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Home Running A Business Your Ultimate Guide to Understanding Business Structures
Why would anyone want to lock their small business down into a business structure? Just the term “structure” might be enough to give some entrepreneurs the heebie-jeebies. After all, modern folks value flexibility. It’s why so many of us own personal vehicles instead of relying on public transportation, why we prefer to book hotel rooms with free cancellations, and why we don’t purchase lifetime subscriptions to streaming services like Netflix or Hulu. We enjoy the freedom afforded by a variety of choices and want to be able to reverse course on decisions whenever the need arises.
This love for flexibility extends to our professional lives. While workers in prior generations often chose a career and stuck with the same company for decades before ultimately claiming their pensions, many Americans now experiment with various options and avoid being tied down to 1 company. This approach often means freelancing for your entire career or taking a meandering journey through the entrepreneurial jungle.
The benefits of a malleable career include fewer constraints on your creativity, pursuits, and accomplishments. If you can dream it, you very well might be able to do it.
“In my case, when I worked as a writer in my full-time job, I was only writing about my beat—articles and features,” explains entrepreneurial guru Mukti Masih. “When I started freelancing, I learned blogging, which was quite different from in-depth articles that I was used to. Thereafter, I co-founded a video production company with my brother so I got the exposure to script and screenplay writing. I have also written scripts for audiobooks, website content, copies for ad films and TVCs, product descriptions for e-commerce websites, white papers, and e-books. I am quite sure, a few jobs down the line wouldn’t give me the freedom to write all these kinds of things.”
At the same time, there’s something to be said for structure in the business world. And there are compelling reasons to set your small business up as an entity. Here are some benefits to consider:
It’s also worth noting that when you set up your business as an entity, you don’t completely surrender your flexibility card—you may actually have the opportunity to change structures if necessary.
Some business decisions bring limited consequences. For example, let’s say you decide to put most of your marketing budget toward a Facebook campaign. After running your ads on Facebook for a few weeks, you might decide that you’d get a better response on Instagram. No big deal: you simply discontinue the Facebook campaign and then start advertising on Instagram. The cost is minimal, and there are no long-term complications.
It’s a different story when it comes to your business structure, however. While there might be the possibility of switching your structure down the road, you certainly won’t be able to hop from one to another like you would in the social media advertising example given above.
“Of all the decisions you make when starting a business, probably the most important one relating to taxes is the type of legal structure you select for your company,” explains a business report from Entrepreneur. “Not only will this decision have an impact on how much you pay in taxes, but it will affect the amount of paperwork your business is required to do, the personal liability you face, and your ability to raise money.”
You might be wondering which structure is ideal for small business owners—and there’s no boilerplate answer. Your best match will depend on a wide range of factors, including your business model, your industry, your growth goals, and your patience for procedural red tape.
These details, and many more, are best distilled through a business plan. This document outlines why you’ve started your business, how you’ll structure it, how you’ll run it, and where you want it to go.
If you’ve already assembled these details, putting a business plan together is merely a process of assembling your research and goals into a centralized place. For those who have yet to begin, you’ll want to start with some crucial questions. Here are some examples:
Each question you answer will provide the information needed to build your plan. The process takes time, so don’t expect to cobble together a plan over a single weekend. As you can see from the questions above, conducting the competitor analysis and other research required could easily take several weeks. Put the time in so that you can get the best results out.
“Research and analyze your product, your market, and your objective expertise,” explains the Houston Chronicle. “Consider spending twice as much time researching, evaluating, and thinking as you spend actually writing the business plan. To write the perfect plan, you must know your company, your product, your competition, and the market intimately.”
Completing your business plan is a major accomplishment. It will guide all your subsequent business decisions, such as how to structure your business. Additionally, it’ll serve as a representation of your vision and abilities as you seek financing (more on this later).
Armed with the information from your business plan, you can choose a structure that aligns with your goals and maximizes your financial strategies. The 6 main options chosen by small business owners are general partnership, limited partnership, sole proprietorship, corporation, S corporation, or a limited liability company (LLC). Each has unique strengths and limitations, so let’s take a look at the highlights:
Also known as a general partnership, this structure is a great option if you’re going to share ownership with other individuals. Each of the partners in these entities has an equal stake, helping to run the operations and sharing the burden of financial liability. If problems arise and the business incurs debts and losses, the partners would all be on the hook from a personal perspective. This means that assets such as homes, vehicles, real estate, and inventory could be in jeopardy.
One of the biggest reasons small business owners choose partnerships: it simplifies your tax situation and can save you money. With this structure, you can take advantage of “pass-through” laws that mean your business doesn’t have to pay taxes on profits and losses. Instead, those profits and losses pass through to the personal taxes of each partner.
Another benefit: partnerships are simple to form, and there aren’t too many costs associated with the process.
This structure shares a lot of common DNA with partnerships, as they’re both fairly easy to set up and the costs are modest. Additionally, limited partnerships also qualify for “pass-through” laws, making tax season more enjoyable—you can simply account for your business’s profits and losses on your personal taxes and potentially save a lot of money in the process.
The chief difference is that limited partnerships allow for a hierarchy among the partners. Rather than everyone sharing in the profits, having a voice in decisions, and sharing liability for losses, some of the partners can serve in an investor role, where they don’t take on personal liability for the business.
The clear advantage here: partners can take on a role that aligns with their priorities, whether that’s a full-fledged seat at the table that brings higher risks and rewards or a safer position that comes from the “limited” role.
