The Small Business Guide to Understanding Business Structures
Business structures aren’t a one-size-fits-all type of thing. Just like every human is unique, so is every business. Imagine if everyone tried to fit into only one pair of jeans. A cut that might look great on some people, might look terrible or not even fit someone else.
Business structures are the same way. A 5,000 employee tech company and a local bakery probably shouldn’t be squeezing into the same business structure. There are a lot of structures to choose from. And between entities and limited liabilities, choosing the right business structure can seem overwhelming. This guide is here to make it easier for you. Let’s break it down.
Picking The Right Business Structure
The business entity structure that works best for you depends on two key factors. First, the amount of individual or personal risk you are willing to take on. And second, the tax implications of the structure.
Let’s look again at the company with 5,000 employees versus the 10 employee company. The 10 employee company will require less money and it’s not as complex. So, a simpler business structure would be fine. But the company with 5,000 employees—you can imagine the complexities that come with that. Your decision is also affected by whether you plan on creating the structure yourself or hiring someone to do it for you.
There isn’t always one business structure that is better than the other. It all depends on your business and what’s most important to you as an owner. Let’s check out the different options you can choose from.
The Pros And Cons Of Each Business Structure
If you’re doing things solo, this could be for you. Like it sounds, a sole proprietorship involves a single person running the business. Restaurants, plumbing businesses, even consulting firms can be sole proprietorships. This is the simplest form of legal business structure, plus it’s easy to launch and maintain.
Few people get excited about filing tax returns. Sole proprietors can report business income and expenses through an individual tax return. There’s no need to file a separate business return! The big benefit here is that any business losses you have will deduct from your income, meaning you may owe less taxes.
It’s not all good news, unfortunately. When you’re a sole proprietor, it’s all about you. It sounds nice, until something bad happens. Any business liability that arises can come back on you. If your business loses money, you will likely have to pay up. Your personal assets—like your house and vehicles—may be at risk. And if a customer sues you, there’s more bad news—you’re personally liable for this.
Another disadvantage happens with funding. Sole proprietorships aren’t very attractive to banks. No matter how awesome your business is, it could be harder to get the loans that you need to start.
If you’re teaming up with others to launch a business, a partnership may be the best way to go. There are two types of partnerships: general and limited.
With a general partnership, you and your partner(s) will be responsible for managing the business. You’ll also share responsibility for debts and liabilities that come up. This works the same as with a sole proprietorship, but now you’ll share the wealth and risk with your partners. A general partnership can be a big benefit, especially when it comes to taxes. Partnerships don’t pay taxes on income—the individual partners do. Income gets to pass-through to the partners who then claim this income on their personal taxes. This can cost you on your personal tax deduction, but it’s better for the business taxes.
With a limited partnership, you will have both general and limited partners. General partners run the business. Limited partners contribute funding. But, limited partners can’t participate in management. It’s not a commonly used form of business structure because of this.
The big difference in partnerships is that you’re not alone—both in wealth and risk. In a partnership, you’re not just responsible for yourself and any debt or liability you may create. You’re also on the hook for what your partner, or partners, do! Each partner can take out loans, make promises to customers, and make decisions that impact the business. This can be good or bad.
Partnerships can complicate managing from an administrative standpoint. They need more legal and accounting resources than a sole proprietorship.
Corporation (or C-Corporation)
The corporate structure setup comes with some big benefits from both a tax and liability standpoint. Corporations are standalone business entities, separate from their owner, or owners. Let’s put it simpler: In a corporate structure, you won’t be personally at risk if the corporation gets into financial trouble. Better yet, the corporation can keep the profits. This means that the owner(s) won’t have to personally pay taxes on those profits.
A corporate structure is also a good thing for raising money—both from banks and investors or by issuing stock. However, you won’t be the sole owner, and bringing in co-owners can complicate things if you’re used to flying solo.
But, even the best come with their faults. Forming a corporation can be a costly, time-consuming, and confusing process. It’s not usually something you can set up yourself, so get ready to have your accountant, attorney, or both on speed dial. They can set it up and make sure you’re following the rules as well.
Another downfall is that you’ll face the possibility of being taxed twice—once as a corporation and again as an individual. Shareholders in the corporation are responsible for paying taxes on any dividends, or profits, they receive.
Let’s look at a bit of workaround here: You can pay yourself through the corporation, which will then reduce the profits of the corporation. But, these maneuvers can be complex and costly. No one enjoys getting audited, so you need to have everything done correctly.
For small business owners, you can still roll in the corporation’s benefits. There’s an alternative to the C-Corporation just for you—the S-Corporation. It’s designed especially for small businesses. S-Corps provides some of the same benefits as a C-Corporation, but it’s not as complex or costly to start.
What you make and lose from the S-Corporation will be passed on to shareholders. They then include this on their personal tax returns. Another benefit? You can have up to 100 shareholders, which boosts your ability to raise money when you need it.
Limited Liability Company (LLC)
LLCs are fairly new in the world of business formats. Think of them as contemporary business structure. A Limited Liability Company combines the benefits of partnerships and corporations. And just like its name, it limits the liability for a company. Even better, LLCs also let owners pass earnings and losses to their personal income filings.
Let’s look at the one important difference between an S-Corp and an LLC. LLCs don’t have any limits on the number of shareholders they can have—the more the merrier—unlike S-Corporations’ 100 shareholder limit.
Limited Liability Partnership (LLP)
They may have only changed one word, but it’s one big change. The difference between an LLC and a Limited Liability Partnership is that LLPs cover more than one person. In an LLP, all partners have limited liability. Additionally, they can put debt and expenses on their personal taxes.
For future reference, we’ve simplified the pros and cons of each:
Choose What Works For You
Keep in mind: Once you’ve made a decision and established your business entity, you’re not stuck with it. You may decide that you want to change your structure as your business expands, which is a common approach.
Study the differences between each business structure before making a decision. Because there are multiple options for your business, it’s wise to get help from an attorney, accountant, or both. They can help ensure that you’re protected from potential liability.
In the end, you know what’s best for your business! And while the structure will affect your personal liability and your tax return, it’s not likely to make or break your business. Once you make your decision, let’s explore how to license your new business.