How to Choose a Business Structure
Business Structures
Part 6 of a 10 Part Series
5 minute read
Accounting for Small Business 101
This 10 part guide will provide you with the most basic fundamentals of accounting for your business. Whether you’re a budding entrepreneur with your first start-up or a stay-at-home mom selling knit hats on Instagram, lay the groundwork. Here’s how.
Part 6: How to Choose a Business Structure
Choosing a business structure is one of the very first steps to starting your business. You have to choose a structure before you can register your business in your state.
Setting this up right will make accounting and taxes easier. It will also protect you legally and financially. Switching your structure later on can cause many headaches. So take your time when choosing. This guide will make it simple.
What is a Business Structure?
A business legal structure (or business entity) is a set of rules for how your business operates. When you choose a business structure you’re making an agreement with the government that you’ll run your business a certain way. Your chosen business structure will effect:
How you pay taxes, and how much you pay.
What paperwork and reports you will need to submit to the government.
How you raise funds, including offering stocks.
Whether you need a board of directors.
What will happen to your business if an owner leaves the business or when a founder dies.
If your personal assets will be at risk in the case of a lawsuit against your business.
Here’s a breakdown of the different business structures and which may be the right choice for you.
Sole proprietorship
This is the most basic of business structures. It basically means you are the only (sole) owner (proprietor). You have total control over every aspect of your business. You are also the one person responsible for all the business’s profits and debts. Sole proprietorships do not separate or protect personal from professional assets.
If you don’t register your business, congratulations! Your business is automatically considered a sole proprietorship.
Sole proprietorships are easy to set up with little paperwork and no corporate hierarchy. It’s also easy to end your business, there’s no special requirements or paperwork needed. Sole proprietorships generally have the least amount of fees and business taxes. You may even be eligible for special tax deductions.
But, there is no separation between personal and professional assets with this structure. You’re personally on the hook for debt and lawsuits. This can become risky as your business (and the numbers) grow. It also can be difficult to fundraise. You can't sell shares of your business, and banks are hesitant to loan to sole proprietors.
Sole Proprietorship Breakdown
Pros: Easy to set up, low taxes and fees, tax deductions, easy exit.
Cons: No protection of your personal assets, more difficult to raise money.
Good fits for sole proprietorships:
A solo owner of a small business with low risk. For example: freelancers, housecleaners, landscapers, tutors, web designers, graphic designers, local small retail shop owners, photographers, artists, and day care owners.
Partnership
This is the simplest structure for 2 or more people who own a business together. There are different ways to set up a partnership based on how much liability one or all partners would like. In general, control is shared evenly between partners. And everyone shares responsibility for profits and debts.
Partnerships can be more expensive to set up than sole proprietorships. That's because you'll want an attorney to look over your partnership agreement. But they are easy to set up, since there’s little paperwork. And since you’ll have two or more credit histories in the mix, it can be easier to get a bank loan.
The most important thing for a successful partnership? Good communication and complete agreement on terms. Partners should agree on how much work and money each person contributes, and what share of the profits each person gets. Whoever has the highest share percentage is the majority owner.
Partnership Breakdown
Pros: Easy to set up, more likely to get loans, special taxation.
Cons: Limited or no protection of personal assets.
Good fits for partnerships:
Businesses where two or more people in the same line of work play an active part in running the business. For example: medical professionals, lawyers, accountants, consultants, investors, and architects.
Limited liability company (LLC)
This business structure is like a hybrid of a corporation and a partnership. It provides some protection of your personal assets. Members will not be personally liable “if it can’t be proved that they did business in a negligent or wrongful manner that results in injury to another.”
Your business is not subject to corporate taxes with this structure. However you will need to pay self-employment taxes. Filing for an LLC costs around $40 to $500 depending on where you’re located. LLCs may have to be dissolved and re-established if a member joins or leaves the LLC.
LLC Breakdown
Pros: Lower taxes than corporations, flexible, protection of personal assets.
Cons: Complicated when members join or leave.
Good fits for LLCs:
A wide range of businesses, from solo freelancers to large companies. LLCs are especially popular with attorneys and law firms and physicians’ groups.
Corporation
Pretty much all the biggest companies are corporations. Incorporating your business makes it into a separate legal entity. The corporation is almost like its own person. It can sue, be sued, buy property, and sell rights of ownership in the form of stocks.
Corporations have the strongest protection of personal assets. Shareholders are only responsible for their investment. They are not responsible for covering losses and debts. They receive part of the profits as dividends. If a shareholder joins or leaves a corporation, it has little effect on the corporation. It can keep running indefinitely regardless of those changes.
Corporations are more costly to set up than other business structures. They also have stricter and more complicated rules of operation. Corporations sometimes end up being double-taxed since they pay income tax on their profits. Taxes are paid when the corporation makes a profit, and again on the dividends paid to shareholders.
There are a few different types of tax statuses for corporations. C corps are taxed as separate entities. S corps are small businesses that avoid double taxation. And B corps are for-profit entities with social responsibilities. Corporations also may be open (anyone can buy shares) or closed (shares are privately held and allocated). There are also nonprofit corporations that are tax-exempt and exist to help others in some way.
Corporation Breakdown
Pros: protection of personal assets, business can operate indefinitely regardless of changes in ownership, much easier to raise funds, can take bigger risks that lead to growth.
Cons: High cost to set up, extensive record-keeping, operational processes, and reporting required.
Good fits for Corporations:
Businesses that are already established and have capital, may be at risk for legal issues, make more than $60,000 in taxable profits a year, and anticipate large growth.
Still need help deciding on a business structure?
Contact Pioneer Accounting Group. Not only are we expert accountants, we're here to help with all your business questions. Our financial consulting is top-notch and we're always available to assist. Start a live chat to talk to a real accountant right now. Or contact us to schedule a meeting or ask a question.