It can be intimidating choosing a business structure as an entrepreneur and wondering which one is best for you. To try and make the decision easier, we've broken down the pros and cons of all types of business structures.
Whether you're choosing a business structure, considering a change, or planning on starting a new business, read on for our overview of all options available to you.
There's no one size fits all business structure. There's benefits to each type of business, but they also have their own limitations. Which one is right for you depends on what you want to accomplish.
Below are some questions to ask yourself when choosing a business structure to help you define what you should prioritize during your decision.
These are complicated questions to answer on your own. Many of these questions, you might not even have an answer to. This is where talking it over with someone with expertise and unbiased support can help. Our small business advisors offer free consultations which can provide you with all the background information you need to make the best decision for you.
Here are the five main business entities you can choose from.
Sole proprietorships (sole props) are one of the most common types of businesses. According to CENSUS data from 2015, sole props make up 73.1% of all businesses in the United States and the number is steadily increasing. Part of this is because of how easy it is to start one. If you're making money from a side gig or doing contract work, you might be a sole prop without knowing it.
Sole props are unincorporated businesses owned and run by one person. In the eyes of the IRS (Internal Revenue Services), they are the same entity.
There are two main benefits to becoming a sole proprietorship: the ease of starting up and the flexibility of taking or adding cash to the business. Since you and your business are considered the same entity, your money is your business's money and vice versa. Other business types aren't as forgiving and have strict rules about money flowing to and from the business and business owner. If you want to maintain that flexibility, a sole proprietorship may suit you.
The downside is that the business owner is personally responsible for any debts or legal action on the business. This is called personal liability. For example, a lender can pursue personal assets—like your house—as collateral if your business defaults on a loan.
If you're wanting to start a business now without choosing a business structure right away, you can start as a sole proprietor. Then, after being operational for a while, you can reevaluate and change your business structure. Changing to something like a Limited Liability Company (LLC) can offer you liability protection while offering you tax flexibility.
Further reading: How to Change a Sole Proprietorship to an LLC
General partnerships are much like sole proprietorships. Partnerships are also unincorporated and don't have liability protection. Personal assets are on the line in the case of bankruptcy or defaulting on a loan.
A general partnership is the easiest way for two or more people to go into business together. It can be started with something as simple as a handshake. There is no required paperwork or fees. If you've been doing a side business with a friend, you're likely already in a general partnership without knowing it.
That's not to say you shouldn't hash out the details beforehand. Writing and signing a partnership agreement can protect you and partners from any complications down the line. A partnership agreement should cover the basics like how the profits are distributed, how any losses are covered, and what happens if a general partner chooses to leave.
Partnerships have the same benefits and drawbacks as sole proprietorships. They're cheap and easy to start and there's a lot of flexibility moving money to and from the business. But you are personally responsible for the debts of the business. Lenders can go after your personal assets if your business defaults on a loan.
If you're wanting to start a business right away, a general partnership is the quickest way to get there. Rather than choosing a business structure now, you can start as a general partnership and make the switch to another business type with liability protection later on.
Further reading: Limited Partnerships: A Simple Guide
Limited liability companies (LLCs) are popular for small business owners who want to avoid personal liability. Becoming an LLC is possible for both solo entrepreneurs and individuals starting a business as a group. Solo entrepreneurs can become single member LLCs while multi member LLCs can have a larger ownership group.
LLCs are separate business entities, similar to corporations. This means the business and business owner are separated. Every revenue, expense, asset, and liability belongs to the business, not the business owners.
Because they are separate entities, owners don't have to worry about getting sued or having personal assets taken in the case of bankruptcy. But unlike corporations, LLCs are considered "œflow through entities." Any profits (or losses) "œflow through" to the owners who report that income on their personal tax return.
LLCs have flexibility in how they are taxed. You can choose to be taxed as a corporation. Single member LLCs can be taxed as sole proprietors and multi member LLCs can be taxed as partnerships. This flexibility makes the structure type desirable for its potential to minimize taxes paid.
It's worth noting that how LLCs are taxed and pay fees differs state to state. The first step to forming an LLC is to pick a state of organization. You can keep it simple and choose your home state, or choose somewhere else. For example, there are many benefits to choosing Delaware"¦ There are different costs and limitations based on the state you choose. It's best to check with your Secretary of State's office or consult with a tax professional before choosing a state.
Just like LLCs, C corporations grant shareholders limited liability—they aren't personally on the line for the business's debts and liabilities. But this isn't the only perk available to corporations.
When choosing a business structure, you should consider where you're getting funding from. Corporations can sell stock, add shareholders, and take on investors. This means you're not always depending on traditional funding like loans to get the capital you need.
There's an upfront cost and paperwork required to start a corporation. Services like Stripe Atlas can do the heavy lifting for you for a flat fee. They'll take care of the formation of a company, state filing fees, getting you an EIN, and more.
The drawbacks of corporations are the cost, regulation, and paperwork required to be operational. C corporations also face what's called double taxation: the corporation pays income tax and when company profits are distributed to shareholders, they also pay tax on these earnings.
When you incorporate, you become a C corporation. But there's a special tax designation called an "œS corporation" you should also consider when choosing a business structure.
An S corporation (or S corp) technically isn't a business type. Your business can't become an S corporation right from the start, it must first incorporate. But there are advantages to making the switch, so long as you meet the S corporation eligibility requirements.
Unlike the typical C corporation, S corps pass all business income, losses, deductions, and credits onto the shareholders. The shareholders then report this on their personal income tax. Because the S corp isn't keeping the profit—the shareholders are—they don't pay any federal income tax.
But with this big tax advantage comes strict limitations. Shareholders are maxed out at 100 and all of them must be US citizens or residents. You can also only issue one kind of stock. Shareholders are also required to pay themselves a reasonable salary, even if it means a loss for the S corp.
If you aren't planning to bring on a large amount of shareholders and you believe you can keep up with the IRS's strict reporting requirements, the S corp may be right for you.
Choosing a business structure now doesn't mean you're locked into that choice forever.
Your business is bound to change over time. Maybe that solo endeavour you started could use some partners or maybe you're starting to consider outside investors. That's natural, and you have the freedom to change your business structure to reflect any changes you face.
When making the switch, it's best to consult with a lawyer to make sure you've filled out the correct paperwork to make the transition. Talking with a CPA or tax professional can clarify any changes in reporting you need to make.
Choosing a business structure isn't a question you should lose sleep over. But the process of choosing can help you identify what you want most from your business and when a change might be needed.
A change in business structure means a change in bookkeeping requirements and new tax implications for your business. Your Bench bookkeeper will keep your financials up-to-date so you're making informed decisions and complying with any new requirements. Come tax season, they will work seamlessly with a tax professional so your taxes get filed with minimal input on your part. With Accracy at your side, you receive tax preparation, filing, and advisory services so you're supported no matter where your business takes you.
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