The legal framework under which your business is organized is known as its structure. The structure has an impact on everything from how your business operates to how it’s taxed to how much of your personal assets are at risk. When you start a small business, one of the first things you’ll need to do is decide which structure to adopt.
It’s important to evaluate different types of businesses carefully to choose a structure that gives you the right balance between benefits and legal protections.
Key Points
• Selecting the right business structure is important for legal and tax purposes.
• There are four primary business structures for a small business: sole proprietorship, partnership, corporation, and LLC.
• Sole proprietorships and partnerships offer simplicity and pass-through taxation benefits.
• Corporations and LLCs provide significant liability protection for personal assets.
• Consult legal and tax professionals to help you choose the best structure for your business.
Common Business Structures
As a small business owner, there are four basic business structures that you will likely consider.
Sole Proprietorships
Among the most basic types of business entities is sole proprietorship. In fact, when you open a small business by yourself, you automatically become a sole proprietor. This is the simplest business type and it offers the fewest protections.
There’s no need to stay with this status, though, so you should consider both the pros and cons of a sole proprietorship.
On the plus side, income that’s brought in by your business is passed through to you as personal income. This means it’s only taxed once. (Many businesses must pay tax at the corporate level before paying employees.)
As you might guess, this structure doesn’t create a separate legal entity for the business. You and the business are treated as one and the same. This may sometimes be a drawback, as you are personally responsible for any liabilities, such as debts, taxes, or legal actions.
Partnerships
Partnerships are structures designed for businesses owned by two or more people. Like sole proprietorships, partnerships pass through their income to the partners; the money is taxed only at the personal level. Generally speaking, the partners are responsible for business liabilities, though this will depend on the kind of partnership you choose.
There are three different kinds of partnerships:
• General partnerships: In this structure, every owner is treated as participating in business operations. All partners get an equal share of the profits and have equal legal and financial liability. Personal assets may be used to cover business liabilities.
• Limited partnerships: This structure requires at least one general partner who controls the company and has full personal liability for all of its debts. Other partners are limited, meaning they have far less input into company management. Each one’s personal liability is equal to the amount of their investment in the business.
• Limited liability partnerships (LLP): This is a structure that some states allow for only certain types of businesses, such as law or accounting firms. There is no general partner; LLPs enable partners to jointly manage business operations. State statutes vary on the extent of each partner’s financial and legal liability.
A sole proprietorship terminates when the owner dies; all the assets and debts become part of the person’s estate. Partnerships can make their own arrangements for this scenario; typically the internal partnership agreement specifies what happens to the deceased partner’s share.
Corporations
A corporation is a business entity that is entirely separate from its shareholders. These shareholders are generally shielded from company debts and legal obligations. What’s more, if one owner or shareholder dies, the business continues to exist without them.
A for-profit business can incorporate as a C corp or as an S corp. C corps can have an unlimited number of shareholders, and their profits are taxed at the corporate level before being distributed as dividends to shareholders. That money is taxed again when shareholders file their personal tax returns.
An S corp is limited to 100 shareholders. Like sole proprietorships and partnerships, these are pass-through entities, meaning profits are taxed only once, as personal income.
Compared to partnerships and sole proprietorships, though, corporations tend to be relatively complicated to set up. Establishing one requires drafting articles of incorporation, defining shareholders, setting up a board of directors, and creating corporate bylaws, for instance.
No matter the structure, any type of corporation is eligible for small business loans.
Limited Liability Companies (LLCs)
The LLC is a popular structure that provides flexibility to business owners. They shield owners from personal responsibility for liabilities like business debts and legal obligations. This type of company can work well for owners of businesses of medium to high risk who have significant assets to protect.
There are several LLC tax benefits, including adaptability. Like partnerships, LLCs can be pass-through entities in which income is only taxed once. That said, if it’s advantageous, an LLC can elect to be taxed as a corporation.
Members of the LLC can manage the company themselves, or they can hire a manager.
An LLC’s lifespan may be limited, depending on regulations in its home state and the provisions of its operating agreement. Most states require an LLC to file annual reports in order to maintain active status.
