One of the most important decisions you can make when starting your business is determining its legal structure. This decision will determine how you pay taxes, the amount of liability you face, operations, and your ability to raise money.
Starting a business is a big step, and it’s important to get a solid foundation as you start. Choosing the right structure for your business is something that’s often overlooked as focus is on things like sales, marketing and operations; but your business entity setup can have a major impact on how the company operates.
There are numerous types of business entities, some that require formal registration and some that don’t; some for only one owner and some for multiple owners. Without taking any actions, a business may default into a certain business structure
The four most common types of business entities are: a Sole Proprietorship; a General Partnership (which for the purposes of this article will just be referred to as a “Partnership”); a Limited Liability Company (an LLC) and a Corporation (commonly called a C-Corp). All of them have their pros and cons, and one may be more beneficial to your specific business setup than another. During the startup process make sure you are considering your options, your tax situation, and ownership situation so you can make an informed decision about getting a business structure put in place.
Here’s a more in depth breakdown of the common business set ups, some pros and cons and considerations around each.
Sole Proprietorship
A sole proprietorship is a business that legally has no separate existence from its owner, and as the name suggests, there can be only one owner. It’s the simplest form of business entity to get started; it’s not an actual separate legal entity and there are no filing requirements or formalities involved. You wake up one day and decide you’re in business and that’s it, you’re a sole proprietor.
This is an extremely common business setup for small businesses (somewhere around 20 million businesses are sole proprietorships), and lends itself to be used for a wide variety of businesses, provided there is only one owner.
Pros:
- Easy to get started
- No filing requirements or formalities
- Simple taxation - you report all of your business income or loss on your personal taxes
- Management flexibility - the sole owner is in control, so you basically get to do what you want
Cons:
- The owner remains personally liable for debts, liabilities, obligations and lawsuits/judgments on, or against, the business
- No formal setup and separate legal entity makes it harder to get business financing and raise capital
- Limited business lifespan; if something happens to the owner (death, disability, incapacitation) that usually means the end of the business
- Sole proprietorships are often viewed as less professional than formal setups like the LLC or corporation
The bottom line with sole proprietorships is that while they are easy to form and manage, they leave the owner exposed to personal liability; it’s almost certainly not worth taking on that risk, making this a less than ideal business structure to use for your company.
Partnerships
Similar to a sole proprietorship, a partnership is a business that legally has no separate existence from its owners, the main difference here is that there is more than one owner. This is the simplest form of business structure to set up where there is more than one owner in the company. If you and one or more other people decide you’re in business, that’s it, you’ve got a company. There are no filing requirements and no formalities involved.
Pros:
- Easy to start, no state registration required
- No corporate paperwork or formalities
- You can minimize some of you risk since there is a partner to split responsibilities and losses with
Cons:
- Each owner is personally liable for the businesses debts, obligation and liabilities
- Disputes between partners can tear the company apart (you can set up a partnership agreement to try and minimize this)
- More difficult to get a loan or financing and build business credit without a registered business entity
Limited Liability Company (LLC)
A LLC may be the most flexible business structure available, and is a very common entity used by small businesses. It takes a lot of the positive features from the other structures and discards a lot of the negatives. It’s a formal legal business entity that requires some filing with the state to get up and running, but the filing requirements and paperwork are less formal that what’s needed for a corporation. Setting up the formal entity allows the owners to take advantage of limited personal liability, so unlike a sole proprietorship or partnership you aren’t necessarily personally on the hook for the obligations of the business. It gives you the benefit of looking like a more legitimate business as opposed to a sole proprietorship or partnership, without having some of the formalities that go with setting up and maintaining a corporation. LLC’s can have just one owner, or multiple owners, and be used with basically any type of business.
Pros:
- Owners don’t have personal liability for the businesses debts, obligations and liabilities
- Tax flexibility - you can select various options on how to handle taxes, giving the owners the ability to select the option that best suits their needs
- Not as many corporate formalities as a corporation; easy to get formed and started
- Credibility - partners, creditors, suppliers and vendors may look more favorably on a business that’s set up as an LLC as opposed to a sole proprietorship or partnership, opening up some opportunities
Cons:
- More expensive than starting a sole proprietorship or partnership
- Limited capital opportunities; it may be more difficult to raise investment capital as an LLC, as opposed to a corporation
- Taxes - a pro and con here, make sure you understand how your LLC is getting taxed and are aware of how the self-employment tax may apply to the owners
Corporation
Corporations, similar to LLC’s, are separate legal entities formed by paperwork and registering with the state. This means they also provide the owners, called shareholders, with limited personal liability as well. There aren’t really different types of corporations, but a Subchapter S Corporation (discussed below) is a common term in the business world that causes some confusion around “types” of corporations. Corporations require more corporate formalities and maintenance in order to remain in good standing and protect the owners. The requirements vary by state, but in general it’s the most formal business structure to set up.
Pros:
- Owners don’t have personal liability for the corporation's debts, obligations and liabilities
- May be eligible for more tax deductions than other types of business structures
- The owners may have options to pay lower self-employment taxes
- The organizational structure is set up from top to bottom (shareholders, board of directors, officers) which allows each group to have defined roles and responsibilities, spreading out some to the work
Cons:
- The process is more time consuming, expense and involves more paperwork
- Potential for double taxation - the company pays taxes on its earnings and then the shareholders pay taxes on any dividends they receive
- Regulations may not provide for as much flexibility in operations and management as other types of entities
Subchapter S Corporations
A Subchapter S Corporation, commonly known as an S-Corp, creates some confusion when it comes to business structures. An S-Corp is not what you would consider a traditional business entity, such as a sole proprietorship, partnership, LLC or corporation. It’s not a business structure that you “form.” It’s a creation of the internal revenue service (IRS), and is a tax classification for businesses. For example, provided they meet certain requirements, LLC’s and corporations can elect with the IRS to be treated as an S-Corp for tax purposes.
Have questions about business entities or want to discuss any legal or risk management questions? Contact us to schedule a free consultation.