Types of Business Structures. How to Make the Right Choice?
What is a Business Structure?
A business structure is a legal representation that defines the owner(s) and the formula for profit sharing among stakeholders. Examples of business structures: sole proprietorships, partnerships, corporations, LLCs, and cooperatives
Before you start a business, choose the right structure that suits your needs. Are you better served as a sole proprietorship, partnership, corporation, cooperative, or limited liability company (LLC)? What are the benefits and cons of each?
Choosing the right structure is crucial for business success. Although you can change it at any point, you want to avoid making a carefree choice. Why? Your initial choice can lead to tax consequences and put your personal assets at risk.
Read on to learn which structure provides the best legal cover and benefits for your business.
What is a Business Structure?
A business structure is a legal representation that defines the owner(s) and the formula for profit sharing among stakeholders.
The requirements for registering any example of business entity depend on the type of structure chosen. No business can legally function without a structure.
Your business structure determines the activities your organization can perform. For example, a sole proprietorship can legally mix personal and business assets, an action a partnership cannot do.
Before choosing a structure, provide honest answers to these questions.
- How do I intend to raise capital?
- Do I want to share control?
- Do I need liability protection?
- How can I reduce my business tax?
- What are my future business needs?
|Comparison Criteria||Winner Structure||Loser Structure|
|Business Control||Sole Proprietorship||Corporation|
|Capital Investment.||Corporation||Sole Proprietorship|
|Business Growth||Corporation||Sole Proprietorship|
|Limited Liability||Limited Liability Company (LLC)||Sole Proprietorship|
|Taxation||Limited Liability Company (LLC)||Corporation|
Common Business Structures
A business structure impacts an organization's day-to-day operations, taxes, and liabilities. Whatever structure you choose, ensure it provides an adequate balance of legal protection and flexibility.
There are different business structures:
1. Sole Proprietorship. Best for Low-Risk Small Businesses.
A sole proprietorship is the easiest business structure to set up. Only one individual is responsible for the business's day-to-day activities. This structure is ideal if you want to run your business as a one-person army.
However, running a sole proprietorship has some risks because it’s not a separate business entity. The owner is liable for its financial obligations, including debts, losses, and taxes.
Sole proprietorships are suitable for low-risk small businesses. Some sole proprietorship examples include:
- Retail Businesses.
- Independent Freelancers.
- Housecleaning Businesses.
- Catering Services.
- Tutoring Services.
- Photography Businesses.
- Plumbing Services.
Running a sole proprietorship structure is cheap compared to others. You pay the lowest registration fee. The only costs are business taxes you pay as personal income tax and operating license fees.
Anybody can be a sole proprietor. There are no requirements such as shareholder meetings and elections.
A sole proprietorship is perfect if you want complete control over all its activities. But you should be ready to deal with the restrictions and limited legal protections that come with it.
Pros of Sole Proprietorship
- More Control: A sole proprietor controls the business and enjoys all its profits. There is no board of directors or partners to consult before making decisions.
- Easy Setup and Low Cost: Forming a sole proprietorship is easier than other structures. The requirements are minimal, you need less paperwork, and the registration costs are low.
- No Corporate Taxes or Pass-Through Taxation: A sole proprietorship doesn’t pay Corporate Income Tax (CIT). Instead, the owner reports the business income or loss and pays Personal Income Tax (PIT) on earnings.
Cons of Sole Proprietorship
- Unlimited Personal Liability: Sole proprietors are personally liable for all business debts. They bear the losses and face the creditors.
- Difficult to Raise Money: Business owners struggle to raise long-term capital with this structure. Banks are reluctant to grant loans or credit lines to sole proprietorships. Although there are several small business loans without credit checks you can get, their interest rates are usually high.
2. Partnership. Suitable If You Have Business Partners.
A partnership has two or more business owners. Like a sole proprietorship, it doesn’t exist as a separate legal entity from its owners. All the individual partners in the partnership business structure add up to a single person (head) for legal reference.
There are three partnership business structures:
- General Partnerships (GP)
- Limited Partnerships (LP).
- Limited Liability Partnerships (LLP).
Every partner in a general partnership shares equals business responsibilities and liabilities. The action of a partner affects others. For example, if a partner signs an agreement without informing others, they must honor it.
