Have you decided to start your own company, but do not know what business structure to choose? Nowadays, there are 5 main types that are popular in America:
- Sole Proprietorships;
- General Partnerships;
- Limited Partnerships;
- Limited Liability Companies;
Business structure is not just a formality. The legal structure you choose will affect the company’s future operations, therefore we recommend that you pay attention to such aspects as:
- Start-up costs;
- Ongoing legal requirements;
- Responsibility and ability to protect the personal assets of the owners;
- Tax treatment.
Deciding on the best business structures for a business can cause some difficulties for aspiring entrepreneurs.
To ease your choice, we’ll take a look at the features of the popular business types and compare them to each other to show their advantages and disadvantages. Also, let’s talk about what types of businesses fit best to help you choose the perfect one.
What Is a Sole Proprietorship (SP)?
A sole proprietorship is an informal business entity where the business is conducted on behalf of its sole owner or a married couple. The business and its owner are legally linked.
The main advantages of this structure are its simplicity and low cost. There is no need to be formally registered and pay the state fee before starting a sole proprietorship. All you do is get down to business.
Moreover, being an unincorporated company, a sole proprietorship is not burdened by a number of requirements that an LLC or a Corp is. You don’t have to worry about filing annual reports or paying franchise taxes on time to uphold the reputation of your company.
There is no requirement to separate personal and corporate funds as well. The customers pay directly to the owner, who is free to manage the finances as they wish.
The tax issue of a sole proprietorship is not complicated, since all profits and losses are reported only on the owner’s personal return.
Thus, a sole proprietorship is a simple one-person business that allows you to enter into deals quickly but does not offer any protection for your personal assets. It can be a good way to start a business, but it doesn’t work for everyone. If you aim at making big money, or your business has a high risk of financial responsibility, then we recommend that you choose another business structure.
What Is a Partnership?
A partnership is also an informal business structure that brings together two or more people to conduct business.
The income and losses of a partnership are taxed only when distributed among the owners. However, a partnership itself does not pay any separate taxes.
As with a sole proprietorship, the formation of a partnership does not involve any state registration or fees. Nevertheless, the partners can usually conclude a written agreement to regulate the operation of the joint business.
Depending on the roles assigned, there are two basic types of partnerships:
- General partnership;
- Limited partnership.
General Partnership (GP)
Except for some peculiarities related to having at least two owners, a general partnership is similar to a sole proprietorship.
The main feature of this structure stands out in the distribution of the rights and duties of the participants. Unlike other types of partnerships, in a general partnership, all partners participate in the management and the profits and losses are divided equally.
The key advantages of the general partnership are:
- Simplicity and ease of formation, because it is an informal business structure applied by default;
- “Pass-through taxation”;
- Each owner can take an active part in the work of the company;
- High level of control.
To avoid possible conflicts and problems, you should outline the roles of all partners and the basic principles of the company in a general partnership agreement.
Actually, a general partnership is a good choice for informal businesses if you want to set up a business together without wasting time on the formalities. However, like a sole proprietorship, it does not protect the owner’s personal assets, which makes it suitable only for a no-risk business with a small budget.
Limited Partnership (LP)
Another common way to start doing business with partners is a limited partnership. It has a number of significant differences from a general partnership.
To begin with, a limited partnership is a formal partnership, which requires compliance with a formal business formation process established by state law. It is not enough to enter into a limited partnership agreement and begin conducting business together if you want to choose this type of enterprise. A limited partnership is not a default option and requires registration with a specialized state agency.
A limited partnership consists of one general partner, whose liability is unlimited, and multiple limited partners. Sometimes they are also called “silent partners” because these participants are usually investors and are not directly involved in management.
As for taxes, the IRS treats the limited partnership as a pass-through tax entity, so the LP does not have to file a separate tax return. However, a general partner of a limited partnership has an additional tax obligation. Because the law treats him as an employee, a general partner must pay self-employment tax among other things. It is a 15.3% tax, which consists of two parts: employee portions of Medicare and Social Security, the amount of which depends on the amount of income received.
What Is a Limited Liability Company (LLC)?
An LLC is a hybrid type of business structure that combines the best features of sole proprietorships, general partnerships, and corporations. A limited liability company is a separate legal entity, that is considered separately from its owners.
Since it is a formal enterprise, then the legislation has a special registration procedure for it. To form an LLC, you must file the Articles of Organization with the Secretary of State and pay the mandatory fee.
An LLC is a popular business structure among entrepreneurs because it provides advantages such as:
- Flexible management structure: you can start a business either on your own or with unlimited number of partners;
- Personal asset protection: as well as limited partners in a limited partnership, the owners of an LLC are not liable for its obligations. The company conducts business on its own behalf and is responsible for its debts. In other words, if an LLC is sued, the creditors’ claims will be limited to the company’s assets. Regardless of its financial status, the personal assets of the owners will not suffer;
- Choice of tax treatment: An LLC is taxed by default as sole proprietorships and general partnerships, i.e. it delegates the obligation to pay income taxes to the owners. The latter report all profits or losses on personal returns, while an LLC does not have to file separate tax returns. However, an LLC can also be taxed like a corporation if the members apply to the IRS.
