The selection of your business structure impacts various aspects, including your daily operations, tax considerations, and the extent to which your personal assets may be exposed to risk. It is essential to opt for a business structure that provides an optimal blend of legal safeguards and advantages to suit your needs.
The choice of your business structure has far-reaching effects on various aspects of your enterprise, including taxation, fundraising capabilities, regulatory obligations, and personal liability.
Before officially registering your business with the state, it’s imperative to make a thoughtful selection of your business structure. Additionally, many businesses will need to obtain a tax identification number and apply for the necessary licenses and permits.
Caution is advised in your choice, as transitioning to a different business structure in the future might be subject to location-specific restrictions, potential tax implications, and unforeseen complications, such as dissolution. Seeking guidance from business advisors, legal experts, and accountants can prove invaluable in this decision-making process.
Here’s an overview of some common business structures:
Sole Proprietorship: A sole proprietorship is a straightforward choice, granting you full control over your business. If you engage in business activities without formally registering as any other business type, you are automatically considered a sole proprietor. However, it does not establish a separate legal entity, meaning your business assets and liabilities are entwined with your personal ones, potentially exposing you to personal liability for business debts. Raising capital can be challenging since you cannot sell stock, and obtaining loans from banks may be difficult. Sole proprietorships are often suitable for low-risk ventures and entrepreneurs looking to test their business concepts.
Partnership: Partnerships are a simple way for two or more individuals to co-own a business. There are two common forms: limited partnerships (LP) and limited liability partnerships (LLP). LPs have one general partner with unlimited liability, while other partners have limited liability and control as defined in a partnership agreement. Profits are passed through to partners’ personal tax returns, and the general partner is subject to self-employment taxes. LLPs provide limited liability to all partners, shielding each from partnership debts and the actions of other partners. Partnerships are suitable for businesses with multiple owners, professional groups, and those wishing to validate their business idea before formalizing their operations.
Limited Liability Company (LLC): LLCs combine the advantages of both corporations and partnerships. They offer personal liability protection, safeguarding your personal assets from business-related bankruptcy or legal issues. This structure provides a degree of flexibility, taxation benefits, and limited administrative burdens. As a result, LLCs are a popular choice for many entrepreneurs seeking a balance between protection and operational freedom.
Profits and losses within an LLC can flow directly into your personal income without being subject to corporate taxes. However, it’s important to note that LLC members are regarded as self-employed individuals and are obligated to contribute to self-employment taxes, covering Medicare and Social Security.
In several states, LLCs may have a limited lifespan. When a member joins or departs from an LLC, certain states may necessitate the dissolution and subsequent reformation of the LLC, unless a pre-existing agreement within the LLC addresses the purchase, sale, and transfer of ownership.
LLCs can be a prudent choice for businesses with medium to higher levels of risk, owners seeking to safeguard substantial personal assets, and those desiring a more favorable tax rate compared to corporations.
Corporation
C corp: A corporation, often referred to as a C corp, stands as a distinct legal entity apart from its proprietors. Corporations can generate profits, incur taxation, and be held legally accountable. While corporations provide robust personal liability protection, their formation costs are higher than other structures. Furthermore, corporations demand more comprehensive record-keeping, operational procedures, and reporting.
Unlike sole proprietorships, partnerships, and LLCs, corporations are subject to income tax on their earnings. In some instances, corporate profits may face double taxation—first when the company earns profits, and again when dividends are distributed to shareholders on their individual tax returns.
Corporations enjoy an autonomous existence that is separate from their shareholders. If a shareholder exits the company or sells their shares, the C corp can typically continue operations without significant disruption.
Corporations hold an advantage in terms of capital raising because they can secure funds by issuing stocks, which can also serve as an incentive for attracting employees.
Corporations can be a sound choice for medium to higher-risk businesses, those seeking substantial capital, and companies with plans to go public or be sold in the future.
S corp: An S corporation, also known as an S corp, is a specialized type of corporation designed to circumvent the double taxation drawback associated with regular C corps. S corps enable profits, and to some extent, losses, to be directly passed through to the owners’ personal income without being subject to corporate tax rates.
The taxation of S corps varies among states, but most adhere to federal government standards and tax shareholders accordingly. Some states impose taxes on S corps for profits exceeding a specified limit, while others do not recognize the S corp election, treating the business as a C corp.
S corps must file with the IRS to acquire S corp status, which is a distinct process from state registration. Special eligibility criteria apply to S corps, and they must adhere to the rigorous filing and operational procedures of C corps.
Like C corps, S corps also possess an autonomous existence. In the event that a shareholder departs or sells their shares, the S corp can generally continue its operations without significant disruption.
S corps can be a suitable choice for businesses that would otherwise opt for C corp status but meet the requirements for S corp classification.
B corp: A benefit corporation, often referred to as a B corp, is a for-profit corporation recognized in a majority of U.S. states. B corps differ from C corps in their mission, accountability, and transparency goals but share similar taxation treatment.
B corps are driven by both financial profit and a broader mission. Shareholders hold the company accountable for producing some form of public benefit alongside financial gains. Some states require B corps to submit annual benefit reports demonstrating their contributions to the greater good.
While several third-party B corp certification services exist, they are not mandatory for a company to legally operate as a B corp in states where this legal status is available.
Close Corporation: Close corporations share similarities with B corps but have a less conventional corporate structure. They eschew many of the formalities typically associated with corporations, making them suitable for smaller companies. Rules regarding share trading in close corporations usually prohibit public trading, and they can be managed by a small group of shareholders without a board of directors.
Nonprofit Corporation: Nonprofit corporations are established to engage in charitable, educational, religious, literary, or scientific activities. Given their public benefit focus, nonprofits can achieve tax-exempt status, exempting them from state and federal income taxes on their profits.
Nonprofits must undergo a separate process with the IRS to attain tax-exempt status, distinct from state registration. They must adhere to organizational regulations similar to those governing regular C corps and follow special guidelines regarding the use of any profits they generate, such as refraining from distributing profits to members or supporting political campaigns. Nonprofits are often referred to as 501(c)(3) corporations, alluding to the section of the Internal Revenue Code commonly used for tax-exempt status.
Cooperative: A cooperative is a business or organization owned and operated for the benefit of its members, who use its services. Profits and earnings generated by the cooperative are distributed among its members, also known as user-owners. Typically, a board of directors and officers, elected by the members, manage the cooperative, with members possessing voting power to influence its direction. Members can join the cooperative by purchasing shares, with the quantity of shares not impacting the weight of their voting power.
Hybrid Structures: It is possible for an LLC to adopt tax statuses such as C corp, S corp, or nonprofit. These arrangements are less common and often more complex to establish, requiring consultation with business counselors or attorneys.
