Business Structures: Which One is Best for Your Business
Choosing from all the different business structures - LLC, partnership, sole proprietorship, or corporation - for your business can be difficult and will depend on your preferences and the type of your business.
Whenever you start a business, you will have to select one organizational type from out of all the different business structures,. This choice determines how your business will be set up and organized. In most instances, you will probably have to choose between a limited liability company (LLC), a partnership, a corporation or a sole proprietorship.
Making the right choice for your business will generally depend upon the type of business, how you want the business to be run, how many owners the business will have, and the financial situation of the business. It may not be possible to find the business structure that will perfectly fit with the needs of your business, but there are some criteria that you can use to find the one that works the best. These criteria are:
- The different types of liabilities that come with each business structure
- The expenses and procedures associated with establishing and continuing to run the various business structures
- Income tax
- Investment needs
The general rule for this category is that the more dangerous or risky the activity that your business will engage in, the less personal liability you want to have. For example, if your business is going to be engaging in risky activity, such as window-washing high-rise buildings, or constructing bridges for highways, you will probably want to form your business in a way that will minimize any potential liability that you, personally, will have for anything that goes wrong.
Both corporations and LLCs allow business owners a type of "limited liability," where anyone seeking claims against the business will have a very hard time placing personal liability on you as the owner. Conversely, if you were to organize your business as a partnership or a sole proprietorship, you could be personally responsible for anything the business did wrong.
In a general partnership, every partner can be held personally liable for any claims against the business. For example, if a plaintiff won a lawsuit against the partnership for $1 million, and every other partner, including the partnership, except you was broke or in bankruptcy, you would probably be responsible for paying out the entire $1 million. The same is true for a sole proprietorship, except that there is no one to spread the liability to because you are the sole owner. As a sole prorietor, you are personally responsible for all liabilities incurred by your business.
Expenses and Procedures
If all of the business structures were placed on a scale that depicted how difficult and expensive it is to establish and maintain them, partnerships and sole proprietorships would be near the bottom. In general, there is no special paperwork that needs to be filed in order to establish either of these business structures. In addition, there are rarely any fees associated with establishing or maintaining either of these business structures.
LLCs and corporations, on the other hand, are almost always more difficult and expensive to establish and maintain. In order to establish a corporation or limited liability company, you must file "Articles of Incorporation" with your secretary of state and pay fees associated with the incorporation. The details of the articles of incorporation and is the amount of the fee will vary depending upon the state where you set up your business. In addition, when deciding to form a corporation or LLC, the owners of the business must decide which officers to elect to run the company. The officers typically must include at least a president, vice president and secretary. LLCs and corporations must keep specific and detailed records of any important business decisions, and follow many other formalities that are associated with these business structures.
If you are forming a business on a limited budget or a tight timeframe, it would probably make more sense to use one of the simpler forms of business structures - either a sole proprietorship or a partnership. You would use a sole proprietorship if you are going to be the only owner of the business, and a partnership if there is going to be more than one business owner. If you are going to be engaging in a risky business activity, however, you may want to put in the time, effort and money associated to organize your business into a corporation or LLC in order to gain the advantages associated with limited personal liability.
The easiest way to think about the different income tax structures that these business structures will use is to break them into two categories -- one comprised of those business structures where the business owners pay taxes on business profits, and one that includes all business structures where the business owners do not pay taxes on business profits.
The first category includes sole proprietorships, partnerships and LLCs. These business structures are often referred to as "pass-through" tax entities because the taxes on the business profits and losses pass through to the business owners on their personal income taxes. This means that owners of these three business structures can expect to have complex income tax returns.
Business owners of sole proprietorships, partnerships and LLCs must report and pay taxes on all net profits from their business, even if they take no money out of the business' account during the tax year. For example, suppose a partnership that has four general partners makes $1 million in a tax year. The partners do not take any money out of the business account because the business must pay its bills in the next tax year. However, because the business had $1 million in net profit for the tax year, each partner must report $250,000 of income on his or her personal taxes.
Unlike the pass through tax businesses, the owners of a corporation do not pay taxes on the net business profits of the corporation. Instead, the business owners of a corporation pay taxes only on the profits they actually take from the corporation in the form of salaries, dividends and bonuses.
Because a corporation is a separate tax entity, it must pay taxes on any profits that remain within the company during a tax year, and also on any profits that it pays out in the form of dividends to shareholders.
There is a tax benefit to forming your business as a corporation. The owners of a corporation do not pay taxes on any profits that the corporation keeps, and the corporation pays taxes at a lower rate than do some individuals. This means that a corporation and its owner may pay less in the form of taxes than if the owner had organized his business as a sole proprietorship, or any of the other business structures.
Structuring a business as a corporation allows a business to sell shares of ownership in the business through stock offerings. This is different than the other three business structures, which do not allow the selling of part of the business through the sale of stocks. Because of this investment scheme, it may allow owners of a corporation to attract investors and retain employees more easily by offering stock.
If you never plan on having your business go on sale to the public, however, and don't need the investment incentives to retain employees, you probably do not need to go through the added procedure and cost of forming a corporation. If you desire the limited personal liability that comes from a corporation, you could instead form your business as a LLC. An LLC provides many of the advantages of a corporation while remaining more flexible.
Changing it up
You shouldn't worry about having your business organization plan set in stone, it rarely is. Often, businesses that start out as sole proprietorships or partnerships grow and convert to LLCs and corporations. If your business needs and plans change, your business structure can probably change with them.