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If you’re setting up a business in the US, you can choose from a number of different legal structures depending on the type and scope of the project.
In this article, we present all relevant business structures and give tips on the best choice for tradespeople, small businesses, and freelancers.
Choosing the right business structure
One of the most important choices you will make when starting up your new business is to decide which structure it should have. As a business owner, you have the option of quite a few structures including partnerships, LLCs, sole proprietorships, corporations, S corporations, and many more. The entity you settle on depends on several factors such as liability, taxation, and record keeping. It’s important to do thorough research so you choose the right one, since your choice can greatly affect the way you run your company – from liability and taxes, to the control over the company. Our explanations of the different structures will help you find the business structure that fulfils your organizational and personal financial goals.
Which business structures exist?
There are many different legal structures for businesses, but the law classifies businesses so that most of them fall into one of these three legal forms:
- Sole proprietorship
We will go into more detail with each of these structures, but bear in mind that there is no right or wrong answer, just choose which option is most beneficial for your business.
This is the simplest business structure and also requires the least amount of paperwork. All you need is to file paperwork with a fictitious name if you’ve decided not to use your own name, as well as the licenses required to begin your operations. Not many business owners hire a professional for this kind of legal structure since there are barely any forms to fill and you can’t really go wrong. This kind of business entity is owned solely by you – hence the name. You make all the decisions and don’t have to answer to anyone else.
You also receive all the profits and losses from the business, which you will need to report on your individual income tax return. Because you’re in charge, you can shift funds in and out of your business accounts or withdraw from any account without seeking permission first or experiencing legal repercussions. However, a disadvantage of being the only owner is that you’re responsible for any debt that the business incurs, and since you and your company are seen as a single entity by the state, your business AND personal assets may be taken away if need be.
It’s just as easy to cease this business as it is to set it up. Since you’re the sole owner, you can close it at any point: there is no legal waiting period or any formal paperwork to file. The downside is that the business will be terminated if you die, since you’re the only one responsible.
Nearly three quarters of all businesses in the US operate as sole proprietorships, making it the most popular out of all the structures. A lot of businesses that are now partnerships and corporations probably started out as a sole proprietorship before it became more beneficial to change.
Advantages of a sole proprietorship
Disadvantages of a sole proprietorship
Easy to form
Harder to raise capital/get loans
Least expensive to set up
Business growth limited to personal circumstances
Limited tax savings for fringe benefits
Tax-free asset withdrawal
Business is terminated if owner dies
Owner is sole recipient of profits
Unlimited personal liability
Most states have adopted the “Uniform Partnership Act,” and according to this act, a partnership is an “association of two or more persons to carry on as co-owners of a business for profit.” It’s important to choose the right partner to complement your skill set and expertise so the business can flourish. There is unlimited liability for partners, just like with a sole proprietorship, but one difference is that you can share the responsibility i.e. make decisions together and both can invest their own money.
There are different types of partnerships, for example, there are general partners who split the managing, financing, and liability tasks. There are also those who don’t play an active role in managing the business, known as limited partners. Their liability is limited to their investment. Partnerships don’t necessarily have to be equal: choose the right one for your business.
A partnership is also easy to establish since there isn’t a waiting period and no formal paperwork to fill out. It’s recommended to draw up an “Articles of Partnership” agreement, which specifies what each person’s role is in the company.
There is stronger growth potential in this business structure, since the more people you are, the more likely you are to be approved for a loan, as banks favor partnerships more than sole proprietorships. Although it is not required to pay federal income tax, a partnership is required to file Form 1065, U.S. Return of Partnership Income, to report its income and loss to the IRS Form 1065. This is because each person declares the income on their own personal income tax return. The downside, however, is that both people are responsible for any debt the business may incur.
If one of the partners dies, the business will have to be closed, since it can only operate with both parties. Another disadvantage is that the partnerships can make decisions independently of one another, meaning one person could commit to something that the other isn’t on board with.
Advantages of a partnership
Disadvantages of a partnership
Easy to set up
Unlimited personal liability for the company’s debts
Business terminates if partner dies
Any partner can commit the company to obligations
Stronger growth potential
Freedom from government control
This type of business structure is the most formal and complex of the three. It generally costs more, is more complicated, and requires more paperwork. This kind of legal entity is organized depending on the state and federal statutes, and ownership is decided based on the shares of stock. The business has to adhere to a charter stating what the company can and can’t do. This is helpful to make sure everyone is on the same page, but it does mean that the power is limited since this charter dictates how the company is run. If the company conducts business in more than one state, it must comply with the relevant federal laws since not all are the same.
