As a small business owner, choosing the right business structure is vital for your business’s growth. Just as there are different types of businesses, there are different types of business structures.
To understand what business structure will benefit your new business, you’ll first want to create a business plan that outlines your company’s goals. For example, if your goal is to use your business for charitable purposes, you would want to file with your state as a tax-exempt organization.
The most common types of businesses are: sole proprietorship, partnership, Limited Liability Company (LLC), corporation, and S corporation. Legal and tax considerations enter into selecting a business structure, so you should always discuss your options with an attorney or CPA.
Before choosing your business structure
When deciding what type of business structure is right for you, there are a few factors to keep in mind:
Debt and liability
When starting a small business, most business owners accept full personal liability for debts incurred by the company.
However, if your business’s industry could leave you open to higher liability risks, like if you sell firearms or CBD, you may want to limit your own personal liability. This process requires more paperwork and money upfront, but the protection it will afford outweighs the cost.
You’ll want to consider whether you want to file your own personal tax returns for your business or file as a business entity. Most small business owners file individually, but there are personal benefits in keeping your individual and business income and finances separate.
Partners or investors
If you are creating a business on your own, you may want to choose a sole proprietorship structure. However, if there will be two or more partners, you may want to consider the different types of partnerships.
Depending on your preferred debt and liability structure as well as your preferred tax structure, you may want to create a corporation so that you can benefit from investors or tax-exempt status.
Types of businesses
Choose your business structure based upon your type of business. As your business grows, you’ll be able to switch structures to meet your needs.
There are many types of business structures, but choosing one doesn’t have to be confusing. Read on as we simplify the types of businesses to help you choose the best structure for you.
If you are a solopreneur
As a solopreneur, you are in complete control of your business. You brainstormed the ideas for your business and you got the ball rolling. New small businesses generally fall under this category.
As a solopreneur, if you wish to stay in complete control, run your business without a storefront, and don’t mind having your personal and business assets merged together, you can run your business as a sole proprietorship.
Sole proprietorships are owned by one person. You are automatically considered a sole proprietorship if you don’t register your business with your state. Sole proprietorships don’t have any liability or tax structure.
As a sole proprietor, you are personally responsible for all of your liabilities, debts, and taxes. You can use a trade name or a “Doing Business As” (DBA) instead of your personal name, but this does not create any legal protections. The federal government may require you to register your DBA name for federal tax purposes. Registering your DBA gives you a federal tax ID number (EIN) and allows you to open a business bank account.
If your business is starting to grow or has the potential for growth, you may want to consider a partnership. As your business expands, more aspects can hold you liable and — as a sole proprietorship — you have no separation of your personal and professional assets. A partnership would give you more protection.
You can enjoy the benefits of an LLC by filing as a single member-managed LLC with your state. You would be afforded the same liability as a corporation and your earnings and losses would pass through on your own personal tax returns.
If you have partners
A partnership is formed when two or more people go into business together. When considering what type of partnership to form, you should consider what type of liability each partner will have.
A General Partnership allows you to work with one or more partners to pool your resources and knowledge. It does not require you to form a business entity with the state. Each partner has total liability, meaning they are each personally responsible for the business’s debts and legal obligations. Ownership and profits are split evenly among all partners.
A Limited Partnership (LP) consists of one general partner with unlimited liability while all of the other partners have limited liability. Generally, limited partnerships are good for businesses that want to raise capital from investors who are not interested in the day-to-day operations of the business.
The general partner is involved in the business’s daily operations and assumes all personal liability. General partners have to pay their own self-employment taxes because all profits pass through the general partner’s tax returns.
The limited partner or partners are usually investors with limited liability and limited control of the company. You should create a partnership agreement to define each partner’s debts and liabilities.
Limited Liability Partnership
A Limited Liability Partnership (LLP) is like a general partnership with all owners actively maintaining the business. However, it protects all partners by providing limited liability as defined by your partnership agreement. All of the owners are protected from debts against the partnership and are not held responsible for the actions of other partners.
LLPs are not permitted in all states. Often, they are limited to certain professions such as lawyers, doctors, and accountants.
