Entrepreneurs are very passionate when discussing business ideas, growth potential, and investment opportunities, but often overlook the process of picking a business structure. Choosing the best structure is critical, especially for small businesses, as it establishes a solid foundation for growth and development, so make sure you understand all of your options. We’ve listed 5 types of legal entities that are ideal for you to consider below.
What is a business legal structure?
A business structure describes how a company is organized, in regard to its legal status, daily operation, liability exposure, tax implications, and compliance requirements.
In the US, business structures are largely creations of state law, so there are minor variations in the details from state to state. Generally, there are five common models sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, C corporations, and non-profit organizations.
A sole proprietorship is the most basic type of business, with only one owner. In exchange for complete control over business operations, the owner is personally liable for all debts and obligations of the business.
In terms of taxation, a sole proprietorship must report all business income or losses on the personal income tax returns; the business itself is not taxed separately. The current personal tax rate for sole owners in the US is 37%, plus 15.3% for self-employment tax.
This structure is ideal if you want complete freedom and control over business decisions without having to worry about raising capital, resolving partner disagreements, transferring ownership, and so on. However, you must consider the amount of tax you will be required to pay as well as the possibility of being held liable for business debts.
A partnership is a business owned by two or more people, who each contribute something valuable such as money, property, skills, or expertise to the business. Partnerships can be established through formal agreements and written contracts, or through informal, verbal agreements.
Partnerships are subject to pass-through taxation, meaning business income is reported on personal income tax returns and taxed at the owner’s personal tax rate.
There are several types of partnership arrangements, depending on each partner’s level of involvement in the business, their profit share, liability, and control. In the United States, the three most common types of partnerships are:
- General partnership
In a general partnership, each partner is equally liable for the business’s debts and obligations, which means that personal money, assets, and property can be seized to settle business debts.
- Limited partnership
A limited partnership is similar to a general partnership, but with at least one partner (known as a silent partner) who contributes capital but does not participate in business operations. This partner has limited liability, which means they are only liable for the amount they invested.
- Limited liability partnership
A limited liability partnership is a type of partnership in which all partners have limited debt and obligation liability and can actively participate in business matters.
Limited Liability Company (LLC)
A limited liability company (LLC) is a business structure that provides its owners with limited liability protection.
The two most common types of LLC structures are single-member LLCs and multi-member LLCs, each with its own set of tax implications.
Single-member LLCs are taxed as pass-through entities, just like sole proprietorships and partnerships. Multi-member LLCs are taxed as partnerships by default but can elect to be taxed as corporations by filing the appropriate IRS form.
An LLC is a good option for small business owners who have significant assets and want to protect themselves from potential liabilities or obligations that may arise from daily operations.
An S corporation combines the limited liability protection of a corporation with the tax advantages of a sole proprietorship or partnership for business owners.
By definition, an S corporation is a type of federal tax designation rather than a formal business structure. This means that you cannot simply choose to be an S corporation; you must first register as a C corporation or an LLC and file the necessary forms in order to qualify for S corp status.
Registering as an S corporation entails being taxed as a pass-through entity. Moreover, all shareholders of an S corp must be US residents or US taxpayers.
A C corporation is the most common type of corporation, offering owners limited liability protection and being subject to corporate income tax.
Under corporate law, S corporations and C corporations are identical—the only difference is how they are taxed. C corporations are subject to double taxation, once at the corporate level and again when dividends are distributed to shareholders. S corporations, on the other hand, are taxed only once at the personal level.
Due to the burden of double taxation, C corporation is less appealing to startups and small businesses. However, it may be a good option for businesses planning to go public or sell to another company because profits can be re-invested in the business without being taxed.
How can you make sure the business structure you choose is the right one? Check again with our US Business Entity Selection Tool, with a few simple quizzes to help you make up your mind.
Top factors for best legal business structure
A number of factors that small business owners must consider when deciding on the best legal structure include
The legal structure will determine how much personal liability you have for potential debts and obligations.
As mentioned above, operating as a sole proprietor will increase the risk of being held personally liable, as there is no legal distinction between you and your business.
