When starting a new business, the structure you choose will determine how your business functions, the way it pays taxes, and the legal liability you may sustain as the owner.
You may start your business as a sole proprietorship or partnership. But, it may eventually evolve into a larger entity and change structures to suit your growing needs.
Every business structure has its pros and cons, so it’s important to consider your options before launching your start-up. To help you make a decision, we’ll go through several business types: sole proprietorships, partnerships, and corporations.
Related documents: Business and Employment Forms
What is a sole proprietorship?
A sole proprietorship is an unincorporated business that you run and own yourself. It’s often the starting point for most business owners.
As a sole proprietor, you’re responsible for your company’s debts, mistakes, and agreements. So, if the company goes bankrupt with outstanding debt, you’re personally responsible for paying back the money owed. If you fail to repay a loan, a creditor may sue or seize your personal assets to settle the score.
Sole proprietorships don’t change your tax status. You’ll file your personal income tax return the same as you would with a regular employer, but should include your profit (your company’s income) as well.
You may also be subject to self-employment tax because you’re working for yourself. If needed, consult with an accountant before filing your annual return in your business’s first fiscal year.
Advantages of a sole proprietorship:
- Straightforward legal structure
- Low formation costs and little paperwork
- The owner has full control over company management
- Easy to change structures as your business grows
- Pay taxes at a personal income level (low rates)
Disadvantages of a sole proprietorship
- The business dissolves if the owner dies
- The owner is liable for all business obligations, contracts, debts, violations, and more
- Investors may consider the business a high-risk investment, as there is often no equity to give as collateral
- May be subject to self-employment taxation
What is a business partnership?
A partnership is when two or more individuals form a business together to generate a profit. Partnerships can occur in different forms: general partnerships, limited partnerships, or joint ventures.
What is a general partnership?
In general partnerships, each partner owns either an equal amount of equity or an amount relative to their investment and contribution. Each partner also shares liability regarding the partnership.
Like sole proprietorships, each partner pays taxes on their individual income tax returns (so the income from the partnership itself isn’t taxed). This is called pass-through taxation because the taxes pass through the business to the people that operate it.
However, partnerships must report their earnings, losses, and deductions in an annual information return. You should also use a Partnership Agreement to define the responsibilities of each partner and outline the distribution of income and losses.
Advantages of a general partnership:
- A simple business structure
- Partners combine resources, cash, and skills
- Partners often share responsibilities
- Pay taxes at a personal income level (low rates)
Disadvantages of a general partnership:
- Partners are liable for the actions taken on behalf of the business
- Partners may disagree on business decisions
- If one of two partners withdraws from the agreement, the business dissolves
- Partners may be subject to self-employment taxes
What is a limited business partnership?
In a limited partnership, partners are only liable for their share of the business.
For instance, if you contribute $10,000 into a company worth $200,000, you’d only own a 5% stake in the business. Therefore, you’re only responsible for the 5% stake and not accountable for the company’s entire debt.
Usually, limited partners are investors who don’t partake in the daily operations of a business. Instead, the general partner handles day-to-day management.
Advantages of a limited partnership:
- Your liabilities are equal to your contributions
- Limited partners often avoid management duties
- Pay taxes on your investment at a personal level
Disadvantages of a limited partnership:
- General partners must tend to daily operations
- General partners are mainly liable for the company
- Limited partners often require periodic updates on the business
What is a joint venture in business?
A joint venture is a temporary arrangement in which two or more business partners collaborate on a project for mutual benefit. This structure involves sharing costs, risks, strategies, and resources.
Generally, joint ventures occur between established businesses. For example, if your company lacks resources to expand, this type of enterprise can be a fast and effective way to build your business and access new markets.
Advantages of a joint venture:
- Pooled resources and capital contributions
- Diversification of skills, services, or products
- Access to new markets and distribution channels
- Pay taxes at a personal income level (low rates)
Disadvantages of a joint venture:
- Partners may be liable for each other’s actions
- Potential for conflict when making business decisions
- Imbalanced levels of investment
Want to write a joint venture proposal?
Draft a sample Joint Venture Agreement to get an idea of the terms you’re willing (or unwilling) to compromise on.