Choosing the Right Type of Business Structure
When choosing the right business structure for your new company, it’s crucial to consider your current circumstances and your intentions for the business.
Liability, Taxes, and Growth Considerations
Partnerships may be advantageous for small, closely-held businesses among a group of trusted individuals. They are cheaper to launch than corporations and cost less to maintain.
Both partnerships and sole proprietorships have pass-through status. This means the company’s income is taxed only on the individual level, and business losses may be used to offset personal income on individual tax returns.
Corporations and LLCs offer more risk protection. For example, if the company has a small business line of credit that slides into delinquency, the lender may take legal action. If your type of company is an LLC or corporation, your personal assets are shielded from seizure.
If you expect your business to grow swiftly and you need funding, having a corporate structure may give you more options. Instead of borrowing, you may be able to raise capital by selling shares of the company, a strategy known as equity financing.
Startup business loans aren’t always easy to qualify for, but if you’ve registered as an LLC or corporation, lenders may be more inclined to see your company as viable and financially responsible.
Consult a business attorney and your tax professional to determine the business structure best suited to your needs and long-term goals.
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Changing Your Business Structure
Your business structure is not set in stone. As your business needs evolve, you may decide to change the structure you use. For example, if you’re considering a sole proprietorship vs. an LLC you might shift from one business type to the other under certain circumstances, such as:
• Your business is stable and growing.
• Your revenue is high enough to offset the cost of forming and maintaining an LLC.
• Your business activities could expose you to potential lawsuits.
As noted previously, you might decide to change from a partnership to a corporation to limit personal liability or increase opportunities for raising capital.
When and How to Transition
If any of these concerns become urgent, it may be time to change your business structure. Before you begin that process, you’ll want to evaluate your business goals, consider tax implications, and assess any potential changes in your personal liability.
To turn a sole proprietorship into a partnership, you’ll likely need to draw up a partnership agreement and file it with the state.
There are several ways to make your partnership into a corporation:
• Statutory conversion: You file a partner-approved conversion plan with the state and the new status follows automatically. This method is simplest and least expensive, but not all states allow it.
• Statutory merger: You form a new corporation and merge the partnership into it; partners become corporate shareholders. The process involves approving a merger agreement and filing a certificate of merger with the state. This method can be used in places that don’t allow statutory conversion.
• Nonstatutory conversion: You create a new corporation and do extra paperwork to officially transfer the partnership’s assets. This method is the most labor-intensive, and it can be time-consuming and expensive.
It’s wise to consult an attorney who can help you sort through the options available in your state.
The Takeaway
Choosing the right business structure depends on many factors, such as your specific type of business, your goals for the company, the number of owners, and their willingness to accept personal liability. Each structure has pros and cons related to taxation, liability, funding options, and administrative complexity. As your business grows and changes, you may switch structures to suit your unique needs.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How does liability protection differ among business structures?
Liability protection is a major consideration in the business structure you choose. A sole proprietorship offers no protection of your personal assets. Partnerships may provide various levels of limited protection, while LLCs and corporations typically guarantee the most protection.
Which business structure offers the most tax advantages?
The most advantageous structure for you probably depends on your type of company. Choosing a pass-through structure means that income flows through the business directly to owners, who pay personal income tax on it. Only C corp revenues get taxed twice: at the corporate level and then again when the income is passed on to owners. As for deductions and credits, those will depend on the structure and the specifics of your business.
Can I change my business structure after formation?
You can change your business structure as your needs and goals evolve. Of course, it will require some time and some paperwork.
What’s the simplest business structure to set up and maintain?
A sole proprietorship is the simplest type of business structure, as long as you’re the only owner of the enterprise. This structure requires no special setup or maintenance. In fact, opening an unincorporated solo business automatically gives you sole proprietor status, according to the IRS.
How do business structures affect raising capital and investment?
Choosing a corporate structure, which requires shareholders, may be advantageous if you hope to raise capital by selling shares of the business. Other structures may make this kind of fundraising difficult.
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