Choosing the right legal framework for your small business is critically important for determining your taxes, legal liability, and regulatory burdens. The major differences between business structures are mostly based on how many people are involved, the separation of personal assets from business assets, and regulatory red tape. Business structure can additionally impact how you find outside funding or investors.
It’s important to note that your structure doesn’t have to be static—you could start as a sole proprietorship, decide to form a limited liability company, and then eventually incorporate.
The most basic type of business organization is a sole proprietorship, which is for companies owned and operated by a single person. In this arrangement, the business is not considered a separate entity from the individual. All income, as well as losses, through a sole proprietorship is reported on its owner’s personal tax return. You also aren’t required to register your business with the state if you have a sole proprietorship, although you might have to register with your city or county. At the same time, the individual is personally liable for all business debts and lawsuits. If you earn a living as a freelance writer or run an Etsy store, for example, you are likely already organized as a sole proprietorship and don’t even know it, although you may need to file for a business license.
General partnerships are the second most basic type of business arrangement. They are fundamentally different from sole proprietorships because more than 1 person is involved. However, general partnerships offer relatively weak legal protections for those involved, so many opt for more robust business distinctions. If one of the partners runs up significant debt, all of the partners are personally liable. Still, general partnerships are less complex to register and, unlike a corporation, you don’t have to pay taxes on the company’s profits.
A limited partnership is a more rigorous partnership compared to a general partnership. Limited partnerships typically require additional government intervention. You will have to register with a state agency and pay an annual registration fee. The tax requirements are more complicated than a general partnership, and there might be more intense regulations from federal and state securities agencies. However, creditors are unable to go after the personal assets of the partners in limited partnerships.
A special type of limited partnership is the family limited partnership (FLP), where the partners are family members. In many cases, this arrangement is used for managing property owned by a family.
A limited liability company, or LLC, is a popular type of business designation in the United
States because it is a hybrid of general partnerships and corporations. As an LLC, your personal assets are not liable for business debts or lawsuits. You can also choose whether to be taxed as a sole proprietorship, a partnership, or a corporation. This flexibility is what makes LLCs so common. You will have to keep your personal and business finances separate and follow your state’s regulations closely, but LLC formation requires much less paperwork than forming a corporation. The LLC designation was created with small businesses in mind.
Depending on how you see your business expanding, you may want to opt for a corporation instead of an LLC. A corporation is an entirely separate entity from its owners. Unlike LLCs, corporations are recognized internationally. Corporations also are preferred by outside investors—in the same way, this is the preferred designation if you ever want to consider an initial public offering (IPO). Shares of stock owned by stockholders determine the ownership of a corporation. The stockholders have limited liability but also have limited control of the business. A board of directors, as elected by the stockholders, determines the activities of the business, including hiring the leadership.
A Subchapter S Corporation (S-corp) is taxed like a partnership but has the strong limited liability benefits of a corporation. The profits or losses of the business are passed down to the individual shareholders of the corporation. The business is limited to 100 stockholders or less, and they must all be US citizens or resident aliens. You must register your corporation in your state and then opt for Subchapter S status with the Internal Revenue Service. There are time periods and special rules around this process, so it is best to consult with a legal professional about what to do.
For a Subchapter C Corporation (C-corp), there is no limit to the number of stockholders. Also, the business must pay corporate income tax, unlike S-corps. If dividends are distributed to stockholders, taxes are levied on the individual level, too. As your company grows further, you may want to opt for C-corp status.