By Jade Yeban, J.D. | Legally reviewed by Aviana Cooper, Esq. | Last reviewed November 10, 2023
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Picking the right form for your business is an important step for small business owners. There are many options, such as sole proprietorships, partnerships, and limited liability companies (LLCs). It also includes for-profit corporations and nonprofit corporations. Each one comes with its own set of rules for things like income tax, tax returns, and protecting your personal assets.
When choosing a business form for your organization, you need to consider a number of variables, such as the cost of starting up and plans for the future. However, businesses sometimes change their legal structure when conditions change, such as a merger or significant growth. Below are 10 important issues every entrepreneur should consider before settling on a legal structure for their business.
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Cost considerations are paramount when selecting a business form. A sole proprietorship or general partnership can be set up very inexpensively. Limited partnerships and LLCs are more expensive to set up.
Setting up a corporation can be a very expensive undertaking. Corporations demand a heftier investment due to complex requirements for incorporation. Registrations, such as business names and licenses, add to the financial burden. There are also recurrent expenses related to business taxes to consider.
The ease of formation and maintenance varies significantly between business types. A sole proprietorship is easy to set up. Sometimes, all it takes is opening up a business checking account. Similarly, a general partnership is easy to set up, although a partnership agreement is something that the partners should create prior to beginning operations.
Limited partnerships, LLCs, and corporations involve more work. Corporations are bound by more rigorous standards, including the establishment of a board of directors and regular shareholder meetings, which can be resource-intensive. Since the state must recognize all three entities, it is important to adhere strictly to the state requirements or run the risk of losing the advantages that the particular business entity provides.
Dissolution processes differ across business forms. Some business entities automatically terminate upon such events as death, the withdrawal of a partner, or even divorce. In addition, some businesses are allowed to exist only for a state-mandated period of time. LLCs, for example, often allow for more straightforward termination procedures compared to the intricate winding-up affairs of corporations.
The Internal Revenue Service (IRS) scrutinizes the distribution of business income during the dissolution of more complex entities.
How much information do you want the public to know about your business and finances? A corporation is required to provide much more information to the state, which is then available to the public, than an LLC or a limited partnership (LLP). Corporate entities are typically required to disclose substantial information publicly, including the details of ownership and financial performance.
Conversely, LLCs and LLPs enjoy a greater degree of privacy, protecting sensitive business information from public scrutiny. Sole proprietorships and general partnerships offer the individuals involved a great deal of privacy.
Risk exposure is a critical factor. Sole proprietors and general partnerships risk personal assets. If the business involves a great deal of risk, a sole proprietorship or general partnership may be a bad idea because the owner and general partners are personally liable for the business debts and obligations. LLCs and corporations provide limited liability protection, shielding personal assets like private bank accounts from business liabilities.
Operational demands can influence business form decisions. If you want total control, a sole proprietorship provides the businessperson with the greatest degree of control. In turn, sole proprietorships also have the greatest degree of potential risk. LLCs grant operational flexibility, whereas corporations are subject to stringent operational protocols, including corporate governance and mandatory meetings.
Nonprofit organizations, meanwhile, must adhere strictly to their mission and comply with regulations to maintain tax-exempt status.
An undercapitalized business may result in a loss of protection provided by the business entity. In addition, some business forms make it easier to raise capital when it is needed. Capital acquisition can be more streamlined for entities with a structured corporate framework. This can appeal to lenders and investors. Corporations, especially C corporations (C corps), are advantageous for raising capital through stock issuance.
Startups and smaller ventures may rely on simpler financing methods, such as small business loans or personal funds.
The ease of transferability is another important consideration. A sole proprietorship is easy to sell. Usually, you sell the assets of the business, and your business ceases to exist. Selling a partnership interest or a member's interest in an LLC can be tricky because it requires the approval of the other partners or members. C corps are structured for equity sales and attracting substantial investor interest, albeit with increased complexity.
State-level taxation varies depending on the legal entity chosen for your business. The form of business significantly impacts how state tax systems view your company.
For example, an LLC is recognized as a separate legal entity from the business owners. LLCs benefit from pass-through taxation, meaning profits are only taxed as personal income tax. This avoids the sting of so-called “double taxation," a scenario where both corporate taxes and personal tax returns take a bite out of your income.
A C corp experiences double taxation. Income is taxed at both the federal tax level and again at the shareholder level when distributions are made. This can affect the business's bottom line and the personal tax liability of its shareholders. Entrepreneurs must weigh the implications of each tax rate and consider how it aligns with their business goals.
Moreover, sole proprietorships and partners in LLPs must contend with self-employment tax, which covers their Social Security and Medicare obligations. This tax is levied in addition to personal income tax and is determined based on business earnings reported through income tax returns.
Every entrepreneur wants to be as successful as possible. Some business entities are limited to the number of shareholders they may have. A sole proprietorship ceases to exist the moment the sole proprietor takes on a partner. It is important to choose a business form that allows you the greatest room to grow if that is what you envision. Although the business form may be changed, this involves additional expense and energy.
There is so much to think about when starting up a new business, including which type of business structure is the best fit. Some business structures provide a simpler process for paying taxes, while others provide more protection from personal liability. In order to choose the best business form for your organization, consider consulting with a business and commercial law attorney first.
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