Fact checked for accuracy by Billie Anne Grigg, a bookkeeper and Mastery Level Certified Profit First Professional.
As you embark on your entrepreneurial journey or business venture, you must decide on the ideal business structure. There are a lot of choices to accommodate different needs. Let’s dive into what you need to know about each one. As you study each option, envision which structure allows you and your business to flourish.
A sole proprietorship is the simplest, most cost-effective business structure. It’s good to know about them when researching which is the best business structure. Considered one of the most popular ways for entrepreneurs to start a business, it is an unincorporated entity run by one person.
With this business structure, there is no difference between the owner and the business. The sole proprietor is 100% responsible for the business profits, losses, liabilities, and debts.
Depending on your industry or line of work, you might need to hold a license. To make sure you have your bases covered, feel free to check out this guide to understand what you might need to operate legally.
Advantages of Sole Proprietorships
One of the first advantages of a sole proprietorship is the minimal paperwork. Other business structures involve registering with the state government to get operations up and running. However, a sole proprietor will begin through the normal course of doing business. Unless however you want to run the business under a different name than your own. Some states will have you register a trade name if you decide to do business under a name other than your own individual name.
With sole proprietorships, you can also expect fewer business fees.
For sole proprietors who operate on a tight budget, this is an attractive feature. Because sole proprietorships do not have to register with the state, they also do not have to pay the yearly fee to hold a registration.
Sole proprietorships also come with a much more straightforward tax setup. The other business structures must submit an application to the IRS for an employer identification number (EIN), whereas sole proprietorships do not have to do that. However, some sole proprietors choose to get an EIN so their SSN isn’t exposed on W-9s and other documents.
Disadvantages of Sole Proprietorships
One of the first disadvantages of a sole proprietorship is that it is much more difficult to obtain credit and financing. Banks and other financial institutions prefer to work with more established entities.
Because a sole proprietor operates on its own, there is no liability protection. Sole proprietorships do not need to register with the state, which means they do not receive the benefits of protection that come with owning a legal entity. Sole proprietorships can get liability insurance, but their personal assets remain at risk.
A common problem that sole proprietors face is the challenges in selling the business.
When the company links directly to a person, it makes it difficult to hand down or sell the business to another individual. If the owner passes away, the business will terminate immediately unless you designate someone else to run it.
Limited Liability Company
A limited liability company (LLC) is a business structure that offers your business legal protection without the expense and hassle of starting a corporation. File paperwork for the organization, pay a small fee, and you’re ready to go. You don’t even need to hire a lawyer.
Types of LLCs
The broad definition of an LLC sounds pretty simple, but there are several different types you can form. Be sure to understand the differences, so you know what will work best for your business. For steps on how to form one, read our guide on how to start an LLC.
A single-member LLC is the most popular option for individuals who want to form a business and protect their personal assets. You can use your social security number without needing to form a separate employer identification number (EIN) from the IRS, although most LLCs will want to get an EIN though.
Multi-member LLCs are for businesses that have two or more owners. Because you have several people involved, you’ll want to draft paperwork that clarifies the structure of the company, including titles, duties, and how to dissolve the business.
When you form an LLC, you’ll file paperwork in the state where the business operates. If everything takes place within one state, then you’re classified as a domestic LLC and only need to follow your state’s guidelines.
A foreign LLC means you’re doing business across state lines. You can base your LLC out of one state that has the best tax benefits and operating fees. After filing your paperwork in the state of origin, you register as a foreign entity in each additional state where you’ll conduct business.
A series LLC breaks your business down into independent units. For example, you can have assets and operations function separately. They’ll each have their own name, records, and bank account. Real estate investors benefit from series LLCs because what happens with one property can’t impact any other properties the investor owns.
You can’t form series LLCs everywhere; they’re limited to certain states, including:
- Puerto Rico
If your state doesn’t allow you to form a series LLC, you can form it in a different state and register it as a foreign LLC in your home state.
A professional LLC is designed for some businesses that require professional licensing to operate, like doctors and lawyers. You can read our entire guide on how to start a professional LLC for more information.
Advantages of LLCs
Forming an LLC can give your business more credibility than a sole proprietorship. Instead of running a company under your own name, you’re using a business name that looks more legitimate.
Another major advantage an LLC offers is legal protection and limited liability. You’re typically not held liable for any debts or lawsuits brought against your business. Assets like your house, car, and individual bank accounts are off-limits from collections. Unless of course you are not operating your LLC correctly and pierce the corporate veil.
Because you’re not forming a corporation, it’s simple to run an LLC. You don’t need to have a board of directors or other shareholders involved in your business.
This makes it easier to run an LLC than a larger company. No matter how many owners you have, they are all typically involved in the day-to-day aspects of running the business.
With owners so active in the business, LLCs are eligible for a pass-through business tax. Your personal tax rate applies to any profits the company makes. You file a Schedule C with your own tax return, which gives you a tax deduction of up to 20%.
Disadvantages of LLCs
Personal protection and tax deductions make LLCs an attractive option, but there are some disadvantages as well.
As an LLC, you have to pay state taxes annually. If you don’t, the penalty can be very expensive. Requirements vary by state, but in general, you must pay any taxes personally since an LLC is a pass-through business.
If your LLC has employees, you have to pay employer taxes to the IRS and possibly to your state. Otherwise, you have to pay quarterly self-employment taxes. You can calculate these payments based on projected earnings for the year.
LLCs are less complicated than corporations, but this comes with some restrictions. You can’t issue shares of stock and any outside investors that you bring in will become partial owners in the company. This could potentially limit your business’s growth.
