Business Structures Guide: Choose the right business entity type
By: VentureHow Staff Writer
Updated on: May 19, 2021
VentureHow.com Business Structures Guide is a comprehensive overview of various types of business structures (in the American context) and what are the criteria and drivers for picking a specific structure for a new venture. A business structure is synonymous with a business entity type.
VentureHow.com Business Structures Guide is organized into different sections, and you can jump to any part by clicking on the hyperlinks below.
VentureHow.com Business Structures Guide: Table of Contents
Why is a business structure important?
What are the various types of business structures?
What criteria drive the decision of a business structure?
What are my next steps in choosing a business entity?
Please remember that while we strive to provide high-quality content, you will need to evaluate the specific business entity type that is right for your business based on your unique personal circumstances and consult an attorney and a tax advisor.
Why is choosing the right business structure important?
A business structure is one of the critical decisions an entrepreneur must make – very early in the evolution of the business. In most states and cities, a business owner must choose a business entity or business structure before filing a business registration form. While some business structure decisions are amenable to change quickly, others are complex and costly. Changing a business structure involves legal fees, paperwork, regulatory restrictions (in some states), continuity of a business, and of course tax consequences.
For example, if an entrepreneur selects the most straightforward business structure – sole proprietorship – he/she may not be able to raise equity capital from others. Or the personal assets may be at risk. On the other hand, another entrepreneur selects a “C Corp” as the business entity type of choice, without considering the paperwork, the potential for double taxation, and heavens forbid, the complexity of liquidating a business. And when one forms an “S Corp,” they have to consider the fact that it can only have 100 shareholders and they all must be American citizens.
The business entity type will also limit the size of accumulated earnings a business can shield from immediate taxation.
So, a choosing a business structure is a balancing act between risk, reward, and complexity. Oh, well, no one said being starting and running a business is easy!
In the business world, the rearview mirror is always clearer than the windshield. – Warren Buffet
What are the various types of business structures?
The following are some of the most popular types of business structures.
Common Business Entity Types of Business Structure Types:
Sole Proprietorship
Partnership
Limited Liability Company
C Corporation
S Corporation
Cooperative
Non-Profit
Below are brief descriptions of the popular forms of business structure and entity types:
Sole Proprietorship
A sole proprietorship is an epitome of “Be your own boss.” It is the primary and straightforward of company structures. A sole proprietor owns everything, and she/he owes everything. If you engage in any business activity – irrespective of whether you have registered or not – you are a sole proprietor.
However, if you wish to use a name for your business, such as “Pretty Flowers” or “Sam’s Sausages,” many local towns and cities will require filing a “DBA” (Doing Business As) and register your sole proprietorship.
Among the corporate entity structures, a sole proprietorship is not conducive to raising capital from external investors.
Remember, even if you register as a DBA, there is no separation between you and your business. Your business and personal matters are intertwined and synonymous. If you are a sole proprietor, you can keep all the assets, and there is no separation of business and personal assets. Similarly, on the flipside, your business liabilities are also your personal liabilities. Hence, a sole proprietorship bears the brunt of any adverse risk events.
What it means let’s assume you have – through other endeavors, inheritance, or savings – a quarter million dollars. Now, you start a sole proprietorship, and while that business hardly earns more than a few hundred dollars a month, there is a litigation and you are found liable. Your entire personal estate could be in jeopardy. (Of course, there may be exceptions to what the creditors or plaintiffs may take but that is not the point here. Just know that a sole proprietor exposes herself/himself to unlimited risks.)
Not everything is gloom and doom, though. A sole proprietor can make decisions about the business, have unfettered access to cash flows, and except for filing taxes as an individual, there aren’t arduous paperwork to fill out, except for what the local jurisdictions may mandate for specific businesses, irrespective of the entity structure. For example, a restaurant owner can be a sole proprietor and avoid complex formation and periodic tax filings, but they may have to comply with local business rules and obtain a food service license, a DBA, and if appropriate a liquor license.
