Choosing A Business Structure: A Helpful Guide For Entrepreneurs
If you’re thinking about starting a business, you know there are lots of things to consider before you can be fully operational. One of the most important is establishing your company as a legal entity. Each type of business structure has specific requirements you’ll need to be aware of as well as potential advantages and disadvantages. So how do you decide which is the best legal structure for your new business? Let’s find out.
In this article, we’ll explain what the legal structure of a business is, the various types, and how to choose the right structure for your new organization. After reading this, you’ll have the information you need to decide how to best establish your business as a legal entity.
What is the legal structure of a business?
The legal structure of a business is a government classification that regulates certain aspects of your organization and its day-to-day operations. For example, the type of business structure you choose can impact everything from the taxes you’ll pay and the ability to raise capital to potential liability if your company is sued, so it’s important to consider your options carefully. We’ll cover the various types next.
What types of business structures are there?
As your business idea comes to fruition, you’ll need to choose a legal structure before you register your company in your state. As you think about how to best structure your new entity, here are the 5 most common business structures to choose from. Keep in mind that you can start with one structure like a sole proprietorship then convert to a different one in the future as you grow.
If you’re a solo entrepreneur, this type of business structure may be the best option when you start your company.
- Pros: A sole proprietorship is simple to set up so you can get your business underway quickly. And the fees are minimal to register; in many states, you’ll just have to pay any necessary license costs to operate your specific business type. Once up and running, you won’t have to worry about requirements like shareholder meetings. You’ll also have total control over your business.
- Cons: With a sole proprietorship, your assets are not separate from your business’. So you won’t file separate income tax forms since the business doesn’t exist as a separate legal entity from its owner. The downside of this? Since the business is not a separate entity, you’ll be responsible for any debts, liabilities, or obligations of the business. The other potential disadvantage of a sole proprietorship is that it can only have one owner; if you plan to go into business with someone else, for example, you’ll have to choose a different type of business structure.
A general partnership is an easy way for two or more people to go into business together.
- Pros: Like a sole proprietorship, there’s not a lot of formal paperwork to worry about to set up your business; however, it’s a good idea to have a partnership agreement. Partners will generally share profits and losses, jointly run the business, invest money, and own property together.
- Cons: With a partnership, there’s no corporate shield so each partner is personally liable for the debts of the business. In addition, you may not be able to contribute to pre-tax plans like an FSA if you own more than 2% of the company. Another potential drawback is that partnerships are usually destroyed when one partner leaves. Lastly, disagreements between the partners can negatively impact the operations of the business.
An S corporation is a popular option for small businesses because you won’t be personally responsible for the business’ debts or liabilities and it’s what’s known as a pass-through entity, meaning, it’s not taxed separately.
- Pros: With an S corporation, your business will be a separate legal entity from the owners, giving you personal protection. You’ll also get the added advantage of favorable tax treatment so you’re not double-taxed like a C corporation since income, losses, deductions, and credits are passed through to the shareholders for federal tax purposes.
- Cons: You’ll need to file to become an S corporation, and setting up this type of legal structure can be complex and expensive – many corporations hire an attorney to oversee the registration process. An additional potential downside is that there are special limits on S corporations. For example, these entities can only have one class of stock. Also, most fringe benefits are taxable as compensation to employee-shareholders who own more than 2% of the corporation.
Like an S corporation, a C corporation provides business owners limited liability so your personal assets are protected from the claims of business creditors. However, where the two types of corporations differ is in their tax treatment; profits of C corporations are subject to double taxation.
- Pros: You’ll get the strongest protection from personal liability with this type of business structure making this a good choice for medium or higher-risk businesses. And, if a shareholder leaves or sells their shares, the C corporation can continue to do business.
- Cons: The costs for setting up a corporation can be higher and these businesses require more administrative time and effort for activities like reporting. And, as we said at the outset, profits of C corporations are subject to double taxation: once when the business makes a profit and also when dividends are paid to shareholders.
Limited Liability Company
With this type of business entity, you get the benefits of both corporation and partnership structures, making this a popular choice.
- Pros: You’ll realize the limited liability features that a corporation affords so that means your personal assets like your house or savings won’t be at risk in the event of a lawsuit or bankruptcy. And you’ll get the tax benefits of a partnership since you’ll pay a lower rate than you would if you formed a corporation.
- Cons: With this type of legal structure, you’ll be considered self-employed so will need to pay self-employment taxes. In some states, if a member joins or leaves, you may need to dissolve the LLC and form a new one with the new members. And like a partnership, anyone with 2% or more ownership can’t participate in an FSA, nor can LLC members take advantage of tax-saving HSAs the same way an LLC employee can.
How Do I Choose The Right Business Structure?
It can be challenging for new businesses to decide what structure to choose. To select the best option, you’ll want to consider your financial needs, risk tolerance, and future growth plans. As you evaluate your choices, you may want to think about:
- How much control you want and whether you want to make the major decisions or have a board involved
- Whether you’ll need to raise money since only some entities allow you to sell shares of stock
- The degree of personal liability you want to be exposed to
- If you want to be taxed as an individual or company
Once you select a structure, it’s important to note that this is just one of the many steps involved in starting a business. Read our first-time business owner’s guide for more steps to take to set your new business up for success.