Every business needs to be organized around a business structure. The most popular business structures are sole proprietorships, partnerships, C corporations, S corporations and limited liability companies (LLC). The business structure affects operations, taxes, your business’ ability to raise capital, and the degree of personal liability protection it offers. It’s important to understand the features of the most common business structures so that you can make the right decision for you.
- Sole Proprietorships
Sole proprietorships is the default business structure if you don’t register your business. Sole proprietorships do not distinguish between you and your business. In other words, you don’t have any personal liability protection. So any losses or obligations suffered by your business, will be assumed by you. Because there’s no separation between you and your business, you will have to pay income tax for your personal income tax bracket. It is very difficult to raise money as a sole proprietor.
As a sole proprietor, you are allowed to use a business name to operate under.
- Partnerships
Partnerships are really simple business structures for a small group of people. There are two types of partnerships: limited partnerships (LP), limited liability partnerships (LLP).
LPs have a general partner who has unlimited liability, and other partners with limited liability. The limited liability partners typically also have limited control of the business. This is usually stated in the partnership agreement.
Partnerships are pass-through entities, so profits are passed through to the partners, who pay taxes on their personal tax forms. The general partner also has to pay self-employment taxes.
LLPs provide limited liability to all the partners. Each partner is protected against the business’ debts and obligations and from the actions of the other partners.
Some businesses can only be organized as partnerships, such as attorneys.
- C corps, or Corporations
Corporations provide the greatest degree of personal liability protection. This is because they have “personhood”. This means that they can earn profits, pay taxes, and are legally liable for their actions.
Corporations have a higher regulatory burden than other business structures, in terms of record-keeping, reporting and operations, and this means that they are more expensive to maintain.
Corporations pay taxes on their profits and, in fact, there is a double taxation issue because corporations are taxed on their profits and their shareholders are taxed on the dividends they receive from that business.
Corporations can go on for centuries. It doesn’t matter if a shareholder sells their shares, because the corporation will go on regardless.
Corporations raise capital by selling shares to investors and they can offer shares to prospective employees to try and attract them. Corporations are able to raise capital more freely than any other business type.
- S corporations
S corporations are special corporations that are designed to avoid the double taxation problem. S corps pass through some of their profits to their shareholders, while avoiding corporate tax returns.
States treat S corps differently, but generally, states treat S corps the way that the federal government does. Some states treat S corporations like C corporations, and so, you lose the advantages of an S corp.
An S corp has to get S corp status from the Internal Revenue Service (IRS), which is a different process from registering a business with the state. They have to meet the requirements of being an S corp, in order to qualify for the status.
S corps have the independence of C corps, and so, the business can go on regardless of what’s happening with the shareholders. So shareholders can trade the business’ shares without affecting the lifespan of the business.
- LLC
An LLC combines the features of a partnership with those of a corporation. An LLC provides limited liability to its owners, who are referred to as members.
Like partnerships, LLCs are pass-through entities, so that profits are passed through to the members, who pay taxes at their own individual income tax rates. The members are considered to be self-employed under the law, and have to make contributions to Medicare and Social Security.
In some states, LLCs have limited lives. So, unlike corporations, when members sell their shares, the business may be forced to dissolve and reorganize to reflect the new membership structure. The only way to avert this is to state clearly in the LLCs Operating Agreement, what happens when the ownership of the business changes.
You can learn more about LLCs here.
- Nonprofit Corporation
Nonprofits can also organize themselves as corporations. These nonprofit corporations exist to undertake some charitable mission. As nonprofits, they enjoy tax-exempt status, freeing them from paying taxes at the state or federal level.
The organizers have to apply for tax-exemption status as nonprofits with the IRS. They have to meet the requirements of section 501(c)(3) of the Internal Revenue Code.
Just like C corps, nonprofit corporations have the same organization principles. Indeed, the principles are quite similar. If they earn profits, they have to comply with certain regulations about what they can do with those profits. So, for instance, those profits cannot be distributed to the organizers.
Other Considerations
It’s important to consult with a lawyer or accountant before choosing your business structure. This is because of the tax and legal implications of choosing a business structure. You should also speak to the Secretary of State’s office to understand the regulations around your preferred business structure.
You also need a clear idea of your goals. For instance, very risky businesses that need to raise a lot of capital and provide a maximum of liability protection, should be organized as corporations. Entrepreneurs with medium-risk businesses who want to have the protections of corporations but avoid double taxation, need to organize themselves as LLCs. Each business structure exists to solve a specific set of organizational problems.
You should also think about the state that you want to register in. Some states have very low tax rates, or, even, none, for example, and others have very good environments for starting a business. Understanding this will help you find the best home for your business.