The business structure you choose influences everything from day-to-day operations, to taxes and how much of your personal assets are at risk. You should choose a business structure that gives you the right balance of legal protections and benefits.
The type of business structure you choose impacts your tax obligations, fundraising potential, required paperwork, and personal liability. It's essential to select a business structure prior to officially registering your business with the state. Additionally, most businesses will be required to obtain a tax ID number and apply for the necessary licenses and permits.
Make your choice wisely. Even if you decide to switch to a different business structure later on, there might be limitations depending on where you are located. This could lead to tax implications and unintentional dissolution, as well as other complexities.
Seeking advice from business advisors, lawyers, and accountants can be beneficial.
Examine typical business frameworks.
Sole proprietorship
A sole proprietorship is a simple business structure that offers full control to the owner. If you engage in business activities without registering as a different entity, you are automatically considered a sole proprietor. Unlike other business types, sole proprietorships do not create a distinct legal entity, meaning your personal assets and liabilities are tied to those of the business. This can result in personal liability for business debts and obligations. Sole proprietors have the option to use a trade name but may find it challenging to raise capital due to restrictions on selling stock and banks' reluctance to lend to this type of business. While suitable for low-risk ventures and individuals looking to test their business concept before formalizing it, sole proprietorships lack the separation of personal and business finances.
Partnership
Partnerships provide a straightforward way for two or more individuals to jointly own a business. There are two main types of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
In limited partnerships, there is one general partner with unlimited liability, while all other partners have limited liability. Partners with limited liability typically have restricted control over the business, as outlined in a partnership agreement. Profits are distributed through personal tax returns, and the general partner, who lacks limited liability, is also subject to self-employment taxes.
On the other hand, limited liability partnerships offer limited liability to all owners, shielding each partner from the partnership's debts and relieving them of responsibility for the actions of their co-partners.
Partnerships are a suitable option for businesses with multiple owners, professional groups such as attorneys, and entities looking to validate their business concept before establishing a more formal business structure.
Limited liability company (LLC)
By forming an LLC, you can combine the advantages of corporation and partnership structures. This offers protection from personal liability, ensuring that your personal assets such as your home, vehicle, and savings remain safeguarded in the event of bankruptcy or legal action against the LLC.
Profits and losses in an LLC can flow through to your personal income without being subject to corporate taxes. However, LLC members are viewed as self-employed individuals and are obligated to make self-employment tax contributions towards Medicare and Social Security.
In various states, LLCs may have a restricted lifespan. In the event of a member joining or leaving, certain states might mandate the dissolution and reformation of the LLC with new members — unless there exists a prior agreement within the LLC concerning the buying, selling, and transferring of ownership.
LLCs can be a suitable option for businesses with medium to high risk levels, owners possessing substantial personal assets seeking protection, and those desiring a lower tax liability compared to corporations.
Corporation
C corp
A corporation, sometimes called a C corp, is a legal entity that's separate from its owners. Corporations can make a profit, be taxed, and can be held legally liable.
Corporations offer the strongest protection to its owners from personal liability, but the cost to form a corporation is higher than other structures. Corporations also require more extensive record-keeping, operational processes, and reporting.
Unlike sole proprietors, partnerships, and LLCs, corporations pay income tax on their profits. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns.
Corporations have a completely independent life separate from its shareholders. If a shareholder leaves the company or sells his or her shares, the C corp can continue doing business relatively undisturbed.
Corporations have an advantage when it comes to raising capital because they can raise funds through the sale of stock, which can also be a benefit in attracting employees.
Corporations can be a good choice for medium- or higher-risk businesses, those that need to raise money, and businesses that plan to "go public" or eventually be sold.
S corp
An S corporation, also known as an S corp, is a specialized type of corporation created to avoid the issue of double taxation that regular C corporations face.
S corps enable profits, as well as some losses, to be directly passed on to the owners' personal income without being subject to corporate tax rates. While not all states tax S corps in the same manner, most states acknowledge them similarly to the federal government and tax the shareholders accordingly. Certain states impose taxes on S corps for profits exceeding a specific threshold, while others do not recognize the S corp election and treat
the business as a C corp.