To summarize, an LLC is a convenient and reliable business structure that fits a wide range of businesses. Thanks to its flexible options, it is well-adapted to the needs and peculiarities of each particular business, providing the best possible conditions.
What Is a Corporation (Corp)?
A corporation is a formal business entity based on the principle of shared ownership.
Despite its significant advantages, such as personal asset protection, aspiring entrepreneurs rarely choose this business structure. It is mainly used by experienced companies, because a corporation has more strict managerial structures and complex formation requirements than, for example, an LLC.
To get to work, you will need to meet the following conditions:
- Designate a board of directors and officers who will ensure the smooth running of the corporation;
- Set up meetings for directors and meetings for shareholders.
The main difference between a corporation and other types of businesses is the ability to issue stocks to attract investment. This makes it extremely convenient for outside investors.
Depending on the specifics of the business and its goals, the needs can differ. For that reason, most states recognize several types of corporations. Here we will discuss the most common ones.
If your business is socially oriented, then consider setting up a B corporation. In fact, this is not a separate type of business structure, but a traditional corporation that has been proven to have special status and tax advantages.
The B corporation is not a non-profit organization. The difference between them lies in the approach to ownership. While a nonprofit organization has no owners, a B corporation has shareholders.
In addition, despite its social purpose, a B corporation is primarily a commercial, profit-oriented entity.
A C-corporation is a special tax treatment rather than a separate type of entity. According to the IRS, a C corporation is an independent tax entity. It files its own tax return as well as the personal tax returns of its owners.
Because of the so-called “double taxation,” the profit of a C corporation is taxed both at the company level and when distributed among shareholders as dividends, which is not usually favorable. Although it provides additional advantages and non-tax benefits. The members of C corporations also do not pay self-employment taxes.
This tax treatment is usually used by large corporations with large incomes.
The S corporation tax treatment is characterized by the fact that the business is treated as a pass-through tax unit. This means that the obligation to declare profits and losses “passes” directly to the owners, avoiding the company level. At the same time, the company has no need to file a tax return, which allows it to avoid double taxation and distribute funds efficiently.
Most states have a number of conditions that must be met by a company to choose the S corporation type of taxation. For example, the number of its owners is limited to 100 shareholders, who can only be resident individuals.
In most cases, small or even family-owned businesses choose the S corporation tax treatment.
Depending on the specifics of the state, the criteria for this type of corporation may vary, but the main features are most often the following:
- A small number of owners;
- Prohibition of a public offering of shares;
- Shareholders usually act as managers on their own.
Compared to other types of corporations, there are fewer formal requirements for closed corporations. This type of business gives shareholders some freedom and also allows them to limit the entry of new members.
In contrast to closed corporations, open corporation shares are constantly sold and bought on the public market. Anyone can buy them and become an investor. As a result, business owners constantly change.
A nonprofit corporation is a special type of corporation that focuses on social purposes and assistance rather than making a profit.
Owners of a nonprofit corporation enjoy the benefits of limited liability but do not receive any dividends. All profits of such a company are used to support its activities or charity, which allows it to avoid paying taxes.
What Is a Cooperative (Co-op)?
A cooperative is an enterprise that is owned by the same people it serves, i.e., those who personally use its products or services.
The profits from the activities of the cooperative are distributed among the members, who are sometimes also called user-owners.
What Are the Major Advantages of Each Business Structure?
Sole Proprietorships and General Partnerships
Because these two ways of doing business are nearly identical in structure, it is convenient to consider them together.
Both sole proprietorships and general partnerships do not require money to start or maintain, which is the biggest advantage that makes them popular. If you choose one of these informal business types, you can quickly start to earn without wasting time and money on complying with registration requirements.
Sole proprietorships and general partnerships are acceptable business entities if you are just coming into the business world. They are good for low-income, low-risk companies.
The ability to benefit from uneven distribution of ownership and managerial responsibilities is the most obvious advantage of this business structure. An uneven split makes it an excellent option for companies that prefer to give the lead to a single general partner.
Limited partnerships are common in the real estate investment industry, as well as professional firms providing legal, accounting, engineering, and other services. It is also a popular structure for family-owned businesses because it provides continuity of ownership roles and gradual transfer of experience.
Limited Liability Company
An LLC stands out from other business structures because it provides favorable conditions for a wide range of companies. Its flexible settings allow a company to consider individual peculiarities of a business, increasing its efficiency.
One of the main advantages of an LLC is the protection of owners’ personal property from liability for corporate obligations. Even though a corporation also provides such protection to its members, an LLC is easier to use and has fewer requirements.
