Choosing a Business Structure
Determining how to legally structure your business is one of the most important decisions you’ll need to make when starting a business. Your decision will heavily affect your business on a host of matters, including how much control you have over the business, the level of personal liability you will carry, and the taxes you have to pay. The information below will provide you with a summary of the differences between the most common forms of business entities.
Do you feel the need to have total control of your business? Sole proprietorship provides you with complete authority over the management and operations of your business, whereas a corporation is controlled by directors who are elected by shareholders. Partnerships provide each partner equal power, and LLCs have operating agreements that outline management policies.
Generally, if your business will be participating in risky or threatening activities, then you want to minimize any potential personal liability you will have if problems arise. Sole proprietorship offers the least protection, because the owner has unlimited liability. Corporations and LLCs provide owners with limited liability that helps to protect your personal assets from individuals seeking claims against your business.
All business types must file an annual return. Sole proprietors, partnerships and LLCs are passthrough tax entities, which means they must pay taxes on all net profits for the year. In contrast, owners of a corporation only pay taxes on the income they earn from the corporation such as salaries, dividends or bonuses. Keep in mind that the corporation is a separate tax entity, and it must pay additional taxes on any profits remaining at the end of the year.
Sole proprietorship is by far, the easiest type of business to establish. You don’t have to file any paperwork with the state or pay large fees to start your business. Choosing to structure your business as a LLC or corporation can be complex and expensive. You will need to file documents with the state and pay fees ranging from $50 to $800 depending on where you organize your business. Additionally, you will need to elect officers, hold meetings and maintain records.
Questions to ask yourself when selecting a business structure:
- How much control you wish to have?How will you protect your personal assets?
- How much risk is your business willing to absorb?
- How do you want to be taxed?
- Will you need to access business earnings for personal reasons?
- Which legal structure will provide you with the most flexibility?
- What will happen to the business if you experience an unexpected hardship and are unable to run the company?
Types of Structures Available
Each business structure has certain advantages and disadvantages that you should consider. The information below will provide you with a summary of each type of structure.
Most small businesses are owned by one person, and start out as a sole proprietorship. Usually the owner is responsible for the day-to-day management of the business. Sole proprietors own all the assets and profits earned by the business, but they also assume complete liability.
Advantages of a Sole Proprietorship
- Simple and least expensive business structure to organize.
- Complete control over all decisions regarding the business.
- Receives all profits generated from business.
- Dissolving or transferring business is an easy task.
- Reports profit or loss on personal income returns.
Disadvantages of a Sole Proprietorship
- The law does not distinguish between the business and its owner.
- Sole proprietors have unlimited liability and their business and personal assets are at risk.
- Business may dissolve upon the withdrawal or death of an owner.
Partnerships are similar to starting a sole proprietorship, except that two or more people share ownership of the business. The partners will need to establish a legal agreement that states how the business will be run to avoid future disputes between partners.
Advantages of a Partnership
- Simple and inexpensive business structure to organize.
- Raising capital may prove to be easier with a partnership.
- Partners may have complementary skills to contribute to the business.
- Reports profit or loss on personal income returns.
Disadvantages of a Partnership
- Each partner is individually liable for the actions of the other partners.
- Less control, as decisions must be shared among partners.
- Profits must be shared.
- Business may dissolve upon the withdrawal or death of a partner.
Limited Liability Company (LLC)
The LLC is a hybrid legal structure that provides the tax flexibility of a sole proprietorship (depending on how many owners there are), and the limited liability protection of a corporation. Organizing a LLC is more difficult and formal than that of a general partnership.
Advantages of a LLC
- Offers business owner(s) limited liability protection.
- Can report profit or loss on personal income returns.
- Typically less paperwork than a corporation.
Disadvantages of a LLC
- Business may dissolve upon the withdrawal or death of the owner or a member.
- More paperwork than a sole proprietorship.
Like an individual, a corporation is a legal entity that can be taxed and held legally liable for its actions. Corporations are chartered by the state in which they are headquartered, and require compliance with a multitude of regulations and tax requirements. The owners of a corporation are simply shareholders that help to elect a board of directors that manage the business. The corporation does not dissolve when ownership changes.
Advantages of a Corporation
- Shareholders enjoy limited liability.
- Raising additional funds is easily possible through the sale of stock.
- Can deduct the cost of benefits it provides to officers and employees.
Disadvantages of a Corporation
- Organizing a corporation is the most expensive and time-consuming business structure to form.
- High level of paperwork is needed as corporations must comply with regulations from federal, state and local agencies.
- May result in higher overall taxes.
- Dividends paid to shareholders may be taxed twice.
One business structure is not necessarily better than any other. You need to consult with your attorney, accountant and key advisors to assist you in the process of selecting a business structure for your company.
Your initial choice of a business structure isn't necessarily a permanent decision, and you can change your mind later. If your business grows or the level or risk increases, you can always convert your business to a LLC or a corporation with the help of an attorney.
Have additional questions about starting your business? Contact the Northeast/Texarkana Small Business Development Center (SBDC) for a confidential business consultation at no charge to you. Call (903) 434-8237 to set up an appointment.