So, you’ve decided on what type of business you’re going to start, and you’re ready to learn how to create your business plan. Wait! Before you create your business plan, you need to determine your business structure. What is a business structure? Simply put, a business structure is the specific type of legal entity you choose to file your business under with the government.
Your business structure will determine what type of tax forms you need to file at the end of your business year, and will also help determine your personal liability should your business fail or be subject to a lawsuit. Choosing the wrong business structure for your business can create an abundance of extra work for you in the form of paperwork that you might not need to file, and tax time implications that might cost you more money than is necessary for the type of business you own.
Choosing Between the Different Business Structures
For all of the reasons above, it is vital to learn how to choose a business structure that is just right for the type of business you are creating. Today we’ll go over some basic business structure types and talk about how you can determine which type of business structure is best for your individual business.
A sole proprietorship is the most basic type of business structure. Many smaller businesses operate as sole proprietorship. In a sole proprietorship, you alone are responsible for the business income, assets and liabilities. There is no legal action that needs to be taken to start a sole proprietorship. If you are earning income from a business in which you are solely responsible for, such as a lawn-mowing business, then you are already officially a sole proprietor. You will need to obtain any required licenses and permits that your state may require for your business; however no other legal forms are required to start a sole proprietorship.
If you choose to run your business under a business name, such as Grade A Lawn Mowing Service, you will need to file what’s known as a DBA (short for “doing business as”) with your state. Most state Department of Revenue websites have a search engine that will allow you to search your proposed DBA name before you file it with the state to ensure that no other proprietor has already taken that name. Once you’re certain that the proposed “Doing Business As” name of your business is available, you can file your DBA with the state.
Your state-filed DBA will allow you to use your business’ DBA to advertise, promote and care for your business. Once you’ve filed your DBA, you can also accept checks under your business name, yet still be able to file your business earnings and expenses on your individual tax forms at the end of each calendar year.
With a sole proprietorship, you and your business are one in the same, so your business income will be stated on your individual tax form, along with any other income you might have from an employer or other sources. Along with your standard 1040 form, you’ll use a “Schedule C” form to record any business income and expenses. Any profit from a sole proprietorship business will be counted as income on your 1040 form, and any business loss from a sole proprietorship business will be deducted from the income on your 1040 form.
Advantages of choosing a Sole Proprietorship business structure are:
- Ease/lack of expense to form
- Ease in preparing taxes at year end
- You maintain complete control over your business
Disadvantages of choosing a Sole Proprietorship business structure are:
- You retain unlimited legal responsibility for your business
- You are responsible for the sole burden of running the business
- Sole Proprietorships can be difficult to gain funding for should you need a loan
A Partnership is where two or more people share ownership of that business. Each partner shares both the responsibilities/duties of the business, and the profits/losses of the business. A Partnership type of a business structure should always include a legal partnership agreement that details the responsibilities and duties of each partner of the business. A partnership also details how business profits will be divided, how disputes between partners will be handled, and how a change in ownership will be handled from a legal perspective should one or more of the owners decide they want to separate from the business. A legal partnership agreement is not require by law as a part of a Partnership business structure, but it is a smart legal move when forming a business partnership.
There are three general types of business Partnerships: a general partnership, a limited partnership and a joint venture.
- A general partnership generally indicates that management duties, as well as profits and liabilities for the business, are split equally among all business partners
- A limited partnership allows for more flexibility in business management, allowing partners to structure their business so that one partner can have more responsibilities/entitlements to profits while another partner might have fewer responsibilities and entitlements.
- A joint venture would be a good choice for a business that wishes to work with a partner for a single project or limited amount of time.
To form a business structure under a Partnership, you’ll need to choose a name for your business and file the appropriate forms with your Secretary of State’s office. With a partnership structure, you must also be sure to file for the appropriate permits and licenses required for the nature of your business.
Partnerships also generally require the obtaining of a Federal Tax ID number for the business, as well as the filing of business tax returns at the end of the fiscal or calendar year that the business partners determine.
Advantages of choosing a Partnership for your business structure are:
- Generally easy and inexpensive to form
- Shared fiscal commitment
- The benefit partnering with others who have complementary skills
Disadvantages of choosing a Partnership for your business structure are:
- Shared responsibility for the business. This can be a disadvantage when a business partner makes unwise or illegal business decisions
- Potential for less income because profits are split among the partners
- Potential for legal troubles in the event of partner disagreements
A corporation, also sometimes known as a C-corp, is generally reserved for larger companies. A corporation is an independent company that is legally owned by shareholders, although the shareholders aren’t responsible from a legal standpoint for the actions and/or debts that the company incurs.