Limited Liability Company (LLC)
An LLC allows you to take advantage of both partnership and corporation business structures. It’s a good option if you have a partnership business that’s growing. An LLC allows you to further protect yourself and your business partners with the liability that corporations enjoy.
If you have members, you can share profits and losses with other members, but they do not have to be divided equally among them. An LLC also allows earnings and losses to pass through to the owners on their personal tax returns.
To become an LLC, you have to submit an application with your state. You will then be responsible for an annual fee. The rate depends on the state, but it is usually around $100-$200.
An LLC is governed by an operating agreement. Some states provide a standard operating agreement, which can be good for single-member LLCs. However, if you have multiple members you will want to tailor the operating agreement to your situation.
LLC assets & liabilities
Business owners typically operate as an LLC to gain personal liability protection. You will want to make sure you operate your business as a separate entity to benefit from the personal liability protection. This can include having a separate bank account, business debit or credit card, business cards, and letterhead business stationary.
In most cases, you will be protected from personal liability when it comes to your personal assets like your vehicle, house, and savings account if your LLC faces bankruptcy or lawsuits. However, if you fund your business with a personal asset then you can run into potential issues in maintaining asset protection. Lawyers can argue that your LLC is no longer a separate entity since your personal and business interests have been joined.
LLC tax structure
As an LLC, you can choose how to be taxed for both federal and state income purposes depending on your business needs and circumstances.
Types of LLCs
Choosing the type of LLC appropriate for you depends on the number of members, the type of protection you want for your business entity, and your local and federal tax rate.
Since decisions based on tax structure have significant financial implications, you should discuss your options with an attorney or CPA.
When it comes to LLCs, there are four options:
1. Single-member LLC as a “disregarded entity.” As a single-member LLC you are essentially taxed as a sole proprietor, also considered “pass-through” taxation. Instead of your business filing tax forms, you will report your business income or loss on your own tax forms.
If you are engaged in an active trade or business, like copywriting or selling products, you will have to pay self-employment taxes.
If you are engaged in a passive activity, like real estate investment you don’t have to pay self-employment taxes.
2. Multiple-member LLC as a partnership. If your LLC has two or more members, your LLC will be taxed federally as a partnership and you will have to report your business income on a separate tax return.
Each partner engaged in active trade or business is responsible for paying their own self-employment taxes on their share of the partnership profit. You will also be responsible for Medicare and Social Security.
A partner engaged in passive activity is not responsible for self-employment taxes.
When considering whether a member-managed LLC is appropriate, keep in mind that some states require you to dissolve your LLC if a member leaves your company.
3. LLC as a C corporation. If you elect to be treated as a C corporation for tax purposes, your LLC will use its corporate tax rate to pay taxes when you file.
If owners receive profits as dividends, the dividends are taxed again at the qualifying dividend rate, known as double taxation.
Consider this tax structure if you prefer to keep your profits in the company rather than distribute end-of-the-year profits to owners.
4. LLC as an S corporation. If you elect to be treated as an S corporation for tax purposes your LLC will file a corporate tax return, but the company’s profits will not be subject to corporate income tax.
Individual owners are taxed on their respective shares of the company’s profits.
Profits are not subject to self-employment tax. Instead, your LLC will be responsible for payroll taxes to members that work for the business.
If you want to have stockholders
If your business is further along in growth, you may want to hire more employees and issue stock as part of their compensation. You may also decide to work with business partners to grow your influence and revenue potential.
In this case, a corporation would be the right choice.
A corporation can produce profit, be taxed, and be held liable for its employees’ actions. Since corporations offer the strongest level of protection from personal liability, they require extensive investment in record-keeping, operation processes, and reporting.
A corporation business structure is a good choice for a medium or higher-risk business that needs to raise money, plans to “go public,” or will eventually be sold.
There are a few different types of corporations and which one you choose depends on a few factors:
A C corporation is the basic type of corporation. If you file as a corporation, your business will be considered a C corporation unless you choose something else when registering with the state.
C corporation creation
When forming a corporation you will have to obtain state-specific information on how to start a corporation and register with your state. You can find links to state business offices on the Small Business Administration website.