S corps must file with the IRS to obtain S corp status, which is a distinct process from registering with the state. Special restrictions apply to S corps, and it is advisable to review the eligibility requirements on the IRS website. Despite this, S corps must adhere to the stringent filing and operational procedures of a C corp.
Similar to C corps, S corps have a separate existence. In the event that a shareholder departs the company or sells their shares, the S corp can continue operating without significant disruption. For businesses that would typically be classified as a C corp but meet the criteria for filing as an S corp, opting for an S corp structure can be a favorable choice.
Benefit corporation
A benefit corporation is a type of for-profit corporation that is recognized by a majority of U.S. states. While benefit corporations differ from C corps in terms of purpose, accountability, and transparency, they are not treated differently for tax purposes.
Benefit corporations are motivated by both a mission and profit. Shareholders are responsible for ensuring that the company generates a public benefit in addition to financial gains. In some states, benefit corporations must submit annual benefit reports to showcase their contributions to the community.
Various third-party certification services exist for benefit corporations, but obtaining certification is not mandatory for legal recognition as a benefit corporation in states where this status is available.
Private corporation
Close corporations resemble B corps but have a less traditional corporate structure. They do away with many of the formalities that typically govern corporations and are better suited for small businesses. Regulations vary by state, but generally, shares cannot be publicly traded. Close corporations can be operated by a limited number of shareholders without requiring a board of directors.
Nonprofit corporation
Nonprofit organizations are established to engage in charitable, educational, religious, literary, or scientific activities. Due to their public benefit, nonprofits can qualify for tax-exempt status, which means they are not required to pay state or federal income taxes on any profits generated.
To obtain tax exemption, nonprofits must submit an application to the IRS, a process distinct from registering with their state.
Nonprofit corporations must adhere to organizational regulations similar to those of a standard C corporation. Additionally, they must comply with specific guidelines regarding the allocation of profits. For instance, they are prohibited from distributing profits to members or supporting political campaigns.
Nonprofits are commonly known as 501(c)(3) organizations, a designation derived from the section of the Internal Revenue Code frequently utilized to confer tax-exempt status.
Cooperative
A cooperative is a business or organization that is owned and operated for the benefit of its users. The profits and earnings made by the cooperative are shared among its members, who are also referred to as user-owners. The cooperative is managed by an elected board of directors and officers, with regular members having the voting power to influence its direction. Membership in the cooperative is obtained through the purchase of shares, and the number of shares owned does not impact the voting rights of the members.
Combine different business structures
Terms such as S corp and nonprofit are not just business structures but also represent tax classifications. An LLC has the flexibility to be taxed as a C corp, S corp, or a nonprofit organization. While less prevalent, these options may pose challenges during setup. If contemplating these non-traditional structures, seeking guidance from a business advisor or lawyer is advisable for informed decision-making.
Examine different types of business organization.
Examine the common characteristics of these business structures, keeping in mind that ownership regulations, liability, tax implications, and filing obligations can differ from state to state. The table below serves as a general reference only. It is advisable to consult with a business tax expert to validate your individual business requirements.
Business structure | Ownership | Liability | Taxes |
Sole proprietorship | One person | Unlimited personal liability | Self-employment tax Personal tax |
Partnerships | Two or more people | Unlimited personal liability unless structured as a limited partnership | Self-employment tax (except for limited partners) Personal tax |
Limited liability company (LLC) | One or more people | Owners are not personally liable | Self-employment tax Personal tax or corporate tax |
Corporation - C corp | One or more people | Owners are not personally liable | Corporate tax |
Corporation - S corp | One or more people, but no more than 100, and all must be U.S. citizens | Owners are not personally liable | Personal tax |
Corporation - benefit corporation | One or more people | Owners are not personally liable | Corporate tax |
Corporation - Nonprofit | One or more people | Owners are not personally liable | Tax-exempt, but corporate profits can't be distributed |