Besides, an LLC has 3 taxation options, which the owners can change, with the mandatory approval by the IRS.
By default, this business entity uses the pass-through method, i.e. it is taxed like sole proprietorships or general partnerships. But S corporation and C corporation tax treatments are also available for an LLC, although double taxation makes the latter not much in demand.
When it comes to a corporation, the first thing that comes to mind is stocks. The ability to attract investment and ensure business growth in this way is a key advantage of corporations, which is not available to other types of companies.
We should also remember that shareholders get limited liability protection, thanks to which their personal assets are protected. In the event of a lawsuit, creditors will not be able to claim their owners’ personal assets.
Additionally, among all types of American business structure corporation is the business entity with the greatest stability and predictability. Years of experience of its use provide a sufficient number of judicial precedents, so the risk of an unexpected verdict is minimal.
Finally, it is worth noting that they have no problem with inconsistent legislation. The approach to regulating their activities is uniform throughout the USA, while other types of businesses, such as an LLC, may vary from state to state.
What Are the Major Disadvantages of Each Business Structure?
Sole Proprietorships and General Partnerships
The flip side of the coin for sole proprietorships and general partnerships is the lack of personal asset protection that an LLC or corporation has. In case of a lawsuit or debts, creditors’ claims will not be limited to business assets. They will also be able to claim personal assets of the owners, such as real estate, personal bank accounts, or a car.
But this is not the only disadvantage.
As small-scale business entities, sole proprietorships and general partnerships have little growth potential, and it is difficult for them to attract outside investments. Investors usually prefer to entrust their funds to reliable official companies, which provide more comfortable conditions.
The weakness of a limited partnership is unlimited liability of the general partner because it creates a tremendous amount of risk of financial losses.
Meanwhile, the control over the company’s affairs and the initiative of the other partners is greatly limited, which does not fit every entrepreneur.
Limited Liability Company
Even though an LLC offers many advantages to its owners, there is no one perfect entity.
The most significant disadvantage of the LLC is the need to comply with business formation requirements that do not apply to other business structures, such as sole proprietorships. This requires some time costs, postponing the start of the business.
Plus, LLC members must pay fees for formation and maintenance to comply with state law requirements.
Another disadvantage is that an LLC cannot issue stock, which makes it less attractive to some potential investors.
In short, the corporation’s disadvantages are, first of all, plenty of formalities compared to other types of business. A corporation is a hassle to set up, due to the rigid structural requirements, and a hassle to maintain, which discourages some entrepreneurs.
Moreover, a corporation can be costly from a tax perspective because it is subject to double taxation, which is associated with additional costs. The S Corporation tax treatment prevents this, but it has certain restrictions and is unavailable to most corporations.
Can I Hire Someone to Form My New Business?
If you are planning to form an LLC or corporation and prefer to leave the formalities to professionals, there are several options:
- Hire an attorney: the assistance of a professional attorney ensures that the formation process will be as easy and comfortable as possible. All necessary documents will be carefully drafted taking into account the peculiarities of your business. However, the cost of a lawyer can range from a few hundred dollars to thousands of dollars, which is often out of reach for start-up companies;
- Enter into an agreement with an online business formation service: this option offers a great combination of high-quality services and reasonable costs. The prices of most online companies are much lower than hiring a business lawyer to form an LLC or a corporation, which makes the online services available even to small businesses.
When you haven’t decided which service to choose yet, take a look at the 7 top-rated LLC services whose offerings are the best in the industry.
You can also save time by checking out the list of the top 3 online services below.
ZenBusiness ($39): if you want a quickly and professional ly formed company at an affordable price, ZenBusiness is the best choice. With the purchase of any service package, they will also provide 1 year of free registered agent services. This is a really good deal, which is confirmed by the excellent customer feedback.
Northwest Registered Agent ($225): although their price is higher than some of their competitors, Northwest has a number of undeniable advantages:
- Qualified customer support with an individual approach to each client, which is considered the best in the industry;
- An excellent registered agent service that includes full local scanning of all documents they receive on your behalf. You will also get 1 year of registered agent service for free when you hire Northwest to start your business.
IncFile (FREE): basic business formation package of this company is ideal for those who want to save money, because its price is $0. In this case, IncFile includes in all their packages free services of a registered agent for 1 year.
Considering the most popular business entity types in America, we can conclude that none of them is universal. Each business structure has its own set of pluses and minuses that should be taken into account when planning your future company.
While general partnerships or sole proprietorships are easy to create and use, this does not compensate for the lack of personal asset protection. In the event of a lawsuit, losses can be much higher than the cost of establishing and maintaining formal business structures.
The same applies to limited partnerships, where the general partner is at risk.
Thus, in most cases, the choice of structure can be simplified by reducing the number of options to the LLC or corporation with the most favorable terms.