You will mostly likely have to file articles of incorporation, write your corporate bylaws, and hold an initial board of directors meeting. Additionally, you will have to file with the federal IRS.
C corporation assets & liabilities
Since corporations have lives separate from their shareholders, if a shareholder leaves the company or sells their shares, the C corporation can continue doing business.
C corporations can raise capital through the sale of stock, which can be beneficial in attracting employees.
C corporation tax structure
A C corporation uses its corporate tax rate to pay federal taxes.
C corporations pay income tax on their profits and — in some cases — can be taxed twice through profits and dividends.
Your C corporation will only be taxed on profits and your profits will not be subject to self-employment taxes. Instead, your business will be responsible for payroll taxes to members that work for the business.
An S corporation was designed to avoid the double taxation drawback that occurs with C corporations.
To meet S corporation status, your business must meet these requirements:
- Be a domestic corporation.
- Have only allowable shareholders.
- Have no more than 100 shareholders.
- Have only one class of stock.
- Not be an ineligible corporation (including certain financial institutions, insurance companies, and domestic international sales corporations).
S corporation creation
You must file with the IRS to get S corp status, which is a different process than registering with the state. Your S corporation will still have to follow strict filing and operation procedures like a C corporation.
S corporation assets & liabilities
All S corporations have independent lives from shareholders like C corporations. If a shareholder leaves the company or sells his or her shares, the C corporation can continue doing business.
S corporation tax structure
S corporations are assessed at individual income tax rates. As an S corporation, you elect to pass corporate income, losses, deductions, and credits through to shareholders. S corporations then report the flow-through of income and losses on personal tax returns.
A B corporation is a “benefit corporation.” Companies use this type of structure if they have a dedicated social mission that they want to further as their corporation grows.
B corporations aren’t entirely different from regular C corporations. Rather, they are corporations that have been vetted and approved for B corp status. Some states give tax breaks to B corporations.
The main reason you would choose a B corp over a nonprofit is to have shareholders who actually own the company. A nonprofit doesn’t have any owners or shareholders. A B corporation is basically a for-profit company with a social mission with the end goal of returning profits to shareholders.
Also known as privately held companies, close corporations are similar to B corps but have a less traditional corporate structure. They are held by a limited number of shareholders and are not publicly traded.
Close corporations generally allow for more flexibility as they don’t normally have reporting or annual meeting requirements.
A nonprofit organization is a business organization that is used for education or charitable purposes. Money earned by a non-profit must be kept by the organization to pay for its expenses and programs.
To become a nonprofit, you must file paperwork with both the state and federal governments. It’s similar to forming a corporation because you need to file your articles of incorporation, as well as file for state and federal tax-exempt status.
There are several types of nonprofit businesses that can receive “tax-exempt” status:
If you want member control and community support
If you as a business owner are looking for less risk, member control, and community support, you will want to create a cooperative.
A cooperative is a business that’s fully owned and operated for the benefit of its members that use its services. Any commission is shared among the members themselves and is never required to be paid out to stakeholders.
Cooperatives sell shares to cooperative “members.” These members then have a say in the operation and direction of the cooperative.
Cooperatives are usually found in brick-and-mortar style stores. You may know some farm-to-table grocery stores or even small cafes that operate as co-ops. There are also popular online businesses that operate as cooperatives, such as REI.
No single person is ever fully responsible for financing a cooperative or paying off its debts. It’s owned by members rather than investors, which gives members more control and autonomy. The business model is based on mutual help, lifting up others, and working side by side with a team of trusted partners.
What type of business structure is right for you?
Selecting a business structure that’s right for your online business depends on your business’s purpose and goals. Remember, you can always change your business organization down the road if needed. If you’re just starting out, you may want to consider a sole proprietorship or an LLC and as your business grows you can transition to a corporation.
Ecommerce business plans help you examine every major component of your online business and avoid any possible issues before you get started. Constant Contact offers ecommerce advice that can help guide you through your transitions of growth.
No matter what business structure you are considering, make sure to speak to an attorney or CPA to find out the best first step for your business.
Additional Resources: Forms and tax information can be found at irs.gov, medicare.gov, ssa.gov, and Which Forms Must I File.