How to Choose a Business Structure
Before you start your business, you will have to decide how to structure it. You’ll decide the business structure based on the needs of your company.
After you decide your business structure, you’ll have to make sure that you form your business correctly and know your tax obligations before you start operating your business.
A sole proprietorship is the easiest business structure to set up. Because of this, it is also the most common structure for new businesses. One person owns and operates a sole proprietorship. There is no distinction between the owner and the business.
Pros of a Sole Proprietorship
- A sole proprietorship is easy and inexpensive to set up because there is no formal action required to create one, but you will probably need business licenses and permits to fully operate your business. If you want to do business under a name other than your own, you will have to file a “Doing Business As” (DBA) name, also known as a fictitious name.
- You have complete control over all business-related decisions.
- Because you and your business are one in the same, your business is not taxed separately, so it is easy to file your taxes.
Cons of a Sole Proprietorship
- You are personally liable for all business debts and other obligations. You can also be held accountable for any liabilities caused by your employees’ actions.
- As a sole proprietor, it can be difficult to raise startup funds. You cannot sell stock, so you cannot appeal to investors. Many banks won’t approve a loan due to the risk that you won’t pay the loan back if the business fails.
- You are entirely responsible for the business’s successes and failures, which can be a heavy burden to bear by yourself.
A partnership is owned and operated by two or more people. Each partner shares the profits and losses of the business, so each partner must also contribute to every aspect of the business – money, property, labor, and skill.
When starting a partnership, you and your partner(s) should discuss a range of issues and develop a legal partnership agreement. Partnership agreements are not legally required to form a partnership, but are highly encouraged. A partnership agreement documents how future decisions are made, how partners divide profits, how partners resolve disputes, how to bring in new partners, how to buy out existing partners, and how to dissolve the partnership. During the life of your partnership, you will have disagreements, but by developing a partnership agreement at the beginning, you can limit many of your disagreements before they come up.
Types of Partnerships
- General Partnerships assume that profits, liabilities, and management duties are all divided equally among the partners. If you and your partner(s) choose an unequal distribution of profits, liabilities, and duties, you should indicate those percentages in the partnership agreement.
- Limited Partnerships allow partners to have limited liability and limited management duties. These limits depend on each partner’s investment into the business.
- Joint Ventures are similar to a general partnership, but for a limited time or a single project.
Forming a Partnership
To legally form a partnership, you must first register with your state’s Secretary of State’s office. You will then have to establish your business name, which is either the name given in your partnership agreement or the last names of the partners. If you would like to operate under a different business name, you will have to file a DBA name. You will also have to obtain the necessary business licenses or permits. You’ll have to register with the IRS and your state’s revenue departments and obtain a tax identification number (TIN).
Pros of a Partnership
- Like a sole proprietorship, it’s easy and inexpensive to form a partnership. Developing the partnership agreement will take up most of your time, initially.
- In a partnership, you share the financial obligations with your partner and can pool your resources when raising capital.
- If you take the time to find the right partner, you can find someone who complements you. Each of you will bring unique strengths, resources, and experiences to the table.
- You have the opportunity to attract and hire highly motivated employees because you can offer them the opportunity to become a partner.
- Like a sole proprietorship, taxes are relatively easy to file. The partnership will have to file an “annual information return” to report the business’s income, deductions, gains, and losses, but the business does not pay income tax. Any profits or losses are “passed through” to the partners, so you and your partners will include your share of the business’s profits or losses on your personal tax return.
Cons of a Partnership
- Like a sole proprietorship, you and your partner(s) can be held liable for the business’s debts and obligations. You are not only responsible for your own decisions, but also for the decisions made by your partner(s) and employees.
- Because you have partners, you cannot make decisions on your own, but must consult your partner(s) before making a decision. Be willing to make compromises and try to resolve any disputes as amicably as possible.
- You and your partner(s) share in the successes and profits of the business, but if someone is not pulling their weight, it can cause problems among you and your partners.
A corporation is an independent legal entity owned by shareholders. Because it is an independent entity, the corporation is liable for the debts and other obligations of the business. A corporation is expensive and complex to set up, so it is usually only suggested for large established businesses.
Forming a Corporation
Forming a corporation is more complex than other business structures. First, you must choose a business name and register it with your state government. If you are operating the business under a different name, you will have to file a DBA name.
You will also have to file articles of incorporation with your state. Some states will also require you to establish a Board of Directors and issue stock certificates to the initial shareholders. You will then have to obtain any necessary business licenses and permits.
You will have to make sure you register with the IRS and state revenue agencies and receive a TIN because the corporation will have to pay federal, state, and sometime local taxes. Unlike a sole proprietorship and partnership, corporations pay income tax on the business’s profits.
Pros of a Corporation
- Shareholders are not personally liable for the debts and other obligations of the business. Your personal assets are protected.
- Corporations have the option of raising funds by selling stock in the business.
- Because a corporation files taxes separately from its shareholders, you only pay taxes on the profits paid through salaries, bonuses, and dividends.
Cons of a Corporation
- Corporations are costly and complex to set up.