A general partnership involves unlimited liability. If the business fails to meet its financial obligations to creditors, it can seize partners’ personal assets. General partners have no legal protections against business debts.
Every partner is responsible for filing their individual income tax returns because there are no taxes on the partnership.
Pros of General Partnerships
- Easy to Create and Dissolve: The requirements for creating a general partnership are minimal. Once a partner pulls out of the partnership, you can easily dissolve it.
- No Corporate Tax or Pass-Through Taxation: Partners do not pay corporate tax. Instead, they file their personal tax returns.
- Expertise: General partners bring their expertise to the table. They play active roles in business operations.
Cons of General Partnerships
- Unlimited Personal Liability: The action of a partner affects others. If the business gets into debt, partners are liable. They can be sued and have their personal assets seized to pay business debts.
- Management Issues: Disagreement could arise over deals and the business's direction among partners.
Limited Partnerships (LP)
A limited partnership includes a general partner and several limited partners. The general partner has unlimited liability over the affairs of the organization. This individual is responsible for all business operations and is personally liable for debts.
On the other hand, limited partners have limited control and liability. These partners are primarily investors enjoying a share of profits but have little control over business operations.
In terms of taxation, general partners pay self-employment taxes on their profits.
If the limited partners are individuals, they get taxed on their partnership income based on personal income tax rates. On the other hand, if they are companies, their partnership income gets taxed at the corporate tax rate.
For instance, three friends, Harry, Joel, and Jacob, set up a limited partnership. Harry is the general partner, while Joel and Jacob are limited partners investing $75,000 each.
While Joel and Jacob get a share of the profits, Harry is the only one who actively runs the business. If Harry fails to pay creditors and suppliers, Joel and Jacob are not liable for any business debt.
Limited partnerships are popular in several sectors:
- Real Estate Companies.
- Small and Medium-Scale Companies.
- Manufacturing Firms.
- Production Companies.
Pros of Limited Partnerships
- Huge Capital Investment: Limited partnerships enjoy large capital investments due to the multiple partners involved.
- Limited Liability: Limited partners are only responsible for the money invested in the partnership. They are not personally liable for business debts.
Cons of Limited Partnerships
- Heavy Burden on the General Partner: The general partner is personally liable for business debts. They can be sued and held accountable if the business fails to pay its debts.
- Limited Partners Can’t Contribute to Business Decisions: Limited partners enjoy limited liability, which means they don’t have a complete say in business decisions.
Limited Liability Partnerships (LLPs)
A limited liability partnership is a business legal structure where all partners have limited liability. Every partner is accountable for their actions. Other partners aren't responsible if other partners take loans.
Some common business types that fit as LLPs include:
- Accounting Firms.
- Dental Offices.
- Marketing Firms.
- Law Firms.
- Financial Advising Businesses.
- Physician Offices.
Pros of Limited Liability Partnerships
- LLP Protection: An LLP is a separate legal entity from partners. Individual members are not at risk of losing their personal assets in the event of bad debts. They are only liable for the amount they invested in the partnership.
- Easy Registration Compared to LLCs and Corporations: The requirements for registering an LLP include creating a partnership agreement, state registration, and paying a filing fee. You don’t have to form a board of directors or articles of incorporation.
Cons of Limited Liability Partnerships
- Public Disclosure of Earnings: There is no privacy around earning records with LLPs. They must submit their business accounts, including records of partners’ earnings.
- Not Recognized Everywhere: Some states don’t recognize LLP as a legal business structure, while some limit it to professionals such as lawyers, accountants, and doctors.
3. Corporation. Best for Complex Business Operations.
A corporation runs as a separate legal entity independent of its owners. Under the law, a corporation is an imaginary legal person. It can perform multiple business actions such as enter contracts, own assets, sue and be sued, pay taxes, and loan and borrow money.
Corporations offer the best-limited liability protection. Shareholders or owners are not liable for any decision made by the corporation. For instance, owners' assets enjoy protection if the corporation has business debts.
Setting up a corporation can be tasking. Owners file articles of incorporation containing the business purpose, name and location, and shares issued.
