Starting a small business comes with a laundry list of exciting things to think about and do, as well as some less thrilling tasks that are critical nonetheless. One of the items that belongs on the latter list is choosing a business structure. There are a limited number of options so, on the face of it, it might seem fairly easy to whittle down your choices and simply pick one. But there is a lot of nuance to each option, and choosing incorrectly can be painful down the road. You can often convert to a different structure, but some restrictions might apply based on what state you’re in. You could also face tax consequences and other complications, meaning it’s best to do your research upfront and consult with a lawyer if possible.
What exactly is a business structure and how can it impact you?
A business structure (or entity, as it’s sometimes called) is a regulatory classification required by the government of all businesses. This applies on both federal and state levels. There are several ways the type of structure you choose can impact important aspects of your company.
Taxes: Different entity types are required to use different tax rates and categorize income differently. For example, S corps are pass-through entities and categorize business income as personal income, while C corps categorize business income as company income. Tax rates for personal income versus business income vary significantly, meaning what you pay the government will be strongly impacted by your business entity.
Liability: Certain structures come with more personal liability than others. For example, owners are not personally liable if someone sues their business and it is categorized as an LLC. That means that people cannot go after the owner’s personal assets, including houses, cars, and bank accounts. Conversely, a sole proprietorship has unlimited personal liability.
Company management: Some business structures, like C corps and S corps, are required to have a board of directors. There may be additional requirements around these boards, depending on your location. Partnerships and LLCs usually create agreements that outline company roles, responsibilities, and hierarchy.
Future planning: Do you want to offer stock to your employees down the road? Do you foresee fundraising or will you bootstrap until the end? Do you dream of becoming a publicly traded company? Or maybe you want to stay small no matter what? All of these questions need to be answered before choosing a business structure, as every structure comes with its own benefits and limitations in each of these areas.
Types of business structures
There are five main types of business structures: sole proprietorship, partnership, limited liability company, cooperative, and corporation (which comes in several varieties). In some cases, it’s possible to combine structures, though it’s less common to do so. Below is a high level overview of each entity type:
Sole proprietorship
Sole proprietorships are arguably the easiest entity type to set up. It’s the structure often chosen by solopreneurs with little overhead and without a physical store – think photographers, freelancers, consultants, massage therapists, and coaches. In addition to ease and low cost of set up, sole proprietors also have full control of their businesses, including the ability to choose to close their business at any point with zero paperwork.
Partnership
A partnership can take the form of a limited partnership or a limited liability partnership; both require two or more individuals to own a given business. Limited partnerships or LPs have one partner with most of the control and unlimited liability, while all other partners have less control and limited liability. Limited liability partnerships or LLPs give limited liability to all partners. Partnerships are often formed by professional groups, like psychologists or attorneys starting their own company.
Limited liability company
LLCs are popular primarily for their combination benefits of protection of personal assets and pass-through tax benefits. Tax rates are usually lower than they are with corporations, but LLC members do have to pay self-employment taxes towards Medicare and Social Security. Another thing to consider is, depending on the state you’re in, if certain elements of your LLC change you may have to dissolve and reform as a new LLC.
Cooperative
Cooperatives are made up of members called user-owners; they often have voting rights and distribute profits among all members. Members become part of the cooperative by purchasing shares. These businesses are usually run by a board of directors and exist, in part, to benefit user-owners. Co-ops can be complex to form, so it’s best to loop in a lawyer to understand your options.
C corporation
The next five business structures, including C corporations, are different from the prior entities in that corporations are regarded as completely independent from owners and shareholders. A corporation can be taxed in its own right, be sued or file a lawsuit, buy and sell property, and more.
C corporations are owned by shareholders and allow for any number of investors. They pay income tax on profits, and potentially a second time when dividends are paid to shareholders. For businesses that need a lot of capital or hope to IPO one day, C corporations are often the best path.
S corporation
S corporation shareholders report income and losses of their corporation on their personal tax returns, which allows them to avoid being double taxed on corporate income. This business structure is meant for smaller companies; one of the criteria that must be met in order to file as an S corporation with the IRS is having no more than 100 shareholders.
Benefit corporation
Also known as B corporations, Benefit corporations are held accountable by shareholders in two regards: profit and purpose. They are oftentimes held to higher standards for transparency and public good compared to traditional C corporations. Many B corporations choose certain social causes they want to promote and align themselves and their products with those causes.
Close corporation
A Close corporation is a privately held company that has far greater flexibility in terms of operations and reporting requirements than other entity types. They are held by a small group of shareholders (usually capped at 35 by law), are not publicly traded, and have limited liability.
Nonprofit corporation
Nonprofits, also called 501(c)(3) corporations, are tax exempt due to operating exclusively for the following specific purposes, according to the IRS: religious, charitable, scientific, public safety, literary, or educational. Potential nonprofits must file with the IRS to get tax exemption status, and need to follow unique rules about distribution of any profits.
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