Do you want to start a business but don’t know how to structure it, legally speaking?
Entrepreneurs typically struggle with not knowing the most common business structures, and that’s okay!
Hi, my name is AJ! I recently sold my business for multiple seven figures. Now, I strive to help entrepreneurs build and scale businesses at all levels!
Before I scaled my company, I had to ensure it was filed with the government correctly!
So, if you’re ready to learn about the various ways to structure a business, keep reading! I’m covering everything you need to know!
What is a Business Structure?
A business structure is a government classification that regulates specific aspects of a company.
For example, a company’s legal structure determines its tax burdens on a federal level.
Further, on a state level, business structures can have liability ramifications.
Some people refer to a business structure as a business entity.
Why is a Business Legal Structure Important?
Many first-time entrepreneurs underestimate the importance of choosing the right business legal structure.
However, this is one of the most critical decisions you make at the start of your business because it can impact your personal assets and debts!
Here are six reasons a business structure is an essential factor to consider.
Small Business Taxes
Each type of business entity has its own tax rates and considerations.
Therefore, the structure you choose can impact your personal or business tax burden significantly.
Here are some of the income tax considerations to know about:
- Sole proprietors, partnership owners, and S corporation owners: These individuals can categorize business income as personal income.
- C corporation: The business’s income is separate from the owner’s.
But more on that later.
Liability is another reason a business’s legal structure is essential.
For instance, a limited liability company (LLC) protects your personal assets if you ever face a lawsuit.
E.G., A person or business would sue your business, not you personally.
Why does this matter? Because (in our example) the plaintiff wouldn’t be able to come after your personal assets, just the business assets.
Paperwork & Filing
Although nobody likes doing paperwork, it’s still a critical aspect.
Various business structures have different tax forms and paperwork they must submit.
Typically, a sole proprietorship will have less paperwork/setup, while a C Corp will have much more.
Management & Hierarchy
Some legal structures, like corporations, must have a board of directors.
In some states, this board of directors must meet a certain number of times annually.
Most of this will depend on the type of business you choose.
You must have a business structure before registering your business in your state.
For instance, individuals cannot apply for the following things without a legal structure:
- An employer identification number (EIN)
- Necessary licenses
Lastly, there’s fundraising.
Did you know that your business’s legal structure determines whether you can raise funds (in specific ways)?
For instance, a sole proprietorship cannot offer stocks (usually).
Instead, this right is reserved for corporations.
If you’re planning on raising funds, you’re going to need to know which type of business structure to set up!
Types of Business Structures
The most common types of business legal structures include the following:
- Sole proprietorship
- Partnership agreement
- Limited liability company (LLC)
- C corporation
- S corporations
- B corporations
- Close corporation
- Nonprofit corporation
Let’s look at these types of business structures in greater detail!
A sole proprietorship is the simplest business entity.
What is a Sole Proprietorship?
A sole proprietorship is a legal structure that one person owns and operates.
This structure has no legal distinctions between the owner and the business, meaning the owner is entitled to all profits.
However, this also means the owner is personally responsible for:
A sole proprietorship is straightforward to set up and offers complete managerial control to the owner.
How do Sole Proprietorship Taxes Work?
Sole proprietorship owners must pay self-employment taxes.
This tax covers things like:
- Medicare contributions
- Social Security contributions
The owner’s personal income is subject to individual income tax rates.
Further, the business must file a Schedule C with their federal tax return, reporting profits or losses.
Pros and Cons of a Sole Proprietorship
Here are some advantages and disadvantages to know about with a sole proprietorship!
- License fees and business taxes are low
- Eligible for certain tax deductions, like health insurance education
- Easy exit
- It can expose owners to unlimited personal liability in cases of business debts or lawsuits
- No separation of professional and personal assets
Now, it’s time to learn about another popular business legal structure: partnerships!
What is a Partnership?
A partnership is a company that two or more individuals own.
There are two types of partnerships:
- General partnership: Everything is shared equally.
- Limited partnership: Only one person controls the operations. The other person (s) contributes to and receives part of the profit.
