How to Choose a Business Structure: Advice From Experts
Before starting your company, you’ll need to choose and set it up with the right business structure. The type of entity you register your business as will affect your business’ taxes, liabilities, and investment opportunities. To that end, it’s critical that you select the business structure that best suits your company’s current needs and future vision.
Let’s review how to choose a business structure.
Types of Business Structures
Although there are many types of legal entities, there are five primary ones that the majority of for-profit businesses choose. These include:
- Sole proprietorship
- Limited liability company (LLC)
- C Corp
- S Corp
The simplest to understand of all business structures, a sole proprietorship typically involves a single individual who is responsible for both owning and operating the business. If you intend to start a smaller scale business on your own—such as turning a hobby into a bonafide business—this may be the right option for you.
Registering as a sole proprietor means that you don’t form a separate business entity. As a result, your business assets and liabilities are indistinguishable from your personal assets and liabilities. This means that you may be held personally liable for the obligations or debts related to the business. This is why this structure is common for smaller-scale, low-risk businesses.
So, if you have a business idea and want to test it out before diving head first, a sole proprietorship is an easy way to get started. They are easy and cost-effective to set up, and ensure that you, the owner, have control over business decisions and revenue.
A partnership is the simplest structure for a business that has at least two owners that share both the benefits and burdens of the business. A key benefit is single taxation, meaning that your percentage of the businesses’ profit is considered your annual income. Partnerships aren’t subject to federal income tax. They act similar to a sole proprietor as a pass-through entity. Instead of the business being taxed, each partner is taxed on his or her share of income from the venture.
A partnership can be broken down into two separate entities:
- Limited partnerships – Have a single general partner with unlimited liability (more on that later) where all the other partners have limited liability. Typically, the partner who takes on the greater share of liability is the person controlling the business. The company’s profits are passed through to personal tax returns.
- Limited liability partnerships – All owners have limited liability. This protects every member from debts against the partnership. Further, members can’t be held responsible for the misguided actions of another partner.
Like a sole proprietorship, a partnership is a good way to test the business waters and see whether or not the company is viable. Partnerships are easy to establish and offer improved borrowing capacity. And, if you want to change your legal structure down the road, it’s relatively straightforward to make the switch.
Note: Because partners are not completely immune from liability, most businesses will purchase liability insurance to protect their personal assets.
A limited liability company (LLC) provides the greatest benefits and protections for the business owner, which is why many small businesses begin as an LLC. Although LLCs have been around in some shape or another since the ‘70s, it's only recently that they’ve become the go-to business structure.
An LLC amalgamates many of the best features of a partnership. Per Entrepreneur:
“An LLC is a much better entity for tax purposes than any other entity. LLCs were created to provide business owners with the liability protection that corporations enjoy without the double taxation. Earnings and losses pass through to the owners and are included on their personal tax returns.”
LLCs are easy for taxes since profits and losses are reported and taxed on the owner's individual returns. Business owners’ personal assets are also free from the debts or liabilities of the ownership structure.
That said, LLCs also have their downsides. For instance, tax treatment varies by state. So, if you want to operate your business in multiple states, you need to first perform your due diligence and see how each state will treat an LLC that was formed in another state.
A corporation, referred to as a C corp, is considered a separate legal entity from the business owners. As a result, corporations can make profits, be taxed, and held legally liable.
A corporation legal entity offers the greatest personal liability protection, completely disassociating the owners from the business. Because of this, they also require much more stringent record keeping, reporting, and operational regulations for this ownership structure. One major drawback is that a corporation may incur double taxation, since the corporate profits are taxed, and then dividends on personal returns are also taxed.
Corporations are ideal for medium- to high-risk businesses that may need to raise money or have plans to go public or be acquired.
An S corporation acts similarly to a C Corporation, except that it’s designed to help avoid the double taxation drawback. S corps make it so that profits and some losses can be passed through directly to the business owner’s personal income.
Each state has different criteria for registering and then operating as an S Corp business form. In addition to registering with the state, you also file with the IRS to obtain S Corp status.
Factors to Consider with Business Structures
When making the decision about the type of business to form, there are four main factors you must carefully consider. While some of these elements were briefly touched upon, we’ll go into depth here:
Liabilities are any financial obligation that the business entity owes. Different types of business structures carry different levels of legal liability for owners. LLCs view the owner as a separate entity from the business—completely divorcing them from liability; whereas sole proprietors are intrinsically tied to the business owner and thus are held fully liable.
There are three types of liability:
- No liability – The owner and the business are completely separate from each other, such as in a corporation. Creditors and customers can sue the business, but can’t access the personal assets of shareholders.
- Limited liability – The business owner’s liability for debts is limited to the amount of money they have invested in the business. Corporate loss cannot exceed the amount invested. So, an owners’ personal assets are not at risk should the company fail.
- Unlimited liability – Business owners and partners assume all the business debts with this business form. Such liability is not capped, which means that the owner’s personal assets can be seized to repay debts. The majority of partnerships and sole proprietorships fall under this category.
Types of Liability Risk
There are four primary types of liability risk a business owner must consider when choosing the proper business structure:
- Financial risk – If the company defaults on loans or debts from lenders and creditors.
- Business risk – If the business is unable to generate enough cash flow in order to cover its operating expenses, and thus must shut down.
- Systemic risk – This is the uncertainty all business owners face, especially in regards to a downturned economy, a recession, or a significant market shock.
Some people will base their business structure around minimizing their taxes. Corporations have more tax options but can also be subject to double taxation because of profits and dividends.
Typically, sole proprietorships, partnerships, and LLCs have fewer tax options. The reason for this is that all profits are considered personal income. That said, these structures help you avoid the double taxation problem, especially in the early stages.
Corporations file their own taxes at the year’s end. Taxes are paid on profits after expenses. With a corporation, there are ways to reduce your personal tax liability. For instance, S Corps can reduce personal tax liability by citing business losses.
Note: Visit the IRS website for further details on each entity’s tax obligations.
Do you want to be the only person in charge, have a few people making the decisions, or be answerable to a board of directors?
Naturally, the more people involved in the process, the less control you’ll have. More formal business structures tend to spread control out among various figures within the organization; whereas sole proprietors and partners have complete control over how the business operates.
A single person can control a corporation, but as the business grows, it’ll need to operate in conjunction with the board of directors. The board of directors tends to make major decisions for a company, and they’re accountable to shareholders.
If you’re seeking outside funding, corporations have an easier time finding investment than LLCs, sole proprietorships, and partnerships. As Business News Daily notes: “Corporations can sell shares of stock and secure additional funding for growth, while sole proprietors can only obtain funds through their personal accounts, using their personal credit or taking on partners.”
Ramp: Control Your Finances Regardless of Business Structure
After you’ve selected the right structure for your business, it’s time to get to work. And regardless of what business structure you choose, there will be tools and software you’ll need to succeed.
This is where Ramp comes in. We’re more than just a corporate card with 1.5% cash back on every purchase. We also offer automated accounting capabilities, expense reporting, and other powerful features that help you gain visibility over your cash flow, control your spend, and strengthen your finances.
See what Ramp can do for you.