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Which business structure should you choose? A sole proprietorship, partnership, LLC or corporation?
Compare the benefits and drawbacks of four business structure options.
In addition to ease of set up and registration formalities, there can be different tax implications depending on the type of business structure you choose. Learn how they differ and which might be right for your business.
Quick snapshot: Pros and cons of four business structures
|Business structure||Pros and cons|
What is pass-through taxation?
Pass-through taxation refers to the tax obligations on the business. With this type of obligation, the business isn’t responsible for taxes but rather the owner(s) or customers. An owner may pay taxes to the government once receiving income from the business. A customer could pay taxes in the form of sales tax.
Four types of business structures explained
Owning a business as a sole proprietor is perhaps the easiest way to start a business. As the name suggests, a sole proprietorship is one that has a single business owner. The business owner can choose to conduct business under their personal name or assign a separate name to their business. However, assigning a different name to the business does not mean that you are creating a separate entity. A sole proprietorship can never be separate from its owner.
All the assets as well as liabilities of the business are that of the owners as well. If your business incurs any losses, then you will be personally liable to pay those losses even if it means paying them off from your personal funds. Setting up such a business structure is very easy and generally requires the owner to register the business with the appropriate authorities. Once you have registered the name and procured any licenses that you need for the business, your sole proprietorship is ready to go.
If two or more people are planning to go into business together, then they can use a partnership business structure. While it is not mandatory to do so, every partnership should have a written partnership deed that lists all the important terms and conditions of the partnership. The profit and loss sharing ratio of all the partners should be specified clearly in the partnership deed. If nothing has been specified in this regard, then it is automatically assumed that all the partners have an equal share in the profits and losses of their firm.
All the partners in a partnership are responsible for each others’ actions. If there are any outstanding liabilities of the firm, then all the partners are usually collectively as well as individually responsible for the firm’s liabilities. Any income that arises from a partnership firm is taxed in the hands of the partners. That being said, the individual partners need to account for their share of the income in their personal income tax returns. A partnership firm dissolves automatically if one or more of the partners leave the firm or upon the death of a partner.
Limited liability company
An LLC borrows from both corporations and partnerships, making it a hybrid structure. Limited liability means that any liability for bankruptcy or other debts, in most states, will not personally fall upon the members of the LLC. It is also a pass-through entity, meaning that the business itself is not subject to income tax. Instead, each of the owners or members of the LLC are taxed at an individual income level. Flexibility is abundant in an LLC, as it can choose how it would like to be taxed based on structure – this is if it chooses to stray from the default tax classification. Some states employ a franchise tax based on revenue, profits or members for allowing an entity to operate as an LLC.
An LLC doesn’t have to adhere to a formal corporate structure, this could be seen as either an advantage or disadvantage. Flexibility also reaches out to ownership, profits and general say in the business via the operating agreement. The operating agreement is an outline of how the LLC will operate. of Ownership is distributed how members see fit and not by who has more money invested. Profits can be distributed or allocated by percentages or by fixed amounts and some members have a larger vote percentage. If an operating agreement is never drawn up, state rules apply to the LLC .
Corporations typically adhere to a tight structure and are overseen by a group of shareholders who own the corporation. That being said, the corporation is seen as one entity that offers limited liability, financially protecting its shareholders. To become incorporated, Articles of Incorporation are required to be filled with the state to give a detailed overview of the business itself. Corporations are often required to report company standings in the form of quarterly or annual financial statements.
A corporation will exist perpetually if a firm end date hasn’t been decided. This means that the corporation can continue to operate despite any change in status ranging from disbanding of directors, death of the owner or sale of company. A corporation only ends when it is liquidated and all assets are sold and creditors are paid – anything remaining can be split between shareholders.
Shareholders and employees of a corporation are seen as two separate entities and this can often lead to double taxation. Whatever profits the corporation sees is initially taxed and then the shareholders and employees are taxed again on a personal level.
Which business structure is right for me?
Choosing which structure to use for your business depends on your long-term financial goals. Here are some things to keep in mind when deciding:
- Legal liability. Are you willing to be completely personally liable for any debt your business incurs? Or would you rather take on limited liability, or share it with a business partner? Deciding how much liability you want to take on will help narrow down which structure is best for you.
- Taxation. Your business structure determines how much you pay in taxes. Depending on which structure you choose, you may have to pay double taxation (corporate and personal income) or just pass-through taxation (in which the business won’t be subjected to corporate taxes).
- Administrative costs. Some business structures have more extensive paperwork and record-keeping requirements, which can eat up a lot of time and money when forming a business. Those who are starting a business on their own may consider sole proprietorship for that reason, as it generally has less reporting requirements than other structures.
While starting a new business can be daunting, it’s important to choose the right structure that fits your needs and future goals. Fortunately, you have several options to help you figure out how to shape your business.
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