Usually, partnerships are more expensive than a sole proprietorship because an attorney must regulate the partnership agreement.
How do Partnership Taxes Work?
A general partnership must file federal tax Form 1065 and state returns.
However, they don’t have to pay income tax with a general partnership.
Also, each partner reports their shared income or less on their individual income tax returns.
Pros and Cons of a Partnership
Here are some advantages and disadvantages to know about partnerships!
- Easy to form because there is very little paperwork to get started
- There is a lot of growth potential
- There’s unlimited personal liability
- The business structure may not provide adequate legal protection in case of partner disputes or disagreements
Limited Liability Companies (LLC)
A limited liability company (LLC) enables owners to limit their personal liability (which is highly beneficial!).
What is an LLC?
Limited liability companies allow owners, shareholders, or partners to limit their personal liability while enjoying tax and flexibility benefits.
For instance, members of a limited liability company can be protected from liability for the business’s debts.
A limited liability company was created to offer business owners the liability protection corporations have!
How do LLC Taxes Work?
A limited liability partnership or company does not pay taxes directly.
Instead, the business profits or losses are “passed through” to individual tax returns.
Further, LLC owners, called Schedule E, report their share of profits and losses on their federal tax returns.
Pros and Cons of an LLC
Here are the pros and cons to know about with an LLC!
- Limited liability for owners
- Little paperwork to complete
- Pass-through taxation allows profits and losses to be taxed at individual rates
- Some states have high filing fees for LLCs
- Members must pay self-employment tax on all business earnings
Corporations – C Corp
C corporations are separate entities from their owners.
Therefore, the legal rights are independent of a C corporation’s owner.
What is a C-Corp?
Shareholders own C corporations.
Typically, a C corporation allows an unlimited number of investors.
A C corporation offers the highest protection levels for its owners from personal liabilities.
However, forming and keeping a C corp costs more, and its expenses are higher.
How do C-Corp Taxes Work?
C corps have to pay the corporate tax rate on their profits.
Shareholders also have to pay taxes when C corporations distribute their dividends.
Some examples of companies that file for a C corporation tax status include the following:
- Bank of America
Pros and Cons of a C-Corp
Here are some pros and cons of C corporations!
- Shareholder personal liability is limited
- The possibility of perpetual existence, even if ownership changes hands
- A C corporation can offer stocks to the public
- Higher taxation rates for both the business and shareholders when the company distributes the profits
- More paperwork than other business structures
Corporations – S Corp
Another type of corporation is an S corporation.
Let’s learn more about these business legal structures!
What is a S-Corp?
An S corporation structure is unique because it is designed to avoid the double taxation of C corps.
Further, an S corporation allows profits and (some) losses to pass directly to the owners’ personal income.
What’s better, these profits aren’t subject to corporate tax rates!
How do S-Corp Taxes Work?
The government taxes S corporations differently depending on the state.
However, most recognize these corporations the same way the federal government does.
Some states tax S corporations when profits reach a specific level.
However, in other states, they don’t recognize the S corporation election at all and instead treat it like a C corp.
Regardless, an S corporation must file with the Internal Revenue Service (IRS) to get S corp status.
Pros and Cons of a S-Corp
You must be aware of a few pros and cons of S corps.
- Shareholders have limited personal liability protection
- Pass-through taxation minimizes double taxation on profits and losses
- If a shareholder leaves the company or sells their shares, the business can continue without being disturbed
- Limited only to shareholders, so the number of investors is usually restricted
- More paperwork than other businesses
- Strict filing and operational processes compared to other business legal structures
Corporations – B Corp
A B corp is also called a benefit corporation.
Most (not all) states in the country recognize these for-profit corporations.
What is a B-Corp?
Benefit corporations differ from C corps in the following ways:
Shareholders own a benefit corporation.
These shareholders hold the business accountable to deliver some public benefit as well as financial profit.
In some states, the government requires B corps to submit annual benefit reports to show their contribution to the public.
How do B-Corp Taxes Work?
Governments tax a benefit corporation the same way as a C corp.
Therefore, these corporations undergo higher taxation rates than other business entities.
