A critical decision for all new business owners is selecting the legal business structure that is best for them. Choosing the correct structure ensures better protection of their personal assets, a stronger chance of obtaining business loans, and the best possible tax situation.
Main types of business structures include sole proprietorship, partnership, corporation (C corporation or S corporation), or limited liability company (LLC).
Choosing the Right Business Structure
Understanding the legal and tax implications of each structure is critical to making an informed choice. One of the biggest decisions business owners must make is determining whether to choose a structure that involves incorporating their business.
When selecting how to structure their business, owners need to consider:
- Types of liability. What kind of damage might your business be responsible for if things go wrong? A baker, for example, may be held liable for spoiled food that makes people ill.
- Management and operation needs. Who owns the business? Who else can make decisions? Think of how many people are involved and how much control they have over the business.
- Raising capital. Where is the funding coming from to start the business?
- Taxes. Personal or corporate—which is best? Taxes are often the most complicated matter to navigate for new business owners.
Sole Proprietorship
In a sole proprietorship, the individual who founded the business remains the sole owner. They retain complete control over every aspect of the business. This is the easiest business structure for new or small business owners, as it is cost-effective and there are no other stakeholders to consider when making decisions.
However, a sole proprietorship offers no legal separation between business and personal assets or responsibilities. The owner assumes all risk when it comes to taxes and other legal liabilities, as sole proprietorships are not incorporated. In a worst-case scenario, a business owner could find their house or car up for seizure for debts or because of legal action against the business.
Partnership
Like a sole proprietorship, a partnership is also an unincorporated business. In this situation, there are two or more owners. Each partner contributes money, labor, skills, or property to the business according to their strengths.
Business owners may select a partner to combine resources and skills, trading off full control over decisions they would have as a sole proprietor. Personal assets of the partners are not protected and may be used as collateral in court.
Limited Liability Company
Both sole proprietorships and partnerships can file additional documentation to become a Limited Liability Company (LLC) or a Limited Liability Partnership (LLP), which offers some level of legal protection. An LLC combines the pass-through taxation of a sole proprietorship or a partnership with the limited legal liability of a corporation. In both cases, the business owner would pay self-employment taxes instead of corporate taxes.
The biggest appeal of establishing an LLC is the balance between the control and simplicity of sole proprietorships or partnerships and the legal protection of a separate business entity. Personal assets such as cars, homes, and personal savings accounts cannot become part of a business bankruptcy or a lawsuit.
The exact rules and regulations that govern LLCs vary by state.
C Corporation
When people hear “corporation,” they are thinking about C corporations. This legal business structure offers the most protection to business owners, but it is also the most expensive and intensive structure to establish and maintain.
Taxes and paperwork are far more complicated than they are in the previously discussed options. A corporation reports all profits for tax purposes, often paying twice: once on profits and once when shareholders receive dividend payments.
As far as raising capital, corporations are at an advantage. Banks are far more likely to approve substantial loans and the business can sell shares.
S Corporation
Though similar to a C corporation, S corporations have a significant difference: Profits and losses can pass through personal bank accounts and be reported on individual income taxes. This avoids the double taxation inherent in the C corporation structure.
This is understandably appealing, so why don’t more business owners select the S corporation structure over the C corporation structure? The IRS has stringent guidelines that businesses must meet to be granted S corporation status.
To qualify, the business:
- Must be owned strictly by U.S. citizens.
- Cannot have partnerships, corporations, or non-resident aliens as shareholders.
- May have no more than 100 shareholders.
- May have only one class of stock.
B Corporation
B corporations effectively function the same as C corporations. The difference is that they also aim to provide value and benefits to the public, not just to shareholders. However, a B corporation is not an option in every state, and the exact requirements vary where this type of business structure is an option.
Nonprofit Corporation
Businesses that focus on the public good—such as education, charity, and scientific organizations—are granted a tax-exempt status by the IRS. Nonprofits must maintain detailed records and file additional paperwork to maintain their classification.
What Business Structure Is Best for You?
Lynnise E. Pantin, Pritzker Pucker Family Clinical Professor of Transactional Law and founding director of the Columbia Law School Entrepreneurship and Community Development Clinic, notes that there is no right or wrong choice when it comes to business structure.
“It’s really about looking at the factors,” she says. “What are you thinking about liability, what are you thinking about how the business structure affects the management and operations of the business, how do you interpret how you expect to raise capital, and what are the tax consequences of the choices you make?”
If you are struggling to answer these questions, know that you are not alone. Many new business owners go through the same difficulty.
We invite you to learn how to select the best business structure with the guidance of an expert. Join Professor Pantin and other business owners in the non-credit certificate course: A Legal Toolkit for Starting and Scaling Your Business.