Unlike sole proprietorships and general partnerships, stockholders in a corporation aren’t personally liable for any company debts or claims against the business: they are only liable for what they have personally invested. Another plus is that the business remains unaffected if one of the stockholders dies or the shares change hands. It’s a lot easier to raise capital or to be accepted for a loan with so many stockholders, than if there were a sole owner.
Authority can be delegated to others, which relieves the pressure on the owners. The fact that there are so many owners means that financial and managerial expertise can be pooled together.
Unfortunately, these business entities are quite expensive to set up. A lot of this expense comes from the fees incurred when sending paperwork for incorporation charters and permits. The record keeping can become quite tedious, since it’s an ongoing process due to the many forms associated with the corporation business structure.
Double taxation is often a problem, but you can get around this by filing your business as an “S” Corporation.
Advantages of a corporation
Disadvantages of a corporation
Liability limited to owners’ share of stock
Quite expensive to form
Business unaffected by an owner’s death
Power limited by the charter
Extensive on-going record keeping
Easier for raise capital
Owners can pool their financial and managerial know-how
Now that you’ve been introduced to the main three types of legal structure, there is a hybrid form known as a limited liability company.
Limited liability company (LLC)
This hybrid structure enables owners, partners, and shareholders to limit their personal liabilities while at the same time being able to enjoy the tax and flexibility benefits that come with a partnership. By forming an LLC, members are protected from personal liability in case the business can’t pay its debts. Many business owners choose this business structure since it offers more protectionand separation than a sole proprietorship, and is a combination of a corporation and partnership, which means your personal assets and company assets are separated in most cases, and your profits and losses are not taxed at a corporate level.
Some confusion could arise due to different states having different laws and regulations for LLCs. Some states see the business as a taxable entity and could double-tax it, whereas under some jurisdictions, it’s regarded as a corporation.
Not every company is able to structure itself as a limited liability company. Insurance companies, banks, and healthcare service companies must choose a different structure. Even though limited liability companies offer investors restricted liability, investors may prefer to invest in a more established company like a corporation.
Advantages of a limited liability company
Disadvantages of a limited liability company
More expensive than sole proprietorship and general partnership
Ample opportunity for commercial growth and progress
Difficult to attract investors
Avoids double taxation (pass-through taxation)
Complexity across jurisdictions
Owners not personally responsible for business’ debts and liabilities
Limited eligibility (banks and insurance companies not allowed)
Relatively low amount paperwork required compared to a corporation
How to choose the right business structure
It’s not easy to decide on the right structure for your entity since it may fall into several of these categories. However, it’s important to choose the correct structure at the start because it can be difficult to switch it later.
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If you know which direction your company is headed, make sure that the potential structure allows for this growth and change, otherwise it might hold you back from what you actually envisioned for your business.
If you want the least amount of personal liability possible, then a corporation is a good choice. This is because the law sees this business as its own entity. The business can be sued, but this will never affect the personal assets of any owners or shareholders. An LLC offers the same protection, but has the added advantage of enjoying the tax benefits of a sole proprietorship.
A sole proprietorship is the easiest type of structure to establish since all it requires is for you to register your name, begin your business activities, report the profits, and pay taxes. The downside is that fewer investors will want to fund your business since the entity is quite an uncertain one. Partnerships are more “set in stone” because an agreement is signed which defines the roles and percentages of profits. Corporations and LLCs are also required to report with the state and federal governments.
An LLC pays taxes just like a sole proprietor does. The LLC structure prevents you from being double-taxed by making sure you’re not taxed as both an individual AND a company. If you’re in a partnership, you can claim your share of the profits as personal income and are recommended to make advance payments twice or even four times a year in order to minimize the end effect on your return.
A corporation is responsible for filing its own tax returns annually, paying taxes on profits after expenses. If you pay your own wage from the corporation’s profits, you also have to pay personal taxes like social security and Medicare.
A sole proprietorship or LLC might be the best choice for you if you prefer to have sole or primary power of the business and what goes on. A partnership can give you this too, especially if you sign an “Articles of Partnership” agreement.
A corporation, on the other hand, can start out with one person in charge, but as it grows, it will need a board of directors to make all the important decisions
A corporation is more likely to have an easier time obtaining funding and bank loans than the other structures. Corporations are able to sell shares of stock and get additional funding in order to grow. Sole proprietors, on the other hand, must use their personal accounts and credit, making growth a lot harder. An LLC may also have a difficult time increasing its finances, although the owner doesn’t necessarily need to use their personal credit or assets since it’s its own entity.
Licenses, permits, and regulations
Your business may need certain licenses or permits to operate. Whether it needs to be licensed at local, state, and federal levels depends on what kind of activities your business undertakes. Different states have different rules and regulations, so check first which ones apply to you.