- They may be taxed twice – first when the corporation makes a profit and files an income tax return, and again when dividends are paid to the shareholders, who have to claim those dividends on their personal tax returns.
- Corporations are highly regulated by federal, state, and local governments, so there is more paperwork to keep track of than other structures.
Limited Liability Company
A Limited Liability Company (LLC) can be the best of both worlds – it combines the limited liability features of a corporation with the tax efficiencies and operational flexibility of a partnership. An LLC can be owned by a single person, multiple people, or even a corporation.
Like a partnership, the business is not taxed separately, but the profits and losses “pass through” to the owners, called members, who then report the profits and losses on their personal tax returns.
Forming an LLC
To form an LLC, you must choose your business’s name. Then, you file articles of organization, which includes your business’s name, address, and the names of the business’s members. Some states also require you to create an operating agreement, which structures your business’s finances and organization, details allocation of profits and losses, and outlines members’ rights and responsibilities. You must also obtain the necessary business licenses and permits. Some states, including Arizona and New York, require you to publish a statement about your LLC formation.
Pros of an LLC
- Under an LLC, members are protected from personal liability, and their personal assets are usually protected if the business is in debt or sued.
- There is less paperwork involved in starting an LLC, than a corporation or an S corporation. It is also less expensive to start an LLC.
- There are fewer restrictions on how profits will be divided among members, so members can decide what percentage of profits or losses each member receives.
Cons of an LLC
- If a member chooses to leave the business, the business is dissolved, and the members are responsible for fulfilling any remaining legal and business obligations.
- Members of an LLC are considered self-employed, so they must contribute self-employment taxes toward Medicare and social security. The entire net income of the business is subject to the self-employment tax.
An S corporation is a special type of corporation, formed through an IRS tax election, to avoid the double taxation that corporations are subject to. In an S corporation, profits and losses are “passed through” to the shareholders, who then report the profits and losses on their personal tax returns. The business itself is not taxed.
There is one major caveat when setting up an S corporation: any shareholder who works for the company must pay themselves “reasonable compensation”.
Forming an S Corporation
To form an S corporation, you must first register your business as a corporation. Then, shareholders must sign and file Form 2553 to elect to become an S corporation. After your business elects to become an S corporation, you will have to obtain the necessary business licenses and permits.
If you form an LLC, you can also elect to be treated as an S corporation for tax purposes. You must file Form 2553 before the first two months and 15 days of the beginning of the tax year in which the S corporation election will take effect.
Pros of an S Corporation
- Since an S corporation is not taxed separately, there are tax savings available to you and the business. If a shareholder is an employee of the business, their wages are subject to employment taxes. Any remaining income is paid to the shareholder as a “distribution”, which is taxed at a lower rate.
- Some expenses incurred by the shareholders can be written off as business expenses. However, if an employee owns 2% or more shares, their benefits, such as health and life insurance, are considered taxable income.
- The business is independent of the shareholders. If a shareholder decides to leave the company, the business can continue relatively undisturbed.
Cons of an S Corporation
- Because an S corporation is a separate entity, it is subject to stricter operational processes. The business must hold scheduled director and shareholder meetings, keep minutes from those meetings, adopt and update bylaws, and record stock transfers.
- Because shareholders who work for the company must receive reasonable compensation, the IRS looks for red flags – like low salary, high distribution combinations. If the IRS sees any red flags, the shareholder’s distributions may be reclassified as wages, which are taxed at a higher rate.
A cooperative is owned and operated for the benefit of those using the services. Any profits and earnings generated by the cooperative are distributed among members, known as user-owners. An elected board of directors run the cooperative, but all user-owners have voting powers.
Forming a Cooperative
To form a cooperative, potential members must first agree on a common need and a strategy to meet that need. Then, an organizing committee conducts exploratory meetings, surveys, and cost and feasibility analyses before members can agree on a plan. A cooperative must obtain the necessary business licenses and permits.
To incorporate a cooperative, members must file articles of incorporation, which must include the name of the cooperative, business location, purpose of the cooperative, duration of existence, names of the incorporators (also known as charter members), and the capital structure. A cooperative should also create bylaws, including membership requirements, duties, and other operational procedures. Charter members must also create a membership application, which includes signatures from the Board of Directors and member rights and benefits. Charter members have to hold a charter member meeting to elect the Board of Directors and to discuss and amend the proposed bylaws.
Pros of a Cooperative
- Incorporated cooperatives are not usually taxed on surplus earnings refunded to the user-owners, so the user-owners are only taxed once.
- The cooperative can leverage its size to obtain discounts on supplies and other materials or services.
- Members can join or leave the cooperative without causing dissolution or disruption.
- Because of the democratic structure of the cooperative, a cooperative meets all members’ needs. The amount of money a member invests does not affect the weight of their vote. No one member can dominate the decision-making process.
Cons of a Cooperative
- Cooperatives can have a hard time raising startup capital. The only incentive to contribute involves how much the potential member will use the cooperative’s services and products.
- If members regularly do not fulfill their duties, including voting, the cooperative cannot operate at its full capacity.