How to Pick Your Business Structure
You don’t need an MBA to start an online business, but it sure can feel like it sometimes — especially when you’re dealing with legal details. When you have to weigh options like LLCs and S or C corporations, choosing your online business’ legal structure can leave you feeling completely out of your depth.
We’re here to help you navigate those tricky waters. Legal structure can make or break your business, so it’s important to do your homework and make an informed decision. Your choice of structure has a big impact on matters like:
- How much you’ll pay in taxes
- What protections you’ll have in case of legal trouble
- How easily you can raise money
The information in this article is focused on US-based businesses, where the types of business structures available to you can vary from state to state. As with most essential business decisions, it’s best to consult trusted authorities or professionals, whether that’s the Small Business Administration (SBA) or your certified lawyer and accountant.
That said, this article gives you the basics that you’ll need to know to evaluate your options. Let’s start with some factors you should consider.
Areas to Think About
There are five main factors that you should look at when deciding on your business structure:
- Risk and legal liability
- Tax obligations
- Formation and maintenance costs
- Administrative structure
- Plans for growth
Risk and Legal Liability
How willing are you to put your personal assets on the line? Most businesses involve transactions with other entities–suppliers, contractors, staff, or customers, and so on. Most of the time, those transactions involve money, merchandise, or services, plus accompanying responsibilities, expectations, and guarantees. Simply put, there are more chances for losses to be incurred, mistakes to be made, and lawsuits to be filed.
Your choice of business structure determines if your personal assets can be seized if you need to answer for debts, losses, or other legal liabilities. In the worst cases, that can mean losing your car, your personal finances, or even your home. Some options will draw a line between your personal assets and the business’ accountabilities; others will treat you and your business as one and the same.
Your business structure will also determine how the IRS taxes your business. As mentioned earlier, some options will treat you and the business as entirely separate entities: this can lead to situations like double taxation, where the business pays taxes as a company while you also get taxed on your personal share of the business’ profits.
On the other hand, you’ll also find choices that follow a “pass-through” policy. The business’ earnings proceed directly to the owners and are only reported as part of the owners’ individual tax returns.
Formation and Maintenance Costs
The amount of paperwork you do can also hinge on your chosen business structure. More complex configurations (like the different types of corporations, which we’ll discuss more later) naturally require more record-keeping, as well as higher costs to start with. The administrative demands of staying compliant can also be more effort-intensive and time-consuming; without a well-equipped team to handle these, you might find yourself losing too much time and resources that could have otherwise gone into your actual business.
When you’re listed as the business’ sole owner, details like profit distribution are straightforward. However, when you venture into business structures that involve two or more parties, it can be trickier to comply with legal prescriptions for how the business should be run. Corporations, for example, will have a board of directors, as well as shareholders. By contrast, partnerships may need to draw up custom agreements between parties, the specifics of which will vary with each case.
Plans for Growth
Your options for financing or expanding your business will also depend, in part, on what kind of structure your business uses. Partnerships, for example, don’t have the stock issuing powers that come with incorporation. That can make capital generation more difficult, especially if you don’t have access to other sources like loans or ready investors to finance your venture.
Types of Business Structures
This is the simplest type, and it’s the easiest one to start. Why? You don’t need to file any paperwork. When you start out, you’re a sole proprietor by default.
Sole proprietorship, as the name implies, only allows for one owner. In the eyes of the law, that owner and the business itself are one and the same. (If you want to use a business name other than your actual name, though, you can file for a DBA or “doing business as.”) In practice, you have total control over your business.
For a quick primer on sole proprietorships, here’s a great video from QuickBooks:
When it comes to taxes, you’ll report business earnings as part of your individual tax returns. As Entrepreneur points out, that means any losses your business may incur can offset income from other sources, ultimately lowering your taxable earnings.
However, banks are usually reluctant to give loans to sole proprietors, so you might find have trouble financing your business. Plus, you assume personal liability over your venture, so your personal assets can be used to pay your business’ debts, legal obligations, or other accountabilities.
