What to Consider When Choosing Your Business Structure
By: Melanie Shires, PCC
When you start your business as a new entrepreneur one of the most important decisions you will make is how you will structure your business. Careful consideration of which structure you choose is crucial because it will influence everything from your day-to-day operations, to taxes owed, to how much personal assets are at risk. Choosing the structure that gives you the right balance of legal protections and benefits is key.
Common Business Structure Options
Business structures are largely creations of state law, so there are minor variations on the details from state to state. Here are six common models:
An unincorporated business that is owned by one person who reports business profits on his or her individual tax return. A sole proprietorship is the easiest business structure to form and gives you complete control of your business.
Sole proprietorships can be a good choice for low-risk businesses and entrepreneurs who want to test their business idea before forming a more formal business.
An unincorporated business owned by multiple owners, either people or other businesses. Profits are divided among its owners and reported on their tax returns. Partnerships are the simplest structure for two or more people to own a business together.
There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
Limited partnerships (LP) have only one general partner with unlimited liability, and all other partners have limited liability. The partners with limited liability also tend to have limited control over the company, which is documented in a partnership agreement.
Limited Liability Partnerships (LLP) are like limited partnerships but give limited liability to every owner. An LLP protects each partner from debts against the partnership, they won't be responsible for the actions of other partners.
Partnerships can be a good choice for businesses with multiple owners, professional groups (e.g. attorneys), and groups who want to test their business idea before forming a more formal business.
Limited Liability Company
A limited liability company (LLC) is a hybrid business structure that lets you take advantage of the benefits of both the corporation and partnership business structures. An LLC protects its owners, called members, from personal liability like a corporation but allows the profits to be taxed on either a member level or the corporate level.
LLCs can be a good choice for medium or higher-risk businesses, owners with significant personal assets they want to be protected, and owners who want to pay a lower tax rate than they would with a corporation.
An S corporation, sometimes called an S corp, has one class of stock and no more than 100 shareholders, none of whom can be another for-profit business or a person who doesn’t meet IRS residency requirements. Profits are taxed on shareholders’ tax returns, and shareholders have limited liability.
S corps can be a good choice for a business that would otherwise be a C corp, but meet the criteria to file as an S corp.
A corporation, sometimes called a C corp, is a legal entity that's separate from its owners and can have multiple classes of stock and an unlimited number of shareholders. A corporation’s profit is taxed once on the business level and a second time on an individual basis when earnings are distributed to shareholders, who have limited liability for the business’s debts.
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.
Corporations can be a good choice for medium or higher-risk businesses, businesses that need to raise money, and businesses that plan to "go public" or eventually be sold.
Nonprofit corporations, often called 501(c)(3), are organized to do charity, education, religious, literary, or scientific work. Because their work benefits the public, nonprofits receive tax-exempt status and don't pay state or federal taxes income taxes on any profits it makes.
Nonprofits must file with the IRS to get tax exemption, a different process from registering with their state and need to follow organizational rules very similar to a regular C corp. They also need to follow special rules about what they do with any profits they earn.
What are your long-term goals for your business?
It is important to understand that the right structure doesn’t just depend on the stage of development your business is in currently; it also depends on where you would like to be in three to five years, or even longer.
If you’re looking for fast growth, which takes cash, C corporations allow for multiple classes of stock and don’t restrict the number or type of shareholders. They’re the best fit if you’re seeking investments from venture capitalists, or if you plan on becoming a publicly traded company, rather than a privately owned one.
Another consideration is what happens when you or another owner dies, goes bankrupt or withdraws. Corporations live on after these events, but generally the other types of business structure dissolve unless specified otherwise beforehand.
What is your tolerance for risk to your personal assets?
When you have a business, you are at greater risk for a lawsuit. As a sole proprietor, if your business is sued and loses, your personal assets (e.g. real estate, cars, bank accounts) can be targets for the parties seeking to collect damages. In some cases, the same applies if you default on a business loan and you signed a personal guarantee, or the lender placed a lien on your assets.
In a general partnership, creditors can go after any of the partners’ personal assets to recoup the whole debt. It’s different in a limited partnership, where only the general partners are personally liable for the debts of the business, while limited partners are liable for the business’s debts only up to the amount of their investment.
How do you want the IRS to tax your business profits?
Sole proprietorships, partnerships and S corporations are pass-through entities, as are some LLCs. In a pass-through entity, profits are passed directly to the owners of the business. Therefore, profits are reported on the owners’ individual returns.
C corporations are separate entities from its owners, so the profits are taxed at the corporate level. If a corporation pays out dividends, which come out of its after-tax income, shareholders also must pay taxes on their proceeds.
There are other factors to take into consideration like how formal you want your management structure to be and how much administrative complexity can you handle.
As a business coach, I always encourage clients to consult with an attorney and/or an accountant as they are considering their options.
While you can convert to a different business structure in the future, it’s best to decide early on which one you’ll need for the next few years. Switching business structures can get complicated, not to mention costly in terms of legal fees. It can also be a distraction from running our business.