Choosing between the various types of business structures is probably the most important tax decision you will make when starting a business. Choosing between business structures, on the other hand, can be intimidating and perplexing. Not only will this decision have an impact on how much you pay in taxes, but it will affect the amount of paperwork your business will do, the personal liability you face, and your ability to raise money.
Understand your options before deciding on a legal structure type for your small business.
What is Business Structure?
The legal structure of an organization recognized in a given jurisdiction is referred to as its business structure. The legal structure of an organization is a key determinant of the activities that it can engage in, such as raising capital, responsibility for business obligations, and the amount of taxes that the organization owes to tax agencies.
Before making a choice on the type of legal structure, business owners should first consider their needs and goals and understand the features of each business structure.
Different 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 approaches taxation differently. Some businesses are taxed at the personal income level or are double-taxed at both the business and personal income levels. Continue reading to learn about the various types of business structures and which one is best for your small business.
#1. Sole proprietorships
A sole proprietorship is the most frequent type of business structure. A sole proprietorship is owned and run by a single person. If you want complete control over your business, a single proprietorship is a smart alternative.
Sole proprietorships do not create a distinct business entity. Your business’s assets and liabilities are not distinct. They report both business and personal income on their personal tax returns.
Sole proprietors are personally liable for the company’s liabilities, debts, and losses. If your business goes bankrupt, your personal assets may be at stake.
#2. Partnerships
A partnership is a business that is owned and operated by two or more people. Partnerships can be divided into two types: general partnerships and limited partnerships.
1. General Partnership
A general partnership is a business that is held by two or more people. The partners in a general partnership oversee the business and are personally liable for the partnership’s debts. The partners share all the profits and losses equally.
General partnerships enable partners to collaborate as co-owners. If you intend to form a general partnership, consider drafting a partnership agreement that specifies the particular shares for each partner.
Profits from general partnerships are exclusively taxation is at the individual level.
2. Limited liability partnerships
There are both general and limited partners in a limited partnership. To form a limited partnership, you must have at least one general and one limited partner.
Limited partners often have no business decision rights and just function as investors for the business. General partners own and operate the business while also taking on partnership responsibilities. You have authority and accountability as a general partner. Limited partners gain ownership without bearing responsibility or risk.
#3. Corporation
A company, sometimes known as a C Corp, is distinct from its owners. Corporations are treated as separate legal entities under the law.
Corporations offer the best protection against personal culpability. On the other hand, corporations are more complicated than other types of business structures. If you intend to grow your business and add shareholders, a corporation structure is an excellent choice.
Corporations necessitate meticulous recording and reporting. More restrictions and tax requirements are on you.
They tax the corporations twice. When you pay income taxes twice on the same source of earned money, it is double taxation. Corporations are taxed as a business entity, and each shareholder’s personal income is taxed.
#4. The S-corporation
An S corporation, often known as an S Corp, is a type of corporation in which profits and losses are transferred directly to the owner’s personal income and are not subject to corporate tax rates.
Shareholders must be citizens of the United States. There can’t be more than 100 stockholders in an S Corp.
The taxations are only on the business’s owners, or shareholders. You can avoid double taxes by registering as an S Corp with the IRS.
#5. Limited Liability Company
A limited liability company (LLC) allows you to use the business structures of a sole proprietorship, corporation, or partnership.
Limited liability companies (LLCs) are adaptable business structures. Your LLC divides your personal and business liabilities. Tax liabilities are borne by all owners.
An LLC, like a corporation, protects you from liability while avoiding double taxation. Because you can pass through taxes to the personal income level, your business avoids double corporation taxation.
Unlike other business structures, LLC owners are not personally accountable for the obligations of their business.
LLCs have a finite lifespan in many states. If someone joins or leaves your LLC, your state may force you to dissolve or reorganize it. Because each state regards LLCs differently, tax liabilities vary according to where you live. Check with your state to see if there are any unique LLC restrictions.
Considerations to make before choosing a business structure
It’s not always straightforward to pick which structure to use for new enterprises that could fall into two or more of these types of business structures. You must examine your startup’s financial requirements, risk, and growth potential. It can be difficult to change your legal structure after you’ve established your business, so consider it carefully in the early phases of developing your business.
Here are some crucial elements to consider when deciding on a legal structure for your business. You should also plan on consulting with your CPA for advice.
#1. Flexibility
Where do you want your firm to go, and what kind of legal structure will allow it to grow? Examine your business plan to determine which structure best corresponds with your aims. Your entity should foster the prospect of development and change rather than stifle it.
#2. Complexity
Nothing is simpler in terms of setup and operating complexity than a sole proprietorship. Simply register your name, begin a business, report your profits, and pay personal income taxes on it. However, obtaining outside finance can be problematic. Partnerships, on the other hand, necessitate a formal agreement outlining the duties and profit shares. Corporations and limited liability companies must comply with a variety of reporting requirements with state and federal governments.
#3. Liability
Because the law considers a company to be its own entity, it carries the least level of personal liability. This means that creditors and consumers can sue the corporation, but they cannot seize the officers’ or shareholders’ personal assets. An LLC provides the same level of protection, but with the tax advantages of a sole proprietorship. Partnerships divide liabilities among partners according to the terms of their partnership agreement.
#4. Taxes
An LLC owner pays taxes in the same way that a single proprietor does: all profits are considered personal income and are taxed accordingly at the end of the year.
“As a small business owner, you want to avoid double taxation in the beginning,” Jennifer Friedman, chief marketing expert at Expertly.com, explained. “The LLC structure prohibits this and ensures that you are taxed as an individual rather than a company.”
Individuals in a partnership can also claim a portion of the profits as personal income. To minimize the impact on your tax return, your accountant may recommend quarterly or biannual advance payments.
Every year, a corporation files its own tax returns, paying taxes on profits after expenses such as wages. If you pay yourself from the corporation, you will have to pay personal taxes on your personal return, such as Social Security and Medicare.
#5. Control
If you want complete or main control over your business and its operations, a sole proprietorship or an LLC may be the best option for you. One can also negotiate such power in a partnership agreement.
A corporation is designed with a board of directors that makes significant decisions that guide the organization. A corporation can be controlled by a single person, especially at its birth, but as it grows, so does the necessity to administer it as a board-directed body. The regulations established for larger organizations, such as maintaining notes on every key decision that affects the company, nonetheless apply to a small enterprise.
#6. Capital Investment
If you need outside finance, such as from an investor, venture capitalist, or bank, forming a corporation may be a preferable option. Corporations can receive outside investment more easily than sole proprietorships.
Corporations can sell stock and gain more cash for expansion, but sole proprietors can only obtain funds from personal accounts, using personal credit, or bringing on partners. An LLC may encounter comparable difficulties, but because it is its own business, it is not necessarily essential for the owner to use personal credit or assets.
#7. Regulations, licences, and permits
You may require particular licenses and permits to operate in addition to officially registering your business entity. Depending on the nature of the business and its operations, it may be necessary to obtain licenses at the local, state, and federal levels.
States have varying criteria for various business structures. There may be varying restrictions at the municipal level depending on where you start your shop. Understand the state and industry you’re in when you choose your structure. It is not a one-size-fits-all solution, and firms may be unaware of what is pertinent to them.
Business Structures FAQ’s
What are the 3 main types of businesses?
The three most prevalent types of business structures are sole proprietorship, limited liability company (LLC), and corporation.
What is business ownership structure?
Business ownership structure concerns the internal organization of a business entity and the rights and duties of the individuals holding a legal or equitable interest in that business.
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