If you plan to share ownership of your company, you might want to consider a partnership. Like a sole proprietorship, this option is relatively easy to form. There are different types of partnerships. These vary according to how you plan to divide the work as well as how long you intend the partnership to last. Here are a couple of examples:
- General partnership: Usually entails an even split of profits, liabilities, and responsibilities within the company
- Limited partnership: Used for partners who serve more as investors and play no role in the company’s operations
Again, QuickBooks has a great video summary:
Partnerships are also “pass-through” business structures, meaning each partner reports their share of the profits on their individual tax returns.
However, the risk of personal liability remains, since partners’ personal assets may still be used to cover legal obligations. There’s also the added risk of actually having partners: unless you start with an ironclad partnership agreement, problems between partners–or even a dissolution of the partnership entirely–can quickly get messy (and costly).
Limited Liability Company
Also known as an LLC, this option has been enjoying greater popularity among small business owners due to its flexibility. Many describe LLCs as “the best of both worlds,” since they combine some of the best aspects from partnership and corporation structures.
If you’d like a short summary of LLCs’ unique benefits, check out this video:
In terms of taxes, LLCs avoid double taxation by giving owners the choice to file taxes as a sole proprietorship, a partnership, or a corporation. Often, small business owners choose to file as sole proprietors or partnerships due to more favorable tax rules.
The difference, however, lies in the name: like corporations, limited liability companies give owners liability protection, shielding your personal assets from the consequences of any business losses, problems, or legal obligations. Unlike corporations, however, you’ll have more say over your business’ management structure and profit distribution.
However, LLCs are governed under state law, so the requirements can vary by state. What’s more, they typically have a stipulated dissolution date: 30-40 years depending on the state, as well as dissolution if an owner dies or leaves.
Unlike any of the prior choices, a corporation structure turns your company into a separate legal entity. That leads to one of this option’s biggest benefits: liability protection. Owners’ personal assets aren’t linked to the business, so you’re safe from any debts, lawsuits, or similar troubles that might have otherwise cost you, say, your car or house.
A corporation can sell stock, giving you an easy way to raise funds for your company. The company’s lifespan isn’t tied to its owners or shareholders either, so even if you or a shareholder retire, die, or sell shares, the company lives on.
However, incorporation does come with drawbacks of its own. First, there’s double taxation, as mentioned earlier: corporations pay both federal and state income tax, and shareholders also pay tax for their share of its earnings on their individual tax returns. Second, there’s the complexity of the structure itself. Incorporating a company and remaining compliant with the web of rules and regulations that govern a corporation can eat up your time and resources. Generally, this makes incorporation a structure best left to bigger businesses.
If you are interested in setting up a corporation, though, you could look into the different types available. Generally, you’ll pick between a C corporation and an S corporation.
A C corporation is what we often imagine a corporation to be. This structure allows for multiple classes of stock, an unlimited number of shareholders, and liability protection for those shareholders. The corporation exists as a separate legal entity.
QuickBooks’ primer on C corporations offers a good overview:
An S corporation is often a better choice for small business owners, due mainly to the tax benefits and liability protections it affords. S corporations can pass through profits to shareholders, so that these only get taxed via shareholders’ individual tax returns. In addition, S corporations carry the usual legal liability limits of the corporate structure, so shareholders’ personal assets aren’t at risk.
S corporations can still issue stock, making for better fundraising prospects; however, these corporations are limited to a maximum of 100 shareholders. Since these companies are still corporations, retaining the “S corporation” classification–and its benefits–depends on compliance with strict corporate formalities and regulations.
For a short summary of S corporations, you can also check out this video:
The Bottom Line
Choosing a business structure is one of the most important decisions you’ll make as a new business owner. There are no default answers, because business structure choices depend on business goals and aspects that vary with each case. With the legal details and complexities involved, it’s best to research, consult experts, and take your time to select the best option for your business’ needs.