How to Choose the Right Business Structure

There are numerous ways to structure a business. The structure you choose will determine operational practices as well as how you will file and pay taxes. 

Read on to learn more about the features of each business structure and which options are best suited for different businesses.   

Sole Proprietorship

By default, if you don’t formally register your business as one of the other entities covered in this article, your business will be listed as a sole proprietorship (or partnership, if you have business partners). A sole proprietorship is a non-incorporated business structure that is solely owned by a single individual. This type of business is often preferred by small business owners who wish to have complete control over their operations and profits. 

In a sole proprietorship, the owner is responsible for all aspects of the business, including any liabilities and debts incurred. That means if you were ever sued or owed debts for your company, your personal assets could be seized to meet business expenses that company assets or cash reserves can’t cover.

Sole proprietors are not required to create a separate trade name, as many do business under their own name. The owner of a sole proprietorship reports all profits and losses on their personal income tax return, as the business is not a separate legal entity. This is known as “pass-through taxation,” a concept that will be detailed a bit further down.   

A sole proprietorship is best  if you want to avoid the paperwork and costs of setting up a formal business entity and have a low risk of ever being sued. For example, a freelance graphic designer or someone who sells crafts on Etsy might choose to operate as a sole proprietor.

Partnership

Similar to a sole proprietorship, a partnership doesn’t require the formal registration steps that an LLC or corporation requires. However, you will want to create a partnership agreement that provides identification details for every partner and outlines each individual’s responsibilities in the company.

There are two types of partnerships: general and limited. A general partnership is a business operated by partners involved in day-to-day operations and carrying significant liability for the company. A limited partnership limits the liability of partners who aren’t involved in the daily running of the business.

Filing taxes for a partnership is similar to that of a sole proprietorship in that the business owners report business income on their personal taxes based on their share of the company.

Like a sole proprietorship, a partnership is suitable for businesses with a low risk of being sued. Limited partnerships are commonly used for real estate businesses and when private equity partners invest capital.

S Corp

One of the most popular business structures for small businesses is the S corporation, commonly called an S corp. This business structure provides separation, and therefore protection, of the business owner from the business. The owner's assets are shielded if the company is sued or has debts.

This structure is also popular because of tax benefits. An S-corp is subject to pass-through taxation (like a sole proprietorship and partnership) that exempts the business from corporate taxes. In addition, S corps can benefit from a business income reduction of 20% of net "qualified business income" on their taxes.

To be designated an S-corp, a business must file Form 2553, signed by all shareholders, with the IRS. Like traditional C corporations (below), S corps must pay an annual fee to maintain their corporate status and submit an annual report. In addition, current IRS laws state that a corporation must meet the following requirements to qualify for S corp status: 

• Be a domestic corporation
• Have only allowable shareholders (may be individuals, certain trusts, and estates; may not be partnerships, corporations or non-resident alien shareholders)
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

An S corp might be a good fit if you plan to keep your business private, not issue preferred stock and have less than 100 shareholders.

C Corp

While less common for small businesses, the C corp is another business structure to be aware of. Like the S corp, the C corp is a separate legal entity; therefore, the owner's assets generally can’t be seized to pay business debts. However, many differences exist between S and C corp, including taxation and ownership rules.

C corps are allowed an unlimited number of shareholders with no restrictions on the type of shareholders, but they must also follow several recording and reporting formalities. In addition to filing an annual report like an S corp, C corps are required to have a board of directors voted on by shareholders, hold regular board meetings, and keep meeting minutes.

Tax liability may be the biggest drawback to small businesses seeking a C corp designation. Unlike an S corps, C corps are subject to double taxation. This means taxes are paid on business profits at the corporate level, and then shareholders pay taxes on any dividends they receive. In addition, shareholders (including business owners) can’t write off corporate losses to offset income. 

A C corp might be a good fit if you're considering an IPO or issuing preferred stock. 

