All businesses, large and small, fall into one of five basic structures that define how it is organized, how it operates and how it handles things such as taxes and liability. Each structure contains its own benefits and drawbacks, and what works for one company may prove disastrous to another. Learning the differences between business structures can help an entrepreneur plan his company.
Small businesses can choose to organize as a sole proprietorship, partnership, corporation, S corporation or limited liability company.
A sole proprietorship is an unincorporated company owned (and often operated) by a single individual. It can include small retail stores, mechanic services and even inventors or musicians seeking to sell their products online. It is fairly easy to establish a sole proprietorship, and the process of running them is fairly simple. However, a sole proprietorship cannot sell interests in its business to raise money, and the owner is liable for all of the debts and legal suits of the business.
A partnership is similar to sole proprietorship, except more than one person is involved. Two or more people come together to work at a given business and share in the profits (or losses) or that business. Like sole proprietorship, a partnership is relatively easy to set up and doesn’t have to pay the sort of taxes that larger corporations do. However, the partners themselves are responsible for business losses and liabilities, and partnerships founded on informal agreements may run into interpersonal problems when the company struggles.
A corporation is company controlled by a group of people who own shares in the company’s ownership. The shareholders dictate who runs the company and how it conducts business, then receive profits based on the shares of stock that they own.
Corporations can raise funds more easily and readily than partnerships and sole proprietorships and often have access to more starting capital to boot. They exist separately from the people working for them, which means that the owners need not worry about personal liability, and that the company continues even after the founders have retired.
On the other hand, corporations require input from many people, often making them slow to act, and must adhere to certain organizational standards such as annual shareholders meetings. They also tend to pay more taxes and similar fees.
S Corporations are slightly different versions of standard corporations. Unlike other corporations, they pass all profits, losses and tax deductions to their shareholders, rather than absorbing them as their own entity. The shareholders declare all earnings on their personal tax returns rather than reflecting them through the company.
In order to do this, they must be based in the United States, they must have 100 shareholders or fewer, and those shareholders must be American individuals, trusts and estates rather than other companies (or foreign shareholders).
Limited Liability Companies first arose in 1977, making them a comparatively recent phenomenon. LLCs combine the elements of a corporation with those of a partnership or solely owned business. Like corporations, the owners are not personally responsible for debts and other liabilities. Like partnerships and sole proprietorships, they are comparatively simple and allow for quick operation. Because they are comparatively new, fewer legal precedents control their actions, which may create unanticipated problems in their operation.
As a small business owner, one of the first decisions you make is deciding between the different types of business structures. But, choosing between business structures can be intimidating and confusing.
Before you decide what business structure type to use for your small business, understand your options.
Types of business structures
The type of business structure you choose determines many components of your business, including day-to-day operations, how much you pay in taxes, and the paperwork you must file. You should choose a business structure that gives you the right balance of benefits and protection.
Each type of small business structure treats tax liability differently. Some businesses are taxed at the personal income level or are double-taxed at both the business and personal income levels. Read on to learn the various types of business structures to see which is the best fit for your small business.
Sole proprietorship
The most common business structure type is a sole proprietorship. A sole proprietorship is owned and operated by one person, a sole proprietor. A sole proprietorship is a good option if you are looking to have complete control of your business.
Sole proprietorships do not produce a separate business entity. Your business assets and liabilities are not separate. Sole proprietors include both their business expenses and personal income on their personal tax return.
Sole proprietors are liable for the business’s liabilities, debt, and losses. If your business goes into debt, your personal assets may be at risk.
Partnerships
A partnership is a business that two or more individuals own and operate together. Partnerships can be considered either general partnerships or limited partnerships.
General partnership
A general partnership is owned by two or more people. In general partnerships, the partners manage the business and assume responsibility for the partnership’s debts. Partners have equal shares of all profits and losses.
General partnerships allow partners to work as co-owners. Consider creating a partnership agreement to lay out the specific shares for each partner if you plan on starting a general partnership.
Profits in general partnerships are only taxed at the personal income level.
Limited partnership
A limited partnership has both general and limited partners. You need at least one general and one limited partner to start a limited partnership.
Limited partners only serve as investors for the business and typically have no business decision rights. General partners own and operate the business while assuming liabilities for the partnership. As a general partner, you have control and responsibility. Limited partners get ownership without taking on the responsibility and risks.
Corporation
A corporation, or C Corp, is separate from its owners. Laws treat corporations as independent legal entities.
Corporations provide you with the strongest protection from personal liability. However, corporations are more complicated than other business structures. A corporation structure is a good option if you plan to expand your business and add shareholders.
Corporations require extensive recordkeeping and reporting. You are required to comply with more regulations and tax requirements.
Corporations are double-taxed. Double taxation occurs when you pay income taxes twice on the same source of earned income. In the case of corporations, the company is taxed as a business entity and each shareholder’s personal income is taxed.
S corporation
An S corporation, or S Corp, is a type of corporation where profits and losses are passed through directly to the owner’s personal income without being subject to corporate tax rates.
Shareholders must be U.S. citizens. An S Corp can’t have more than 100 shareholders.
Only the owners, or shareholders, of the business are taxed. You can avoid double taxation by electing to operate as an S Corp through the IRS.
Limited liability company
A limited liability company (LLC) lets you take advantage of the sole proprietorship, corporation, and partnership business structures.
LLCs are flexible business structures. Your LLC separates business and personal liabilities. All owners have shared tax responsibilities.
An LLC provides you with liability protection, like corporations, without double taxation. Your business avoids double corporate taxation since you can pass through taxes to the personal income level.
Unlike other business structures, owners in LLCs are not liable for their business’s debts.
In many states, LLCs have a limited life. Your state may require you to dissolve or reform your LLC if someone joins or leaves. Each state treats LLCs differently, so tax liabilities vary depending on location. Check with your state for specific LLC regulations.
Choosing your business structure type
When selecting a business structure, be sure to choose the one that provides the most benefits and is the best structure for small business.
Consider these factors when choosing your business structure type:
- Legal liability
- Taxes
- Cost
- Flexibility
- Your business’s future needs
After you decide on your business structure, check out your state’s website to set up and register your small business. Consider contacting a small business lawyer or professional to help you get started.
Once you set up your business structure, you need a reliable way to manage your books. Patriot’s accounting software allows you to easily track incoming and outgoing money. Try it for free today!
This article was updated from its original publication date of 4/23/2013.
This is not intended as legal advice; for more information, please click here.