A corporation must be formed within the laws of the state in which the corporation resides/is registered. Certain forms, such as Articles of Incorporation, are required by the Secretary of State’s office in which a corporation wishes to be registered. Anyone wishing to start a corporation must also register with the federal government and obtain a Federal Tax ID number.
Corporations also require separate Federal tax forms to be submitted each year, usually a form 1120, 1120-A or a Corporate Income Tax Return. Depending on the state in which the corporation is registered, there can be bigger tax implications for a corporation than there would be for a sole proprietorship or partnership. C-corporations are some-times doubled taxed: taxed first when the company makes a profit, and then a second time when dividends are paid to shareholders.
Corporations are often formed for companies who wish to hire employees and eventually sell stock in the company.
Advantages of choosing a Corporation business structure for your business are:
- Limited legal liability to your personal assets
- The ability to generate business capital via loans or other funding
- Corporate tax benefits and deductions
- Presenting a more professional business to potential employees
Disadvantages of choosing a Corporation business structure for your business are:
- Complication of starting the business due to forms and legal requirements
- Potential corporate tax disadvantages due to double-taxation
- The extra time and money it will take to own and run a corporation
Another type of business structure under the Corporation umbrella is called an S-Corporation. The main benefit of an S-corp is that it can help business owners avoid double-taxation by allowing the business tax return to pass through the owner’s personal tax return. To learn more about the S-corporation and if it might be a good business structure choice for your business, check out the U.S. government’s Small Business Administration .
Limited Liability Company (LLC)
A Limited Liability Company, or LLC, can be a great option for business owners as it features limited personal liability in the event of a business failure like a corporation does, yet offers the flexibility of operating as a partnership.
The owners of a Limited Liability Company are technically referred to as members. Depending on which state the LLC is filed in, a “member” can be a sole owner, two or more partners, a corporation, or another LLC.
Whereas with a corporation, profits and losses are treated as a separate business entity, LLC profits and losses are passed through the business to each member of the LLC. Members of an LLC treat profits and losses of that LLC just like they would if the business were a partnership.
An LLC is filed a bit differently with each state, but generally, members forming an LLC would:
- Choose and register a business name
- File Articles of Organization, which records the business and its members officially
- Create an Operating Agreement (not generally required but highly recommended for the protection of members)
- Obtain any required licenses and permits for the specific business
Since a Limited Liability Company is not a separate tax entity, the business itself is never taxed, at least not on a federal level. Instead, all profits and losses are passed through the individual tax filings of each member of the LLC. Some states, however, do tax income on an LLC.
Advantages of choosing a Limited Liability Company structure for your business are:
- Limited legal liability should the business fail or be sued
- Ease of operation , including less paperwork and start-up costs
- Flexibility in the sharing of profits, based on how the LLC is set up
Disadvantages of choosing a Limited Liability Company structure for your business are:
- Limited life of the LLC – in some states, an LLC must be dissolved if one member leaves the business
- Self-employment taxes – Because members of an LLC are considered self-employed, the entire net income of the LLC that is passed on to members is subject to self-employment tax contributions
Combining a Limited Liability Company with an S-Corp
At times, it is possible to request an S-Corporation status for your LLC or Limited Liability Company. With this status, your company would still be considered an LLC, but would be treated for tax purposes as an S-Corporation. This type of tax structure is something that should be considered with the help of an attorney who can help you assess the pros and cons of such a move in relation to your particular business.
Starting a business can be a big project, and learning how to choose a business structure can be an even bigger project. By educating yourself and any business partners on the details regarding choosing a business structure, and by seeking legal help when needed, you can be assured that you will choose the right type of business structure for your new and growing business. Choosing the right type of business structure for your business is a vital part of helping to ensure that your business functions for optimum growth and profit.
Becoming an entrepreneur can be an exciting adventure when done with the knowledge you need about the basics of owning and operating a business. Fortunately, there are many resources available online and in your local library that can help you get that knowledge.
For more information on business structure types, on how to file for a business structure, and on how to choose the right business structure for your business, you can visit the U.S. Government’s Small Business Administration website at www.SBA.gov.