On the other hand, business entities such as corporations and LLCs offer you limited liability protection that safeguards personal property and ensures your business debts are separate from you personally.
The amount of paperwork and filing varies for each structure. For example, LLCs require less paperwork than corporations but are subject to more regulations and may be required to file additional paperwork with the state.
As a small business owner, you may prefer to keep everything simple, so make sure to choose a structure that requires less paperwork and compliance requirements
The legal structure of your business can also have an impact on your taxes. Most small businesses elect to be taxed as an S corporation to avoid double taxation and save on tax bills.
The registration process may differ depending on the legal structure you choose for your company.
If you choose to operate as a sole proprietor, for example, you will not be required to register your business with the government. If you choose to operate as a corporation or limited liability company, you must file Articles of Incorporation or Organization with your state.
For small business owners who are planning to seek outside funding, the legal structure can have an impact on fundraising efforts.
Generally, corporations tend to have an easier time raising money from investors than sole proprietorships or LLCs. This is because investors are typically more familiar with the corporate structure and feel confident investing in a company that has a clear hierarchy and management structure.
There can be a number of factors to consider when choosing the best legal structure for your small business. Be sure to consult with an attorney or accountant to ensure that you select the best option for your specific business needs.
How to choose the right business structure?
There are various types of business entities, each with its own set of advantages and disadvantages, and it’s up to you as a small business owner to decide which one best suits your needs.
Below are some questions to ask yourself before making a decision:
Will you manage your business alone or with partners?
If you run a small business by yourself, a sole proprietorship is the best business entity to use. This type is simple to set up and does not require any special paperwork. You will be solely responsible for the company’s debts and obligations, but you will also have complete control over them.
In contrast, the best business structure for collaborating with partners is a partnership. It is set up in the same way as a sole proprietorship and does not require any special paperwork.
Are you able to meet the administrative demands?
A corporation can be a great type of business entity for small businesses, provided you are willing to handle the administrative burdens. It offers liability protection for shareholders, along with several additional benefits such as the ability to raise funds and issue stock.
Do you really need liability protection?
Many small businesses overlook the significance of limited liability, which can have disastrous consequences.
For instance, you may open a small shop to sell products on Amazon. Although you’re starting as a small seller, what happens if your business suddenly gains traction? What happens if people file lawsuits against you? Can you safeguard yourself and your company?
You’ll have to admit that small businesses have a lot of risks, and the best way to protect yourself and everything you’ve worked hard to build is to choose a smart structure that provides liability protection in difficult situations.
How would you like to be taxed?
When you’re small, it might not seem like a big deal. But as your business grows, the tax implications of your business entity choice will become more and more important. So be sure to think for the future and not just the present when making your decision.
How much money do you intend to invest in forming a company?
This might not seem like an important question, but it can have a big impact on your budget. If you don’t have much money to invest, you might want to consider forming a sole proprietorship or partnership rather than an LLC or corporation.
What state should you incorporate in the USA?
There are 50 states in the United States, each with its own set of features, advantages, and disadvantages, so there’s hardly a one-size-fits-all answer to the question of which state you should register your company in the United States.
One thing is certain: Delaware has recently surpassed the competition, being named the most business-friendly state with the best tax laws. Small business owners, particularly Amazon sellers, can use the Delaware LLC structure to establish legal protection, save money on taxes, protect personal assets, and establish a professional brand image for the venture.
Below is a small note for small business owners when deciding on a legal structure:
- Forming an LLC or corporation may cost more upfront, but it could save you money in the long run if you are concerned about personal liability.
- If you are willing to keep up with the administrative requirements, a corporation may offer a number of benefits that make it worth the extra cost
- Partnerships may be cheaper to form than other business entity types, but each partner will be personally liable for the debts and obligations of the business.
BBCInorp is dedicated to illuminating your company’s path in the United States; please contact us for practical advice and consultation. Drop us an email at email@example.com and we’ll be happy to assist you.
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
- What is a business legal structure?
- Top factors for best legal business structure
- How to choose the right business structure?
- What state should you incorporate in the USA?
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