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How to choose the right business structure for your company
It often comes down to taxes, liability and how much work you're willing to do.
What are the 4 main business structures?
|Business structure||Best for…||Ownership||Liability||Which taxes apply?|
|Sole proprietorship||A simple setup with limited paperwork||One owner||Owners are personally liable||Personal taxes|
|Partnership||Testing new ideas with other business owners||Two or more owners||General partners are personally liable, limited partners are not|
|LLC||Avoiding personal responsibility for the business with a more relaxed structure than a corporation||One or more owners||Business is liable|
|Corporation||Establishing an easily scalable business that you might want to sell one day||One or more owners||Business is liable||Varies by type of corporation:|
Why do some business structures require personal taxes?
Some business structures like a sole proprietorship or partnership require personal taxes because of something called “pass-through taxation.” Pass-through taxation means that the owner or customers are responsible for taxes, instead of the business. With pass-through taxation, an owner might pay income taxes on its profits. Or a customer might pay taxes in the form of sales tax.
How a sole proprietorship works
A sole proprietorship is a business run by one person where there is no legal difference between the owner and the business. This means you’re responsible for all debt or legal actions taken against the business.
How to set up a sole proprietorship
You don’t have to do anything to set up a sole proprietorship unless you want to operate under a name other than your own. In that case, you have to register your “Doing business as” (DBA) name for your business in most states before you can legally operate.
Even if you have a DBA name, keep in mind that there’s legally no difference between you and your business.
Remember to apply for licenses and permits
While there’s not a separate business structure for your business, you’re still required to apply for licenses and permits for your business. For example, you need a license from the Alcohol and Tobacco Tax and Trade Bureau if you’re starting a one-man brewery. Otherwise, you risk facing a lawsuit or getting shut down.
How taxes work
Sole proprietors report profits as income on their personal taxes.
Pros and cons of sole proprietorships
- Complete control over business and profits
- Pass-through taxation
- No cost to form
- Fully responsible for debt and lawsuits
- Hard to get funding
- You’re responsible for all the work
How a partnership works
A partnership is a business owned by two or more people, where all owners split control of the business — and share the profits and losses. There are several different types of partnerships:
- General partnership. All owners manage the business together and split the profits and losses. They’re legally liable for all debts and legal actions taken against the business.
- Limited partnership. A general partner manages the business and other “limited” partners provide funding, but don’t have their hands in day-to-day operations and aren’t liable.
- Limited liability partnership (LLP). Several general partners manage the operations of the business, but are legally protected from the actions of other partners. How it works can vary by state.
How to set up a partnership
You can form a partnership by registering with your state and writing up a partnership agreement. While not required, a partnership agreement outlines the terms and conditions of the partnership.
It should state the responsibilities of each partner, outline what types of roles each partner plays in day-to-day operations and describe how profits are split. It should also outline how the partnership deals with certain situations. Otherwise, it’s up to state law. A partnership firm dissolves automatically if one or more of the partners leave the firm or upon the death of a partner.
How taxes work
Each partner is responsible for paying a personal income tax on their share of profits. General partners also typically have to file self-employment tax.
Pros and cons of partnerships
- Pass-through taxation
- Potentially more initial capital to get up and running
- Joint liability for debts
- Sharing profits
- Possible disagreements and compromise
How an LLC works
A limited liability company (LLC) works like a cross between a sole proprietorship and a corporation. Owners — known as members — aren’t legally responsible for the business, but you can still avoid paying a higher corporate tax rate by paying income tax on the profits. But if you change the structure of your LLC — say you want to add another member — you might have to dissolve and restructure the company depending on your state laws.
How to set up an LLC
Typically, you have to file articles of organization or a certificate of formation with your state in order to set up an LLC, depending on your state laws. You also might want to have an operating agreement, which works a lot like a partnership agreement. This establishes ownership percentages and states how profits and losses are distributed between members, as well as voting rights on major decisions. If an operating agreement is never drawn up, state rules apply to the LLC.
How taxes work
LLCs have a few tax options. If you have a single-member LLC, you can be taxed as a sole proprietorship. And two-member LLCs can be taxed as partnerships. But you might have to file self-employment tax. Otherwise, you can choose to be taxed as a C-corporation or S-corporation.
Pros and cons of LLCs
- Pass-through taxation available
- Personal protection with limited liability
- Lack of structure
- Additional taxes on owners
How a corporation works
A corporation works by completely separating legal liability from its owners — in fact, it’s its own legal entity. Its profits are divided between shareholders based on the percentage of the company they own, but shareholders aren’t liable for a corporation’s debts. Each shareholder gets one vote per share they own on major company decisions. The original owners — or shareholders — can eventually sell off the corporation to another set of shareholders by “going public.”
A corporation will exist forever 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 the company. A corporation only ends when it is liquidated and all assets are sold and creditors are paid – anything left can be split between shareholders.
How to set up a corporation
Corporations involve the most paperwork compared to other types of business structures, though it can vary by state. You generally must file articles of incorporation with your state, sell stock to the new company’s shareholders and elect a board of directors. The board of directors is responsible for coming up with the business plan and the general management of the corporation.
Corporations are often required to report company standings in the form of quarterly or annual financial statements.
Types of corporations
There are a few types of corporations that work slightly differently — mostly when it comes to taxes:
- C-corporation. Your standard corporation that’s run by shareholders and goes on indefinitely. But this structure can face double taxation, since the company pays corporate taxes on profits and then the shareholders have to pay personal taxes on their dividends.
- S-corporation. This structure allows you to avoid double-taxation by passing on the profits directly to the shareholders, meaning that they only have to pay income taxes. Some states might have limits on S-corps and requirements for who can be a shareholder.
- B-corporation. B-corps are for-profit businesses with a mission to do public good. They’re taxed the same way as a C-corp, but shareholders are also responsible for holding the company accountable for its mission as well as its profits.
- Nonprofit corporation. Also known as a 501(c)(3), nonprofits are structured like a C-corp but work solely to benefit the public good. They don’t have to pay any taxes on profits they make — but there are restrictions on how they can use those funds.
Pros and cons of corporations
- Personal protection with limited liability
- Perpetual entity until liquidated
- Lengthy and expensive process to become incorporated
- Possible double-taxation
- Tightly governed
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.
- Taxes. 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. Structures like corporations 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 a sole proprietorship for that reason, as it generally has less reporting requirements than other structures.
Consider your legal responsibility, tax obligations and the work it takes to set up and maintain different business structures before you decide which one to choose. After you’ve picked your business structure, you’re ready to start thinking about how to create a business plan — which you need to attract investors or apply for a business loan.
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