For those who like independence and flexibility, a sole proprietorship is the next best thing to freelancing. This type of entity is convenient to set up and is one of the most inexpensive options available—no wonder it’s the most popular business entity in America.
As the name implies, sole proprietorships are intended for business with 1 owner. If you have partners involved, you’ll have plenty of other viable options, such as a partnership, limited partnership, corporation, S corporation, or limited liability company (LLC). Given the independent nature of a sole proprietorship, there are no business agreements to wrangle or outside approvals to seek.
The risks and rewards of a sole proprietorship are high-stakes. All profits come directly to you, but if things go south for your business, you alone will be liable for debts and losses. Personal assets could be at stake in these situations, including if you’re sued.
The tax arrangement for sole proprietorships is similar to partnerships, as the profits and losses pass through to your personal taxes. In the eyes of the government, you and your business are a single entity. The good news: sole proprietorships have low tax rates.
While sole proprietorships create a structure where you and your business are a single entity, corporations essentially put a rock wall between you. This legal separation offers liability protection if your business struggles, preserving personal assets. Your house, ranch, Winnebago, or boat will be safe from anyone seeking compensation.
Of course, it takes a lot more effort and paperwork to create a separate entity. Corporations can be complex, and the setup costs are substantially higher than many of the other options on this list.
Another potential drawback of corporations: you might be required to pay business taxes twice (as if tax season wasn’t already difficult enough). The first payment would be state and federal corporate income tax. If any business earnings were given to shareholders in the form of dividends, you would then need to pay personal taxes for those payments.
Perhaps you find the sophisticated nature of corporations intimidating. Much like how limited partnerships are a more user-friendly version of partnerships, there’s an option called an S corporation that provides more flexibility than a corporation.
S corporations offer a similar degree of personal liability protection, which is obviously a major benefit. If your business incurs debts or losses, you’ll be considered a separate entity and won’t need to worry about anyone coming after your personal assets.
Where S corporations differ: you can add more shareholders than in a corporation. This makes it easier to attract investors. Also, you won’t need to deal with the same complications when tax season rolls around. Your business’s profits and losses will pass through to your personal tax return, which is always the easiest method.
While S corporations are more streamlined than corporations in many ways, they still bring their fair share of challenges. You will be required to hold meetings for your directors and shareholders and keep detailed minutes from each of these meetings. Your shareholders must also be allowed to vote on key business decisions.
While sole proprietorships are the most popular business structure in America, LLCs might be the most beloved. This structure merges some of the best perks from corporations and partnerships into 1 entrepreneur-focused entity.
An LLC advertises its liability protection right in the name. This is a big deal for small business owners who have no interest in a structure that doesn’t shield them on a personal level from business debts and losses.
Another big benefit of LLCs: your business earnings and losses are handled on your personal tax returns. This pass-through arrangement is simple to handle, but it also means that you will owe self-employment tax. Be sure to plan on self-employment tax as the year progresses, so that you won’t be caught by surprise when you receive your tax bill.
You can have an unlimited number of shareholders in an LLC. And unlike a corporation or S corporation, you won’t need to deal with all the red tape associated with shareholder meetings and distributing meeting minutes.
As you can see, there are plenty of nuances to consider with each of these business structures. Your unique situation might immediately rule out some of the options, but you should consult with a tax professional to identify the structure that will best serve your needs and set you up for future success.
This is also a prime time to meet with your mentor and get an insider’s take on the situation. An experienced mentor can alert you to red flags and offer tips for streamlining the setup process.
As mentioned earlier, a substantial benefit of structuring your business is that you can boost your credibility and qualify for financing. Considering the fact that financing is an essential source of capital for most of America’s small businesses, this element of the decision shouldn’t be ignored.
Your business’s financial needs will vary wildly based on your industry. If you have a consulting business, you might be able to operate out of your home and only have moderate costs associated with your operations. On the other end of the spectrum, you might have a restaurant or construction business that would typically require a business location, utilities, equipment, supplies, insurance, licenses, permits, and other various expenses.
Based on the intel in your business plan, you can home in on the amount of money your business needs and the timeline to acquire it. You can then work with your mentor to identify the best financing option for your needs. Popular examples include:
You should also research other sources of capital. Many entrepreneurs prefer microloans because they’re easier to acquire, though the dollar amounts are typically much smaller. Some of the most reliable microloan providers are Kiva, Opportunity Fund, and Accion.
Another possible option is a business grant. This is one of the most challenging of all funding sources to qualify for, but the fact that the money is free certainly helps to justify the effort required to pursue them. Look for federal grant opportunities at Grants.gov, then check out some private sector options from the Halstead Grant, Amber Grant, Idea Café Grant, and National Association for the Self-Employed (NASE).
Whether you’re applying for a business term loan or scoring a grant from the federal government, your business structure will be an important part of your resume. The fact that you’ve set up your business as an entity shows how serious you are about its performance. It doesn’t matter whether it’s an LLC or S corporation or sole proprietorship—the point is that you’ve followed the necessary steps to legitimize your business in the eyes of the government and/or private lenders. And that seal of approval can really boost your odds of getting approved for financing and ultimately reaching the goals you outlined in your business plan.
Grant Olsen is a writer specializing in small business loans, leadership skills, and growth strategies. He is a contributing writer for KSL 5 TV, where his articles have generated more than 6 million page views, and has been featured on FitSmallBusiness.com and ModernHealthcare.com. Grant is also the author of the book "Rhino Trouble." He has a B.A. in English from Brigham Young University.
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