Constructing Your Business’s Foundation

Choosing the right business structure is vital for every entrepreneur. It can determine the success of your business, from day-to-day operations to tax payments and the security of your personal assets.

The structure of your business can impact your tax obligations, funding opportunities, and required documentation, as well as your personal responsibilities as the business owner.

When registering your company with the state, it is essential to carefully choose a business structure that aligns with your goals and maximizes your chances of success. Obtaining a tax identification number and applying for the necessary licenses and permits are also crucial steps.

However, keep in mind that changing the business structure later can have serious consequences, including location restrictions, tax implications, and involuntary dissolution. Consulting with experienced business advisors, lawyers, and accountants can help you make an informed decision and avoid costly mistakes.

Choose your business structure wisely to maximize your chances of success and ensure long-term growth.

Exploring Common Business Structures

The Sole Proprietorship

A sole proprietorship is a simple and straightforward way to start a business, and it provides the owner with complete control over their enterprise. If you’re operating a business without registering it as any other type of organization, it will automatically be considered a sole proprietorship.

Since a sole proprietorship does not produce a separate legal entity, your business assets and liabilities are not separated from your personal ones. As a result, you could be personally liable for your company’s debts and obligations. Sole proprietors may still obtain a business name, but it can be difficult to obtain financing since you cannot sell stock, and banks are hesitant to lend to sole proprietorships.

The sole proprietorship can be an excellent choice for low-risk businesses and entrepreneurs who want to experiment with a business idea before establishing a more formal structure.

Partnerships

Partnerships are the most basic structure for two or more individuals to operate a business together. There are two common types of partnerships: limited partnerships (LPs) and limited liability partnerships (LLPs).

Limited partnerships have one general partner (manager) with unrestricted liability, while all other partners have limited liability. Limited partners typically have limited control over the company, which is outlined in the partnership agreement. Profits are reported on personal tax returns, and the general partner (the non-limited liability partner) must pay self-employment taxes.

Limited liability partnerships are similar to limited partnerships but provide limited liability protection to all owners. An LLP protects each partner from debts incurred by the partnership. Additionally, partners are not liable for the actions of other partners.

Partnerships can be a good option for multi-owner businesses, groups of professionals (such as lawyers), and groups who want to test a business idea before forming a more formal company.

Limited Liability Company (LLC)

An LLC offers the advantages of both a corporation and a partnership.

LLCs protect owners from personal liability in most cases, ensuring that their personal assets (such as their car, home, and savings account) are not at risk if the LLC goes bankrupt or is sued.

Losses and gains can be passed through personal income tax returns without having to pay corporate taxes. However, LLC members are considered self-employed and must pay self-employment taxes, including Medicare and Social Security contributions.

In several states, LLCs may have a fixed term. If a member joins or leaves the LLC, some states require that the company be dissolved and re-formed with the new members unless an agreement has already been established within the LLC itself to purchase, sell, and transfer ownership.

LLCs can be a good option for medium- to high-risk businesses, owners with significant personal assets they want to protect, and those who want to pay a lower tax rate than a corporation

Types of Corporate Structures

C Corporation

C Corporations, also known as Corporations, are a distinct legal entity separate from their owners. They can generate profits, pay taxes, and be held legally responsible.

The major advantage of a corporation is that it provides the greatest level of protection to its owners against personal liability. However, the cost of establishing a corporation is higher than that of other corporate structures, and they necessitate comprehensive bookkeeping, management systems, and reporting.

Unlike sole proprietorships, partnerships, and LLCs, corporations are taxed on their earnings, and in some cases, the profits of corporations are taxed twice: first, when the corporation makes a profit, and secondly when dividends are paid to shareholders through their personal tax returns.

Corporations operate independently of their shareholders, and if a shareholder sells their shares or leaves the corporation, the C Corporation can continue operating with minimal disruption.

Corporations can raise funds by selling shares, making them a suitable choice for businesses that require medium to high-risk capital, plan to “go public,” or are preparing to be sold in the future. They can also be advantageous in attracting employees.

S-Corporation

An S Corporation, or S-Corp, is a unique kind of corporation that avoids the double taxation disadvantage of traditional C corporations. It allows profits and certain losses to be sent directly to the owner’s personal income without being subject to corporate tax rates.

Not all states treat S corporations the same way, although most recognize them similarly to the federal government and tax shareholders accordingly. Some states tax earnings above a specified limit, while others do not recognize S corporations at all and instead treat them as C corporations.

To be recognized as an S corporation, you must file an application with the IRS, which is a different procedure than registering with your state. S corporations have special requirements and must comply with the strict filing and operating procedures of C corporations.

Like C corporations, S corporations operate independently of their shareholders. If a shareholder sells their shares or leaves the S corporation, it can continue to operate with little disruption.

S corporations may be a suitable option for businesses that would otherwise be C corporations but meet the eligibility criteria to register as an S corporation.

B-Corporation

A Benefit Corporation, or B Corporation, is a for-profit corporation that is recognized in most states in the United States. Its purpose, accountability, and transparency differ from those of a C Corporation, although its tax treatment is not.

B corporations are mission-driven and profit-driven. Shareholders hold the company accountable for producing some form of public benefit in addition to financial gain. Some states require you to submit annual benefit reports demonstrating your contribution to the common good.

Several third-party certification services exist for B corporations, but none are required for a company to register in states where this legal category exists.

Closed Corporation

Closed corporations are similar to B corporations but have a less formal corporate structure. They are not subject to the same formalities as most corporations and are commonly used by small companies.

The regulations vary by state, but your shares are generally exempt from public transactions. Closely held corporations can be run by a small group of shareholders without the need for a board of directors

Nonprofit Corporations

Nonprofit corporations are established to carry out charitable or educational, religious, literary, or scientific endeavors. As their work serves the public interest, they are often exempt from paying federal or state income taxes on any revenue they generate.

To qualify for tax-exempt status, nonprofit corporations must apply to the IRS. This process is distinct from registering with the state.

Nonprofit corporations must adhere to similar organizational regulations as traditional C corporations. However, they must also adhere to specific rules governing the distribution of their earnings. For example, they cannot distribute profits among members or contribute to political campaigns.

Nonprofit corporations are sometimes referred to as 501(c)(3) corporations, named after the section of the Internal Revenue Code commonly used to grant tax-exempt status.

Cooperatives

Cooperatives are businesses or organizations owned and managed by the individuals who utilize their services, with profits and income distributed among member owners. Typically, a board of directors and officers are elected to oversee operations, while regular members possess voting power to direct the cooperative’s direction.

Members can become part of the cooperative by purchasing shares. However, the amount of shares they hold does not influence their voting weight.

Combining Different Business Structures

Classifications such as S corporations and non-profits are not solely business structures but also refer to tax brackets. An LLC has the option to be taxed as a C corporation, S corporation, or non-profit corporation, but these options are less frequent and can prove more challenging to establish. Should you be considering any of these non-traditional structures, seek the guidance of a business advisor or attorney to ensure that you make an informed decision.

Comparing Business Structures

While you can compare business structures based on their general outlines, it’s crucial to note that each structure’s ownership rules, responsibilities, taxes, and filing requirements can vary depending on your state. The following list serves as a general reference point, but it’s essential to consult with a business tax specialist to confirm the specific requirements of your business.