Shareholders meet annually to elect a board of directors. The board is responsible for executing the business plan and setting up a management team to oversee its activities.
However, the board is not liable for the corporation’s debts. But they can be personally liable for neglected responsibility. For example, if the board of directors fails to perform their duties and causes the corporation to suffer losses, you can sue them.
Unlike sole proprietorships and partnerships, corporations pay federal and state taxes at corporate tax rates. Shareholders have to disclose their dividend payments when filing their personal income taxes.
There are three corporation types:
- C-Corporation: This legal structure taxes the shareholders and corporation separately. It pays tax on corporate profits before sharing dividends with shareholders. There are no restrictions on the number of shareholders that can join a C-corp.
- S-Corporation: A S-corp is a tax status designed to protect the small business owner from double taxation. In this scenario, the company passes profits and losses on its owner’s personal income to avoid paying corporate taxes. S-Corporations can only accommodate up to 100 shareholders.
- Nonprofit Corporation: This legal entity is formed for social purposes other than profit. Nonprofit corporations receive tax-exemption status. They don’t pay federal income taxes under the Internal Revenue Code. Examples of nonprofit corporations include the Bill and Melinda Gates Foundation and the Chamber of Commerce.
Corporations are suitable for medium to high-risk businesses.
Pros of Corporations
- Protection Against Personal Liabilities: Shareholders are not responsible for the legal liabilities and debts incurred by the corporation.
- Raising Capital through Stock Sales: Corporations offer owners the opportunity to sell stock to raise financial capital for the business.
- Stock Options for Employees: You can offer stock options as an added incentive to attract the best talents available.
- Easy Ownership Transfer: A shareholder can easily sell their shares in the stock market and profit from it.
Cons of Corporations
- Time-Consuming and Expensive Registration: The filing process for corporations is time-consuming and expensive, requiring tons of paperwork.
- Double Taxation: C-Corporation, the most popular type, opens you up to double taxation. The corporation first pays federal income taxes on profits, then pays shareholders' dividends, subject to taxation.
4. Limited Liability Company (LLC). Best for Limited Personal Liability.
A limited liability company runs a hybrid business structure combining partnerships and corporations' best characteristics. Owners enjoy the personal liability protection of a corporation and the pass-through taxation benefit of a partnership.
Limited liability companies can choose not to pay federal taxes directly. Instead, they report the company’s profits and losses when filing their personal tax returns.
Owners set up an LLC operating agreement that provides directions on ownership and business operations.
An unlimited number of shareholders can make up a limited liability company. Although business entities can become shareholders in an LLC, banks and insurance companies are the only exceptions.
An LLC business structure works best for medium or high-risk businesses. Examples of business types that are suitable for the LLC structure:
- Boutique stores
- Coffee shops and cafes
- Family-run grocery stores
- Gyms and workout facilities
Pros of LLCs
- Tax Advantage – Pass-Through Taxation: Running an LLC allows you to choose different tax treatments. Owners can avoid double taxation by passing the company’s profits and losses to their personal income taxes.
- Liability Protection: LLC protects shareholders from liability for the business’s debts and actions. For example, if the company has bad debts, creditors can sue the company but not the owners. The court can order the sale of the company’s assets but not the owners’ assets.
- Simplicity and Flexibility: LLC is a fairly easy legal entity to set up. There are no requirements to create a board of directors for the company.
Cons of LLCs
- Expensive to Run: LLCs are more expensive to set up and run than sole proprietorships. You have to fill in more paperwork, such as articles of organization, operating agreements, and tax forms.
- Attractiveness for Investors: A LLC doesn’t have the same investment pull for investors as a corporation.
5. Cooperative. Best for Individuals and Businesses with the Same Goals.
A cooperative is a private group of small businesses gathering resources together for its members benefit. Member-owners own and control the cooperative and use its products and services. They are the owners and the customers.
There is a clear difference between a cooperative and a conglomerate. A cooperative involves independent businesses uniting to achieve a common goal. On the other hand, a conglomerate involves multiple brands operating under a parent company.
Every member of the cooperative has direct control over its activities. The cooperative is a separate legal entity from its members. A board of directors usually runs cooperatives, and officers get elected into different positions.