For more on the pros and cons, head over to our full article on LLC advantages and disadvantages.
When the state recognizes a business as a legal entity apart from its owners (or shareholders), it is a corporation. Multiple entities or individuals can own a corporation. The transfer of ownership is quick through the selling or buying of stock. So, is a corporation the best business structure for you? Let’s break it down.
Types of Corporations
The concept of a corporation can be complex. Therefore, it is critical to understand the different types of corporations before assembling one.
The S corporation is an entity that transfers all its financial affairs to the shareholders. These finances span from tax deductions, income, losses, and credits. Because of this setup, the S corporation can retain corporate benefits while paying taxes the way a partnership would.
The C corporation is like the S corporation because it can also be a corporation, partnership, or LLC. The company profits are also taxed separately from the owner’s profits, among other tax benefits. C corporations are different in that they can have shareholders of all backgrounds, including employees.
A non-profit corporation has all the components of a standard corporation, but it does not exist primarily to produce a profit. It is possible for a non-profit to show a profit, though…it just isn’t taxed on the profit. This type of business entity must form to support a cause. A non-profit can also earn funding from private and public donors, grants, and other corporations.
Advantages of Corporations
One of the first advantages of a corporation is long-term business security. Because ownership is reflective of a stock percentage, it is much more flexible in conveying ownership. Therefore, the business can endure in the long term.
Access to funding and capital is another key advantage of a corporation. Many corporations gain funding by selling stock, which is available to the public. No other business structure has this access to funding like a corporation, which makes it an excellent advantage for scaling a business.
There is also personal liability protection within the corporation’s business structure. If the business gets sued or faces legal trouble, the shareholders typically aren’t held responsible. Even if the company does not have the funds or assets to repay, the structure protects shareholders.
Disadvantages of Corporations
The complex application process is one of the biggest disadvantages for a corporation. Filing for the article of incorporation is usually quick, but the incorporating process can drag out. There is a lot of documentation involved in outlining the ownership and organization.
Many corporations will also have to deal with double taxation. This concept is when the business pays taxes at both the shareholder and entity levels. Some companies will get around this by forming an S corporation instead.
Corporations also have tight protocols, structures, and formal policies. The application process is extensive, but it also requires a lot of time and resources to maintain the entity.
To retain the corporation status, the business must follow strict regulations and guidelines, including bylaws. The corporation must also keep a board of directors, coordinate yearly meetings, and develop annual reports.
A partnership is a business entity shared by more than one owner. It does not legally need to register with the state government. However, if you elect to partner with another person and go into business, you are operating in a partnership. Some partnership formations are legal entities, which come with liability protection.
Types of Partnerships
When you decide if a partnership is right for you, you must evaluate the different types of partnerships:
- General partnership – considered one of the simplest partnership forms, all partners have individual influence to bind the company to loans and contracts. This option does not need to register with the state government.
- Limited partnership – a formal business structure that registers with the state. One general partner will be responsible for the company, while one or more partners deliver resources or money.
- Limited liability partnership – this structure is much like a general partnership, but it has limitations on everyone’s actions.
Advantages of Partnerships
When you go into a partnership with someone, you can gain critical expertise. There is a good chance the other partner knows something that you do not. Collectively, you could achieve more by covering each other’s weaknesses.
A partnership also offers more access to cash. Perhaps you could bring the brainpower and hard work into the relationship while the partner brings a lot of cash or capital. Maybe one partner has a network of connections, and you have the expertise to carry out the product development or service. Striking this balance could attract investors and gain even more cash for the business.
A partnership could also enable you to explore new business ventures and customer acquisition opportunities. The other partner may not boost your productivity in what you already do, but he or she could free you up with more time to explore new business opportunities.
Disadvantages of Partnerships
One of the first advantages of a partnership is a liability. When you share assets and profits with the partner, that also includes business debts and losses. This business structure could add pressure to your assets and finances.
Partnerships can also bring on emotional problems, arguments, and loss of freedom.
When you partner with another business owner, you do lose a portion of total control within the company. While both professionals want to be successful, they each may have a different idea of how to get there. These differences can bring on emotional issues.
If one partner wants to sell the business and the other one does not, a partnership could complicate this process too. One way that business partners will proactively address this is by integrating an exit strategy into the company’s plan.
How to Choose: Formal vs. Informal Business Structures
As you form your business, you must address the question of whether you want to establish a formal or informal business structure. Each has its advantages, but it is key to know the difference.
In a formal organization, a written document outlines company divisions and management. There will be organizational charts, policies, procedures, and close rules to follow. There is usually a hierarchy with a CEO, president, or executive leaders toward the top. It also may include middle and lower-level managers.
With an informal organization like a sole proprietorship, there are way less regulations. If the disadvantages discussed above don’t seem like scenarios you would encounter in the future, an informal setup might be better for you.
Business Structure FAQs
What is the best business structure for a small business?
Most small businesses begin as limited liability companies. This structure is the most attractive option for this situation if:
- You will not need to gain funds from investors
- You need simplicity to get the ball rolling
- You will reinvest your profits back into the business
Which business structure is the cheapest to form?
The sole proprietorship is the cheapest business structure to form. There is no paperwork required, and you do not need to register with the state.
Can I change my business structure?
If the business structure you choose does not work out for your needs, you can always pivot to a different option. Depending on your current company structure, there is always a path to convert to another.
The Last Word
There’s a lot to consider when deciding on the right structure for your business. Whether you go with a simple single-member LLC, C-corporation, a quick and easy sole proprietorship, or something else entirely, just make sure to think through the pros and cons for where you want to take your business.
Filed under: Advice Columns