What Legal Structure Do Most Small Businesses Choose?
You’ll need to choose a business structure before you register your business in your state. Most businesses will also need to get a tax ID number and file for the appropriate licenses and permits.
How you structure your business affects:
- Your personal liability
- How much you pay in taxes
- The paperwork you need to file
- Your ability to raise money
While you can switch to a different business structure in the future, there may be restrictions due to your location. Further, a change could have tax consequences for you, or unintentionally dissolve your company, among other complications.
What are the most common business structures?
Though sole proprietorship and limited liability corporations are the most common, there are many types of business structures. Before selecting a structure, Pie recommends you seek legal counsel.
Here’s the scoop on the most common types of legal structures.
This is the simplest form of business entity. With sole proprietorship, one person is responsible for all of a company’s profits and debts. Your business is automatically considered a sole proprietorship if you do business activities but don’t register as any other kind of business. However, because sole proprietorships aren’t a separate business entity, your business assets and liabilities aren’t separate from your personal assets and liabilities. This means that you can be held personally liable for the debts and obligations of your business.
Who it’s good for: Sole proprietorships can be a solid choice for low-risk businesses and those who want to test drive their business idea before forming a formal business entity.
Partnerships are the simplest structure for two or more people who own a business together. There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
- Limited partnerships entail that only one partner has control of the operation, while the other person(s) contribute(s) to and receive(s) only part of the profit. As the name implies, partners with limited liability also tend to have limited control over the company, which is detailed in a partnership agreement. Profits are passed through to personal tax returns, and the general partner (the one without limited liability) must pay self-employment taxes.
- Limited liability partnerships are like limited partnerships but provide limited liability protections for every owner. An LLP protects each partner from debts against the partnership and they won’t be responsible for the actions of other partners.
Who it’s good for: Partnerships can be a good choice for businesses with multiple owners, professional groups (like attorneys), and groups who want to test their business idea before forming a more formal business. It’s also ideal for anyone who wants to go into business with a family member, friend, or previous business partner.
Limited liability company (LLC)
An LLC provides the benefits of the corporation and partnership business structures. This hybrid structure allows owners, partners, or shareholders to limit their personal liabilities while enjoying the tax and flexibility benefits of a partnership. Under an LLC, members are protected from personal liability for the debts of the business, as long as it can’t be proven that they have acted in an illegal, unethical, or irresponsible manner. This structure protects you from personal liability in most cases, meaning that your vehicle, house, and savings accounts won’t be at risk if your business is hit with a lawsuit or bankruptcy. Profits and losses can be passed through to your personal income without facing corporate taxes, but because members of an LLC are considered self-employed, they must pay self-employment tax contributions toward Social Security and Medicare. State laws regarding LLCs vary, so be sure to check your state’s specific rules for buying, selling, and transferring ownership.
Who it’s good for: LLCs can be a good choice for medium- or higher-risk businesses, those with large personal assets that they want to be protected, and those who want to pay a lower tax rate than they would with a corporation structure.
The law treats a corporation, sometimes called a C corp, as an entity separate from its owners, with its own legal rights. A corporation can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks. It can make a profit, be taxed, and can be held legally liable.
This structure offers the strongest protection from personal liability to its owners. However, it costs more to form a corporation than the other types of business entities. Corporations also require more extensive record-keeping, operational processes, and reporting, and they must pay income tax on their profits. In fact, in some cases, corporate profits are taxed twice: when the company makes a profit and then again when dividends are paid to shareholders on their personal tax returns. If a shareholder leaves the company or sells his or her shares, the C corp can continue doing business. Another benefit is that corporations can raise funds by selling stocks, which also can benefit employees.
There are several types of corporations, including C corporations, S corporations, B corporations, closed corporations, and nonprofit corporations.
Who it’s good for: Corporations are a good choice for businesses that need to raise money, businesses that plan to “go public” or eventually be sold, or medium- or higher-risk businesses.
S corporation or S corp
S corporations avoid the double taxation of C Corps, much like partnerships or LLCs. Owners also have limited liability protection. S corps allow profits—and some losses—to be passed directly through to owners’ personal income without being subject to corporate tax rates. Not all states tax S corps in the same fashion, but most states recognize them the same way the federal government does and tax shareholders accordingly. In some states, S corps are taxed on profits above a preset limit, while others don’t recognize the S corp structure at all and just treat the business like a C corp. To form an S corp, you must file with the IRS in addition to registering with your state. And, there are some other differences to this structure, including a limit of 100 shareholders, all of whom must be U.S. citizens. You’ll still have the strict filing and operational processes of a C corp, but, just like a C corp, if a shareholder leaves the company or sells his or her shares, the business can keep moving along.
Who it’s good for: S corps are a good choice for businesses that would be a C corp, but meet the additional criteria to file as an S corp.
Benefit corporation or B corp
A B Corp is a for-profit corporation acknowledged by most U.S. states. B corporations, or benefit corporations, are for-profit entities structured to make a positive impact on society. They are different than a C corp in purpose, accountability, and transparency, but are taxed the same way. These organizations are driven by mission and profit. Shareholders hold the company accountable for producing some sort of public benefit as well as a financial profit. Some states require B corps to submit annual benefit reports that outline their contribution to the public good.
Who it’s good for: A company that wants to provide a benefit to the public and to its shareholders.
A closed corporation is typically run by a few shareholders, is not publicly traded and benefits from limited liability protection. It resembles a B corp but has a less formal corporate structure. State rules vary so you may need to do some homework, but typically shares can’t be publicly traded in a closed corporation. These entities can be run without a board of directors.
Who it’s good for: A company that provides a benefit to the public and to its shareholders but operates less formally.
Nonprofits are often called 501(c)(3) corporations, which refer to the section of the Internal Revenue Code that covers tax-exempt status. They are typically formed to pursue charity, education, religious, literary, or scientific work. Because their work benefits the public, nonprofits aren’t required to pay state or federal income taxes on any profits it makes. Nonprofits must file with the IRS to get tax exemption and must follow organizational rules very similar to a C corp. They also need to follow rules about what they can and can’t do with any profits they earn.
Who it’s good for: Organizations performing charity, education, religious, literary, or scientific work without the goal of profitability.
A cooperative, or co-op, is owned by the same people it serves. Its offerings benefit the company’s members, who vote on the organization’s mission and direction. Profits and earnings generated by the cooperative are distributed among the members, called user-owners. Typically, officers and a board of directors are elected to run the cooperative and regular members have voting power to control the direction of the entity. Members can become part of the cooperative by purchasing shares, although owning more shares doesn’t mean holding more power.
Who it’s good for: A group of like-minded individuals who want to operate a business or organization that’s owned by and benefits those using its services. A classic example is a residential building co-op.
It’s important to note that designations like “S corp” and “nonprofit” aren’t strictly business structures; they also can be a tax status. For example, while it’s a bit uncommon, it’s possible for an LLC to be taxed as a C corp, S corp, or a nonprofit. If you’re considering one of these non-standard structures, you should speak with a business counselor or an attorney to help you decide.
Factors to consider when choosing a structure
There are several factors to consider when choosing the structure for your new business:
- Protection for your personal assets
- Tax burden on your business
- Flexibility for your business to grow
- Requirements that aren’t too cumbersome for you or your business partners
- Ability to retain control of your business and its activities, if needed
- Ability to raise capital, if needed
- Additional requirements, such as licenses, permits, and regulations