately from the business entity, and the business entity is subject to corporate income taxation.
In C-corporations, businesses start to encounter a double taxation situation. The business has to pay corporate taxes before distributing the remainder to shareholders, at which point the shareholders are subject to personal income taxes for their dividends.
However, the corporation can reinvest profits in the company at a lower tax rate.
Who It’s For
As with an LLC, C-corp shareholders are protected from liability if the business accrues debts.
There are other benefits as well. For example, a C-corp can have unlimited shareholders and multiple stock classes available, which can make them more attractive to potential investors.
This also means that you can sell off your shares in the business if you so choose and the business can continue to operate without you.
That said, the presence of more shareholders and the corporation’s status as a separate tax entity means that there are many more legal formalities you’ll have to deal with. The decision-making process will also be slowed down since shareholders will have to come to an agreement.
Finally, there’s an S-corporation. It’s similar to a C-corporation in most ways that matter. There is, however, one essential difference: shareholders can pass through profits and losses to their personal income taxes.
It also has certain limitations that aren’t placed on C-corporations. For example, S-corporations must have only one class of stock and no more than 100 shareholders.
None of these shareholders can be a person without a green card or another for-profit company.
Who It’s For
S-corporations require more work than C-corporations since you need to file with the IRS to get S-corp status, which is a completely different process from registering your business in your state.
It’s important to note, though, that not all states recognize S-corps at all, and some treat them simply as C-corps. That said, most states recognize them the same way the federal government does and taxes them accordingly.
An S-corporation, in general, is a good idea for a business that’s looking to avoid the double taxation that comes with C-corporation status. This is a good thing for shareholders–since the dividends go straight to their personal income, they’re never subject to corporate tax, which means dividends are higher.
Choosing the Right One for You
Now, with all of that in mind, let’s talk about choosing the right business structure for your business.
How you set up your business isn’t just a question of whether you want to go it alone or join forces with your closest friend. When considering your business structure, you need to address a few key points:
- Risk tolerance
- The formation and administration process
- What your business will need in the future
Let’s break it down.
One of the biggest issues you need to address is your relationship to risk, which has to do with your legal liability.
If you’re not sure where to start, ask yourself: how much do you need to be insulated from liability? How much liability are you comfortable taking on personally?
If you tend towards risk aversion, then a sole proprietorship or partnership may not be your best option.
In addition, there are certain industries and businesses where it’s a good idea to have insulation from liability, like if you have to invest in a significant amount of equipment and deal with large contracts.
So, ask yourself if your business lends itself to risk, and if so, whether you can personally afford losses from that liability.
Whether you’re making jewelry or renting industrial machinery, most businesses prefer to pay fewer taxes.
The question is how to go about it, given your individual situation and the goals of your business.
In general, there are more tax options available for corporations than sole proprietorships and partnerships. There are even ways around the double taxation issue.
You should also keep in mind that there are ways to get around personal tax liability, depending on what form your business takes. It depends on what your goals are and what would best suit your company’s needs.
Cost of Formation and Administration
While there are definite benefits to corporations (like reduced personal risk and better tax benefits) the unfortunate reality is that corporations cost more to form and maintain.
This is because corporations have a much more formalized management structure in order to comply with IRS regulations. There’s also a lot of administrative requirements, such as articles of incorporation and the record keeping and paperwork that come along with it.
Finally, if you really are planning on creating a business that will last, then you need to consider what your business might need in the future.
If you’ve just launched a business, it can be easy to get caught up in the moment. You want to deal with the here and now, day-by-day. But if you want a lasting company, you need to plan for what it will look like five or ten years down the road.
For example: do you want your business to last after you die? What will happen to your business when you’re not around to run it?
If you plan on having a business that outlives you, then you need a business structure where ownership is easily transferred without shaking the foundations of the company, which means you need a corporation.
However, keep in mind that the business structure you need now may not be the structure you need in the future. That’s okay–many sole proprietorships or partnerships will later develop into corporations.
The key is to have a plan.
Ready to Market Your Business?
Now that you know what business structure will work for your company, it’s time to get your business in gear.
Of course, to have a truly successful business, you need great marketing. That’s where we come in.
Ready to see how we can help you? Use our contact page to get in touch.