Many small businesses are started at kitchen tables or in garages, without much thought about taxes, liability, complexity, or future plans. However, those four issues play a major role in determining which structure makes the most sense for your business.
"A business structure is the legal form of your business," says Rob Stephens, founder of CFO Perspective. "This legal form determines what licensing you need, what taxes you will pay, and what legal rights your business has."
Every entrepreneur's situation is different, which makes choosing a business structure a very personal decision. But remember that you can opt to change your company's existing structure if you realize that another format would be more advantageous to you or your company.
Your Business Structure Options
In the U.S., you can choose from four basic types of business structures. Each type of legal entity has its pros and cons.
- Sole Proprietorship. "You're automatically considered to be a sole proprietorship if you do business activities but don't register as any other kind of business," Stephens says. You don't even have to file paperwork to officially form the business unless you're doing business under a different name, in which case, you need to file a DBA form. David Ciccarelli, founder and CEO of Voices, launched his business as a sole proprietorship because, he says, "it's fast, easy, and, let's be honest, the least expensive option available." The downside is that banks are more reluctant to lend money to sole proprietorships and you can't sell stock, Stephens notes.
- Partnership. When Ciccarelli and his wife became business partners, they "set up a new entity because we changed the name and wanted to create something new that represented our collective ideas, a true partnership." Partnerships are an option when a business has multiple owners.
- Limited Liability Company (LLC). LLCs are a popular choice, says Stephens, because they are "super simple to form" and have no limits on the number of shareholders. That is important if you intend to pursue investors. Deven Patel, founder and CEO of web domain marketplace Alter, has experience making this choice. "I'm a serial entrepreneur who started a number of businesses over the years using every structure imaginable," he says. "The LLC structure is great for small businesses as it's super simple to manage with less paperwork to deal with." Roy Harmon, owner of Advertoscope, went with an LLC because "some of my clients seemed to see that as a sign of credibility versus a sole proprietorship."
- Corporations. There are two types of corporations: C corporations and S corporations. "Every corporation that is formed is a C corporation by default," says Charles Read, CEO of GetPayroll. "The S corporation election (made by filing a Form 2553) is a tax election only." S corporations are popular with small business owners because they are not subject to double taxation like C corporations are—profits flow through to the owner without taxation at the corporate level. S corporations are limited to 100 shareholders, however, and only "natural persons" can hold ownership stakes—meaning U.S. citizens.
Four Factors to Consider
When choosing which business structure is most appropriate for your short- and long-term plans, you'll want to weigh the following issues, Stephens recommends.
- Complexity. How complicated does your business need to be now and in the future? Do you intend to stay a one-person show, or do you hope to build a business empire and sell the venture to investors in a few years? Those two scenarios lead to two totally different choices—sole proprietorship at one end and C corporation at the other.
- Legal protection. Being able to separate your business assets from your personal finances is advantageous if your business carries with it significant liability—such as from customers visiting your store or the product you're manufacturing causing harm. The more protection you want, the more formal you'll want your business structure to be. "I always recommend that my clients (or those individuals asking for advice) choose either a corporation or an LLC for the liability protection it provides," Read says. Both of these structures shelter the owner's personal assets and wealth from outside claims and "is the cheapest liability policy I know of that a person can buy when they go into business," he says. Sole proprietorship and partnerships do not provide that kind of protection.
- Taxes. Sole proprietorships, partnerships, LLCs, and S corporations are pass-through entities, Stephens explains, which means profits are only taxed when they are paid out to the owner(s). However, a C corporation is taxed both as a company and when payouts are made to shareholders.
- Number and type of owners. If your plan is eventually to go public, you may want to establish your business as a C corporation from the start. However, if you're building a business that you don't expect to take public, you may want to choose based on the number of owners you anticipate. A sole proprietorship has one owner, while a partnership, LLC, and S corporation can have multiple owners.
Entrepreneur Vinay Amin, founder of Eu Natural, says, "The best way to choose a legal business structure is to assess your personal risk potential, provide yourself with acceptable asset protection, and optimize the opportunity for sourcing investment for growth."