When opening a new company, there are many nuisances and administrative tasks that have to be completed; despite those tasks, one of the single most important decisions a business owner will make is determining which business structure is appropriate for the business. A business structure is a category of organization for the business that is legally recognized by the state jurisdiction and characterized by the legal definition of that particular category. Most common examples of business structures include sole proprietorship, partnership, limited liability company (LLC), and corporation.
The choice of structure significantly affects the way a business owner operates his or her business, these include:
- Amount paid in taxes
- Personal liability exposure
- Amount of control a business owner has over his or her business
- Growing the business.
Below, we will discuss the variations of business structures and important points for you to consider when selecting the particular business structure.
A sole proprietorship is an unincorporated business that is owned by one person. Sole proprietorship businesses do not need to be registered with the state secretary and start the moment a business owner decides to operate the company as a for-profit business. The sole owner of the business is responsible for reporting all profits on his or her individual tax return. This business structure is known as the “default setup”, that requires little or no paperwork. However, when businesses are operated by a sole proprietor, these individuals will be exposed to any personal liability and for all the debts of the business, which are major disadvantages all business owners should avoid.
A partnership is an entity owned by two or more individuals that begins the moment the partners decide to operate their business for profit. Normally, no paperwork or very little paperwork is required. By default, in a general partnership, all profit and debts of the business are shared equally amongst the partners, unless the partners have created a partnership agreement that divides the control of the business. Additionally, all business profits pass through to the owners’ personal tax returns. However, as discussed earlier and like a sole proprietorship, when operating a partnership, there is no legal separation between the business and personal liability, which can lead to partnership conflicts if no agreement or guidelines are put in place. Aside from the general partnership structure, other common partnership types include limited partnerships (LP), limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs).
Presently, business structures, such as limited liability companies (LLCs) and S Corporations have become increasingly prevalent amongst small business owners by virtue of their personal liability protection for their owners and pass-through taxation. Both LLCs and S corporations have become the primary business structure for small business owners and picking between the two will come down to the nature of the business and how the owner envisions the potential growth in the future.
Limited Liability Company
A limited liability company (LLC) is a hybrid form of a partnership and corporation. Limited liability companies have become the most popular business structure it provides business owners with the best of both worlds from partnerships and corporations. An LLC provides its owners (also known as members) protection from personal liability for the debts of the business (as long as it cannot be proven that the member acted in an illegal), unethical or irresponsible manner when operating the business (discussed further in a later article). LLCs are cheaper to register with the secretary of state, require less record-keeping and the responsibilities of the business can be easily be divided among the members. Additionally, forming an LLC gives owners the benefits of being taxed as an S-Corp in order to avoid self-employment tax on the entire income of the LLC. A disadvantage of forming an LLC can be the difficulty of raising venture capital or investor money.
A corporation is a separate legal entity form for the purpose of conducting business which is owned by shareholders. Like an individual, the corporation can be taxed and held liable for its actions, which provides its shareholders personal liability protection. By default, when a corporation is incorporated, it is taxed as a C-Corp, meaning the corporation is taxed twice; first, once the company makes profits, and second, once the shareholders are paid dividends. C-Corps are essential for startups that plan to go public in the future or for businesses that will eventually raise money from outside investors. A corporation is required to follow more formalities than sole proprietorship or partnerships. Among the requirements to form a corporation include:
- Filing articles of incorporation
- Creating bylaws and organizational resolutions that specify the operating rules for the business
- Appointing a board of directors and officers
- Issuing stock certificated to shareholders
- Appointing a registered agent to receive formal documents on behalf of the business.
On the other hand, a corporation can choose to be taxed as an S-Corp. As an S-Corp, there is no double taxation, the business itself is not taxed, but the shareholder(s) will be taxed provided that they paid themselves a reasonable salary. S-Corp taxation is available to corporations that have fewer than 100 shareholders, none of whom can be another for-profit business or a person without a green card who does not meet the IRS residency requirements.
In all, it is vital for business owners to consider the setup procedure costs, formalities, personal liabilities, potential and ease of raising capital, and tax advantages, for picking the appropriate business structure. Nevertheless, it is also necessary to consult with an experienced attorney who can guide you start a business in the right direction when selecting a business structure.