You are about to launch your own business. Congratulations. Entrepreneurship is exciting, it can be fulfilling, it can be lucrative, and it can be liberating. And along with the laundry list of positives that drive the most ambitious of us to take the reins of their own business, there is also an equally long list of choices to start making.
Yes, you’ll certainly be making plenty of decisions throughout the life of your business and one of the most important will come early: which business structure will you select?
Whether your business is a limited liability company (LLC), sole proprietorship, partnership, or corporation will impact countless aspects of your operations in the future, so selecting the legal structure best suited for you is nothing to gloss over. How you pay taxes, your available avenues for raising money, and your personal liability are just a few things that will be determined by which structure your business is built upon1. With that in mind, they’re the very things that should direct you in making this important decision.
Table of Contents
- What is Pass-Through Taxation?
- Which Business Structure is Right for Me?
- Sole Proprietorship
We might as well cut to the chase on how much money you will (or won’t) keep when operating your business. There is nuance within the subtypes of how LLCs or partnerships must be run, for example, which can influence the assets, profits, and losses an individual will account for on their annual taxes. Regardless, most of the following structures share what is known as “pass-through” taxation2.
Sole proprietorships, partnerships, and even S corporations are all considered “pass-through” entities3. This type of taxation simply means that any business profits will pass through to a business owner’s personal income, and therefore only be taxed once. As a business owner, your personal income and your business income will now be one in the same according to the IRS, avoiding double taxation4 and making it easier to keep track of (and hopefully keep) your income.
Of course, choosing the right business structure for you will require a thorough understanding of your options. It’s important to know there’s no universal “best” business structure, rather there is probably one that is best suited for your particular circumstances, skills, goals. limitations, resources, and so on. Meanwhile, another entrepreneur in your same field may be best served by an entirely different legal structure, from legal liabilities to how taxes are paid or even how profits are made available.
Let’s examine some basic characteristics that define different business structures:
A sole proprietorship is considered the easiest business structure to get up and running, which makes it appealing to entrepreneurs looking for the simplest modes of operation and start up. It typically involves securing any local licensing for your given industry and registering your company name. That’s about it. Costs are generally low and the process is efficient. And as you might guess by the name, it can only be owned and operated by one person.
In the eyes of some, the low costs and short list of formalities involved in creating a sole proprietorship can easily be offset by the liability it brings. As a sole proprietor, you and the business itself are viewed as one entity5. A sole proprietor is allowed freedom to mix business and personal assets but also carries the risk of unlimited personal liability for anything related to their business, potentially risking any of their assets in the process6.
A sole proprietorship is beneficial for:
- A business with only one owner
- A business with no employees
- A business that can operate with minimal legal risks
The structure of a partnership is very much aligned with what the name would imply. It is owned and operated by more than one person, with its owners sharing responsibility across all aspects of the business and in turn, sharing all profits as well.
How those profits, commitments and responsibilities are shared are, of course, up to each partner involved. There may be a 50/50 split of all financial and operational responsibilities, or perhaps one member brings a specific skill set to the operation while another contributes more to finances, and so on. The division of these roles can vary from business to business and is entirely dependent on the individuals involved and what they’ve outlined in their partnership agreement.
Legally, this structure is similar to a sole proprietorship in that the liability of the business is assumed by the owners, leaving all personal assets at risk to the business7. As you might have guessed from that, this means the actions of one partner have the potential to impose liability on the assets of another partner. For this reason, it can be useful to have a partnership agreement documenting a few of the following factors or simply answering these four questions:
- What is each partner’s investment in the business, both startup and ongoing?
- What circumstances might terminate the partnership?
- What happens to the business if one partner chooses to withdraw?
- What are the responsibilities and duties of each partner?
A partnership is beneficial for:
- businesses with more than one owner.
- businesses with more than one owner that can operate with minimal legal risks.
- businesses that won’t likely require money to be reinvested.
This structure is somewhat of a hybrid of the partnership and incorporated structures. A limited liability company (LLC) is an entity that exists separate from its owners, also known as members, therefore affording legal protections that will make it appealing to entrepreneurs and small businesses who want to keep their personal property or finances separate from those of the business. Surprise! This is where limited liability becomes integral to the name and structure.
Say, for example, a business is involved in litigation or is responsible for an unpaid debt — things that are pretty common with operating a business. Because the LLC exists separate from its members, the individuals aren’t held personally responsible for any orders or judgments against that business. As an LLC business owner, this means assets like your home or personal car won’t be at risk to debt collectors. It also means that unlike a partnership, an LLC with more than one member does not require its members to share financial responsibilities or burdens that may be created by another8.
Within the LLC structure, there are classifications like Professional Limited Liability Company (PLLC), in which some states require businesses to register specifically within a field that requires professional licensing9. There are also single-member and multi-member LLCs, which will dictate if the company has just one owner or multiple owners. This is something that should be outlined in the LLC operating agreement upon creation, which can affect factors like ownership interest, distribution of profits, and even how much tax liability each member carries for their portion of the business.
An LLC is beneficial for:
- businesses that may require changes in ownership and management
- businesses that won’t require equity funding from investors
- businesses that operate with potential legal risks and therefore, members who would benefit by protection from personal liability
The corporate structure is perhaps the most complex and is certainly the most intensive and expensive to create. Many corporations started out as a partnership, an LLC, or even a sole proprietorship, growing so profitable and so complex in their operations that they needed to be incorporated to receive new protections. This is why a majority of the most recognizable businesses and brand names you can think of are corporations.
From a legal perspective, think of a corporation as its own person, assuming protections and responsibilities just as an individual would10. From a business standpoint, this is attractive because it grants limited liability to a corporation’s shareholders, managers, employees, and so on. Like the LLC, a corporation’s debt is not the debt of its operators. And it profits without owners paying taxes on those profits, so the corporation itself is responsible for paying necessary taxes11. Corporations are also able to sell stocks (preferred or common), which represent a share of the business available to public investors and can, in turn, be leveraged for new business funds.
You’ve likely heard references to corporation subtypes, which sometimes gets lumped with the LLC structure as well. This is mainly because as mentioned, LLCs and corporations share the distinction of being treated as separate entities from their members. An LLC can even distribute a percentage of its ownership to new members as a means of fundraising, which is similar to a corporation selling shares in an initial public offering. But most often, S Corporations and C Corporations are the most common subtypes people refer to when observing corporations.
- are limited to 100 shareholders
- are taxed just once, with only their shareholders owing taxes on the income of their investment in the business
- grant shareholders voting rights within the company
- can have unlimited shareholders
- are taxed twice. The corporation pays taxes on its profits and the corporation’s shareholders also pay taxes on the income of their investments
- don’t grant voting rights to shareholders