You have to buy shares in the cooperative to be a member. However, with other business structures, you can own a part of the company without using its products.
For example, you can buy shares in Coca-Cola without buying its products or contributing to its day-to-day operations.
However, you must buy the cooperative products to own shares and actively contribute to its running.
There are several reasons why business owners create a cooperative:
- Split costs for inventory.
- Share employees and wages.
- Increase purchasing power through bulk buys.
- Jointly process goods.
Examples of businesses that can benefit from forming a cooperative:
- Retail outlets.
- Credit unions.
- Insurance companies.
- Utility companies.
Pros of Cooperatives
- Less Taxation: A cooperative business doesn’t pay corporate tax. Members pay the tax directly on the income received from the cooperative.
- Unique Funding Opportunities: Cooperatives enjoy massive funding from members. There are state and federal government grant programs that provide support for cooperative startups.
- Equity in Management and Democratically Organized Structure: Every member in a cooperative gets a single vote even if they contributed more than other members. All members are actively involved in decision-making and management.
- Reduced Costs: One of the main reasons owners form cooperatives is to reduce their operation costs. Group owners sharing the same interests pool their resources to make bulk purchases and lower production costs.
Cons of Cooperatives
- Lack of External Investors: Cooperative runs on members' contributions. External investors are only eligible if they want to become active members.
- Slow Decision-making Processes: Decision-making in a cooperative business can be slow because of the requirement to consult every member. Every member has an equal voice.
How to Choose the Right Business Structure
The structure you choose influences your business operations. It influences your tax rates, control, fundraising abilities, and personal liability for the business’s actions.
Before choosing the right business structure, here are some factors you need to consider.
Note: We advise you to consult professionals because you will always have questions when starting a business or doing it. These days many online legal services offer a free consultation on choosing a structure, opening a company, and making a business plan. Use this opportunity.
1. Control. How Much Control Do You Want to Have Over Your Business?
Sole proprietorship and LLC are ideal if you want complete control over your business activities.
Partnership, however, gives you limited control according to the partnership agreement. Set up a corporation if you want to own a part and have limited control over the business. The board of directors approves all major business decisions.
Full control over a corporation is possible if the individual has the majority of the voting power.
2. Capital Investment. How Much Capital Investment Do You Need?
A corporation is the best structure for attracting funding from banks, investors, and venture capitalists. It can sell shares to secure extra business funding.
Sole proprietorships, partnerships, LLCs, and cooperatives face difficulty sourcing funds from external sources and do not have stock (shares).
3. Flexibility. Which Legal Structure Allows Your Business to Realize its Full Potential?
What are your short-term and long-term business goals?
Before you make your choice, write your business plan and check which structure best suits your objectives. The best structure is the one that can support your business growth and changes with no limitations.
Sole proprietorships and partnerships are easier to start but have small growth potential. On the other hand, corporations and LLCs are harder to start but have wider business perspectives.
4. Simplicity. A Simple or Complex Structure?
Do you want a simple structure with restrictions or a complex one with freedom? A sole proprietorship is the simplest structure to run. The only requirement is to register your business name, report profits or losses, and pay personal income tax.
A partnership is not as simple as a sole proprietorship but less complex than a corporation and LLC. Partners need to sign a partnership agreement showing the profit-sharing formula and the distribution of roles.
Corporations and LLCs are the most complex business structures to set up. There are many state and federal government requirements, including corporate tax obligations.
5. Liability. How Much Personal Liability Do You Want to Carry for Business Decisions?
A corporation or an LLC is your option for the least liability. Both structures are legal entities separate from their owners. The owner's personal assets are safe if creditors sue the corporation for unpaid debts.
A sole proprietorship business structure doesn’t provide any cover for its owners. Their personal assets are in danger in the event of a court case.
On the other hand, a partnership shares the business liabilities among partners.
6. Taxation. How Do You Want to Pay Your Taxes?
C-corporations pay corporate taxes since they are separate entities from their owners. Shareholders also pay taxes on their dividends.
Sole proprietorships, partnerships, S-corporations, and LLCs, offer tax benefits. They enjoy tax-exempt status for corporate tax. Instead, they pass their profits directly to the business owners. Owners then pay income tax on their profits.