What is a limited liability company?
A limited liability company (LLC) is a type of legal structure that combines the liability protection of a corporation with the personal tax structure and flexibility of a partnership.
To form an LLC in the US, you must file Articles of Organization within your state. This document includes your business name and the names of each member.
Draft an LLC Operating Agreement to define how your business operates. This contract includes your company’s purpose, member information, capital contributions, profit and loss distribution, and more.
You’ll also need to obtain state-specific permits or licenses to operate. Be sure to check the LLC formation requirements in your jurisdiction. Some states, like New York, require you to publish a notice of your company’s formation in the news.
Advantages of a limited liability company:
- An LLC operates as a separate legal entity
- Members are not personally liable for business debts, obligations, or wrongdoings
- A flexible tax structure allows for pass-through taxation
- Members determine the distribution of profits and losses
- Able to seek outside funding (unless the company goes public)
- Members don’t have to hold annual meetings or take minutes
Disadvantages of a limited liability company:
- The startup requires a fair amount of paperwork
- Cannot issue stock or shares in exchange for funding
- May qualify for corporate taxation, in which case you pay taxes twice—once at a corporate level and again at a personal level
- If the LLC decides to pay taxes individually, there are self-employment taxes
- The LLC may dissolve if a certain member withdraws ownership (avoid this by specifying continuation in your operating agreement)
Read more: Startup Founders: 5 Steps for Success
What is a C corporation?
A C corporation, or “C corp” for short, is an incorporated business that forms a legal entity separate from its shareholders. Shareholders are the owners of your company’s shares (also known as stock or equity).
Corporations can be private or public. In public corporations, people buy and sell shares on the stock exchange. Private corporations don’t issue shares for public trading.
To create a corporation, you must file Articles of Incorporation in the state where your business operates. Your articles should include details about your business, the share structure, and the directors of the company. Like an LLC, your corporation also needs to obtain the necessary permits and licenses.
While procedures vary by state and business, the general steps to take for incorporating your business are as follows:
- Hold an organizational meeting to develop corporate bylaws
- Determine internal management structures
- Elect directors and officers
- Issue stock certificates
- Record everything in a corporate minute book
Advantages of C corporations:
- The corporation deters liability from its shareholders, generally preventing them from being accountable for disputes
- May qualify for taxation as an S Corporation
- Prestige and credibility attracts investors
- Flexibility of ownership and transferability of shares
- Corporations can continue to exist if one shareholder decides to withdraw their portion
- Ability to address shareholders’ rights and responsibilities in a shareholders’ agreement
- Different classes of stock for investors, shareholders, and employees
- Unlimited amount of owners
Disadvantages of C corporations:
- Qualifies for corporate taxation (you pay taxes twice: once at a corporate level and again on a personal level)
- A startup requires a fair amount of paperwork (with associated filing costs)
- In most states, corporations must hold regular shareholder meetings and keep track of minutes during these meetings
What is an S corporation?
An S corporation is any type of corporation that files taxes under Subchapter S after meeting Internal Revenue Code requirements. This allows the corporation to qualify for pass-through taxation, where shareholders pay taxes on their individual tax returns at normal rates.
Some requirements for being an S corporation include:
- Have no more than 100 shareholders
- Operate domestically (within the United States)
- Have no more than one class of stock
- Only have allowable shareholders (e.g., excludes partnerships, corporations, and non-residents)
Advantages of an S corporation:
- No personal liability for shareholders
- Ability to avoid double taxation
- LLCs and C corps can raise funds as an S Corp
- The corporation continues to operate if one partner dissolves their shares
Disadvantages of an S corporation:
- The startup requires a fair amount of paperwork (must set up an LLC or C corp before applying for S corp status)
- Strict requirements for qualifying as an S corp
- Must hold regular meetings and record minutes
What structure is best for your company?
There is no one-size-fits-all approach to choosing a legal business structure. It depends on your situation and your business.
The needs of your business may change over time, which is why it is important to review what’s working for your business and what could improve. If necessary, adjust your business structure accordingly.
Whichever you decide, you can always consult other business owners about their experience choosing a business structure or consult with a lawyer on the best course of action for your company.