As the famous adage goes, “Nothing in this life is certain but death and taxes,” a sole proprietor will be subject to many tax-related filings. You will find a nifty chart on the IRS (Internal Revenue Service) website about the tax filings for a sole proprietor.
A sole proprietorship may be a good idea if you don’t have significant personal assets, the business you are forming is a low-risk venture, and if you are testing the waters before committing to formalizing the company structure and entity type.
Partnership
A partnership business entity type is the next evolution of a sole proprietorship in that a few friends, family members, or like-minded people can get together and start a business. Unlike a sole proprietorship, a partnership may require a partnership agreement outlining the investment, role, profits, and liabilities of each partner.
A partnership business structure does not create a specific legal entity, and other obligations are similar to the sole proprietorships with regards to filing business license, obtaining related permits and filing paperwork.
A partnership allows for the pooling of capital and talent, but also will pose some challenges. Partners co-own everything and also jointly liable (unless the business takes the form of a limited partnership or a limited liability partnership.)
In general, the partnership entity structure may either be a limited partnership or a limited liability partnership.
A limited partnership (LP) is where there is one general partner, and others are limited partners. The limited partner’s liability extends only to the investment they have made. However, the general partner’s entire assets are at risk.
A limited liability partnership (LLP) limits the liability of all the partners, including the general partner.
Limited liability does not mean protection against fraud, willful negligence, and criminal conduct. It just means that in the ordinary course of business, your liability is limited to your investments in the firm.
Like most marriages in the modern era, most partnerships do not work. So, while it may seem very logical and rosy to partner with someone, a smart business owner realizes the consequences of the partnership going awry and makes sure the partnership agreement contains appropriate clauses to handle various eventualities including removal of a partner, buying out the other partner, retirement, death, business interest sale covenants, and liquidation.
For example, a partner who signed up for equal work quits or wants to cash in his/her chips. A partner dies, and her widower intends to sell the partnership interest to a rival. A partner is convicted or an unrelated crime. A partner dies, and her son wants to become the new partner. All these circumstances are not unique, and a good partnership agreement will address these issues. Furthermore, partners in a partnership also execute buy-sell contracts and obtain Key Person insurance in situations where such devices help.
A partnership is not a separate legal or tax entity and must file an annual information return to report the income, deductions, gains, losses, etc., from its operations. However, the partnership itself does not pay income tax. Instead, a partnership is a “passes through” entity and hence passes any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return. A partnership also must furnish the form K1 to each partner. The IRS offers details on the filing requirements for a partnership.
Limited Liability Company (LLC)
Some consider a limited liability company as an ideal business entity type for many businesses as it combines the simplicity of partnerships and the structural benefits of a corporation. A limited liability company is generally constituted and governed by state statutes and hence may offer slightly different terms, conditions. Similarly, the formation and liquidation rules may vary.
An LLC may be a single member LLC or multiple members. An LLC may have limited life or unlimited life.
An LLC can choose to be treated as a partnership or as a corporation. Owners, irrespective of their investment, in a limited liability company, are termed “Members.” Most states do not restrict ownership to specific entities, and if that is the case, the members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members.
Some members, in addition to their ownership, may have management responsibilities. All members, irrespective of their role, are generally limited in their liability and exposure to personal assets.
However, members of an LLC are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security.
The LLC typically needs to register with a specific state and may have to file LLC formation paperwork – a registration form, articles of association or articles of organization that governs the LLC. Please check with your state for the appropriate LLC filing requirements.
The articles of organization for an LLC are an essential document, and a legal and tax advisor can help formulate the appropriate ones for your business. The govern how members may join, leave the LLC, transfer ownership, the valuation of the ownership interest and other essential considerations.
Depending on the nature and size of the LLC, all members may manage the entity – which is called member-managed. Or an LLC may be controlled by a select group of managers, which is called manager-managed.
Since there is no federal statute recognizing the limited liability company entity structure, the IRS treats the entity’s tax status by the selections made by the members of the LLC and various criteria determined by the IRS. Please see details of tax status and filing requirements for a limited liability company on the IRS website.