LLC

An LLC, or Limited Liability Company, has some of the features of a corporation combined with the benefits of a sole proprietorship or partnership. Owners of an LLC are referred to as members, and like a corporation, an LLC must be legally registered. You’ll need to submit an annual report to maintain your LLC status.

Similar to a corporation, an LLC offers protection of personal assets and like a sole proprietorship/partnership, it allows pass-through taxation. If an LLC has only one member, it will be subject to the same taxation rules as a sole proprietorship. If an LLC has more than one member, it will be treated as a partnership for tax purposes. However, an LLC can choose to be taxed as a corporation if deemed appropriate for business operations. 

Regardless of tax decisions made by members, the legal status is not affected.  A registered LLC will continue to operate as an LLC under any tax structure.

If you like the idea of separating yourself and your assets from the business but want to avoid the restrictions that an S or C corporation brings, consider the LLC. And if you’re in certain fields like medicine or law that require licensure, you may be required to operate as a professional LLC.

What is Pass-Through Taxation?

Pass-through taxation has been mentioned throughout this article in relation to sole proprietorship, partnership, S corp, and LLC structures.  Under such structures, the business is not taxed separately from the owner. Instead, the tax obligations of a business entity are transferred to its owner. Under this arrangement, the proprietor of the business is solely responsible for reporting any income or losses incurred by the business on their individual tax return, without being subjected to a separate tax on the business. Therefore, the business's profits and losses are "passed through" to the owner's personal income tax return. This simplifies the tax process and saves the business from having to pay corporate taxes.

Protecting Personal Assets

When deciding how to structure and register your business it’s important to consider your personal assets. If your business couldn’t pay debts, how would you deal with having private funds, a vehicle, or even your house seized to cover those debts?

If this is a concern, the S corp or LLC may be a better choice than a sole proprietorship or partnership.

How to Choose the Best Business Structure

Let’s look at a few things to consider when choosing your business structure.

What’s Your Risk Level?

Your risk of being sued may impact the type of business structure you choose. For example, a freelance writer runs little risk of being sued by an unhappy client, while a general contractor has a much higher risk. In the latter case, incorporating or becoming an LLC can provide a layer of protection.

How Much Admin Work Can You Handle?

Corporations and LLCs require some legwork as well as investment. Not only will you initially file paperwork to establish this business structure, but you may also be required to file annual reports and minutes from your Board of Directors meetings. You will also have to pay yearly business tax as an LLC or corporation, whereas neither an annual report nor annual business entity taxes are required for sole proprietorships or partnerships.

How Much Is Your Business Making?

Another thing to consider is how much your business is making and, therefore, how much will be owed in taxes. 

There are tax savings with specific business structures, like the S corp, which isn’t required to pay corporate taxes. However, even if this is appealing, remember that your business may not qualify if it has more than 100 shareholders or foreign owners outside of the U.S.

For freelancers and smaller businesses, it makes more sense to operate as a sole proprietorship or perhaps an LLC.

What are Your Plans for the Future?

If you plan to bring on investors, set your business up for that from the beginning. LLCs and sole proprietorships can’t sell company stock, whereas an S or C corp can. Investors may not even look at your company if it isn’t incorporated.

And if you plan to take your company public, you’ll need to choose the C corp option.

How Many Business Owners Are There?

If you’re the sole owner of a company, it can be a sole proprietorship. If you have one or more partners, it should be a partnership. If you have 100 or fewer shareholders, you can operate as an S corp, and for more shareholders, consider a C corp.

Formalizing or Changing Your Business Structure

If you want to set your business up as a corporation or an LLC, you can file the paperwork yourself with minimal cost beyond the filing fee. However, most companies are more comfortable bringing in an expert to help with the process. For a few hundred dollars, lawyers, accountants, or document filing service companies can assist with the registration procedures and help you comply with annual requirements.

Wherever your business is in its lifecycle, now is an ideal time to consider its structure.