Pros and Cons of a B-Corp
Here is a quick run-through of the pros and cons of B corporations!
- Shareholders receive limited personal liability protection
- Investors care about income generation and other social benefits, creating two sources for company funding.
- Some consumers prefer to buy from businesses with a positive community or sustainable impact on their local area.
- Higher taxation rates than other business structures
- Slightly more complex operating and filing procedures
- Prepare an annual benefit report so the public can track their progress & social impact growth.
Another type of corporation is a closed corporation.
Let’s see what distinguishes these corporations from others!
What is a Close Corporation?
Usually, a few shareholders run a closed corporation.
Also, these corporations are not publicly traded and benefit from limited liability protection.
These companies are sometimes called privately held companies and have more flexibility than publicly traded businesses.
The stocks are strategically allocated to the shareholders, who have complete control over business operations.
How do Closed Corporation Taxes Work?
Typically, a closed corporation is taxed like a C corp.
However, if the owners and shareholders choose to seek S corp status per the Internal Revenue Code, they are taxed twice.
Pros and Cons of a Close Corporation
Let’s look at the pros and cons of closed corporations.
- Shareholders enjoy limited personal liability
- Stocks are limited to select shareholders (sometimes the business owner chooses shareholders)
- More operational flexibility than other business structures
- There is less protection for shareholders investing in the company than S and C Corps.
- Corporate taxes can be high (if they are taxed twice)
The last type of corporation we’ll evaluate is a nonprofit corporation.
What is a Nonprofit Corporation?
Nonprofit corporations are organized to do any of the following kinds of work:
Nonprofit corporations must follow organizational rules and structures similar to C corps.
Also, these business entities must follow specific rules regarding what they do with the profits they earn.
How do Nonprofit Taxes Work?
Non-profits are eligible for certain tax benefits and multiple tax exemptions.
However, nonprofits must file with the IRS to take advantage of these tax benefits.
Pros and Cons of a Nonprofit
Here are some pros and cons associated with nonprofit organizations!
- They are exempt from several taxes commonly incurred by other business structures
- Their work benefits the public
- There are several special rules to follow
- They can’t distribute earnings to employees or political campaigns
- They must file for tax exemption
The last business structure is a cooperative.
What is a Cooperative?
A cooperative is owned and operated for the benefit of the people using its services.
Therefore, the earnings of the business are distributed among the members.
How do Cooperative Taxes Work?
Cooperative businesses are taxed like other types of business corporations.
However, one difference is that the IRS allows various deductions that would otherwise be taxable.
Pros and Cons of a Cooperative
Here are some advantages and disadvantages to cooperatives.
- Eligible for federal grants to launch the company
- Can obtain discounts on products and services for their members
- Forming a cooperative is complex
- There are filing fees to establish
How to Choose a Business Structure
Some aspects to consider before choosing a business structure include the following:
- Investment requirements
Let’s take a look!
Step 1: Consider Flexibility
Consider flexibility when choosing a legal structure for your business idea.
For instance, what type of growth do you envision?
Your legal structure must consider your day-to-day operations.
Also, your entity should promote growth, not hold you back from reaching your goals.
Step 2: Consider Liability
Next, think about liability.
How much liability coverage do you need when you’re starting your business?
Pro Tip from AJ: An LLC has excellent liability protection but fewer tax consequences than a corporation.
Step 3: Consider Taxes
Tax status and consequences are significant factors to consider.
Are personal tax returns and dedication more sensible? Or can your company handle double taxation?
Ensure your legal entity can handle the tax rules associated with its structure.
Step 4: Consider Investment Needs
Lastly, think about the capital your business idea demands.
Will your personal assets be enough to get your company off the ground?
Or do you need to sell stock to fund your company?
If you’re going to be seeking an investment, it might be best to talk with a tax professional about a C corp.
Final Thoughts on Business Structures
A business structure affects several things, including taxes, ownership, and liability.
An LLC structure is an excellent starting point because it protects you from various liabilities but taxes you like a sole proprietor.
What business legal structure will you choose for your company? Let us know in the comments section!