Corporation
A corporation is the domain of large companies (and temporarily small businesses) and is a separate legal structure carrying many benefits, but also cost, complications, compliance, and complexity.
There are two categories of corporations – a C Corporation (C Corp) or an S Corporation (S Corp). The primary difference is in the tax status of the entity. A C Corp is typically subject to double taxation that an S Corp avoids.
A C Corporation is the most common structure as it offers unlimited flexibility to raise capital, hire employees, limit the liability of the owners, and provide the basis for a professionally managed company where owners may or may not participate in the operations of the business.
A C Corp can raise unlimited capital by the sale of stock. A C Corp also will be able to attract talent by issuing stock options to employees. A classic manifestation of the principal/agency model, shareholders, may only have sway in corporate decisions by electing board members and voting on some resolutions (which may be non-binding). Of course, if an owner is also the executive of a company, then she/he will wield significant influence on the conduct of the business of a corporation.
A C Corp’s main disadvantage the double taxation – once on corporate earnings at a company level and then the dividends or distributions at the individual level. A stock sale on the secondary market will result in short-term or long-term capital gains.
A C Corporation is registered in a specific state, and many companies choose a location based on the flexibility and business friendliness of the local company laws and regulations. For example, many companies register their companies as a Delaware Corporation and in some cases as a Nevada Corporation.
An S Corp passes through the profits and some losses directly to the members. An S Corp is a special election a company has to make and seek IRS approval.
An S Corp has limitations regarding a total number of shareholders which is limited to 100 and also there is a restriction that no foreign nationals are allowed to be shareholders in an S Corp.
What criteria drive the decision of a business structure?
So, now comes the most crucial question. Which corporate structure or entity type is appropriate for my business? It is not an easy choice and depends on various factors.
Questions to ask before choosing a business entity type:
- What type of business are you starting?
- Where is the capital going to come from?
- Do you need to hire employees?
- What are the plans and anticipated growth of the business?
- What are the inherent risks in the business?
- How much money and net worth do you and your family have? Are you OK with unlimited personal liability?
- Are you going to take on shareholders? If so, what is the number? Are they individuals or institutions? Will you take on any foreign nationals as investors?
- How much of structure, operational controls, accounting, and filing requirements are you willing to take on?
- Is it something you are dabbling in or do you intend to make the new business your life’s work?
- Are you OK with double taxation – at an enterprise level and an individual level?
What are my next steps in choosing a business entity type?
The hardest thing to understand in the world is the income tax. – Albert Einstein
Well, if you have come this far reading this article, you are serious about your business and learning the intricacies of how to pick the right entity structure for your business.
We can summarize the next steps as follows:
Deliberate and Discuss: Think about your business idea and your goals, objectives, potential, pitfalls and other aspects of the proposed venture in a dispassionate manner. Discuss with your friends and family to seek another opinion.
Learn More: There is a wealth of knowledge from many trusted sources. Educate and enlighten yourself about all aspects of the business structure and their potential implications.
Hire Professional Help: For significant decisions and steps in your life, it is essential to seek competent help and hire the best possible resources. An accountant and an attorney will be two right professionals you can rely on now and in the future. If you cannot afford to hire professional help, then there are self-help avenues and do-it-yourself kits, and you want to evaluate the integrity and viability of using such resources.
Get Going: Many time procrastination and inertia stop prospective entrepreneurs from taking action. So, after a thorough evaluation, thoughtful reflection, take the next step in making your dream a reality.
All the best in your entrepreneurial endeavor.
Note: The Business Structures Guide article is for informational purposes only. Please consult your attorney and an accountant to make the decisions based on personal circumstances.
High-Quality Resources that complement VentureHow Business Structures Guide:
Internal Revenue Service: https://www.irs.gov/businesses/small-businesses-self-employed
Small Business Administration: https://www.sba.gov/business-guide
Nolo: https://www.nolo.com/legal-encyclopedia/small-business