Choosing a business structure can be critical for all types of businesses. It is important to understand the available options because the selected business structure will affect the business owner’s tax and legal liability, the paperwork they have to tackle every year and their ability to raise outside funds.
Considerations when choosing a business structure
October 16, 2024 | 13 minute read
What is a business structure or business entity?
A business structure, sometimes known as a business entity, refers to the form in which a business is established or maintained. The type of business entity used may impact how the owners of the business are taxed and the potential liabilities they may face under the laws of the state in which the business operates.
A business owner may need to set up a separate business entity to open a business bank account, get a business credit card or apply for a small business loan.
Why is it important to consider what business structure might be appropriate?
There are many reasons it is essential to consider what business entity is better suited for the business.
- Taxes. The type of business entity selected will determine whether the business owner is subject to one or two levels of tax and the tax rate to which the business income will be subject.
- Protection of personal assets. Certain business structures may protect the owner’s personal assets up to their investment if there is a lawsuit or other liability.
- Ability to secure funding. If the business owner wishes to raise funds, they may need to set up a business entity that can issue stock or other equity.
- Separate credit score. Setting up a separate business entity can help the business owner establish credit for the business that is separate from the business owner’s personal credit.
- Paperwork. Certain business entities will require filings, such as annual reports, with governmental authorities.
- Registration. If the business owner wants to register the business in their state for tax or legal reasons, they may need to set up a business entity.
Types of business structures
There are many types of business entities available to small businesses and startups. Here is an overview that may be helpful. Please consult your legal and/or tax advisor to determine what business structure might be more appropriate for your business.
Sole proprietorship
When a person starts a business and does not select a business structure, in many jurisdictions the business will be a sole proprietorship by default. As the name implies, sole proprietorships are owned by one person. They report income, gain, loss, deductions, etc. of the business and pay taxes with respect to the business as part of their individual income tax return. At tax time, they generally must file Schedule SE with Form 1040 if their income from self-employment is $400 or more.
Key considerations
- This is generally the easiest form of business to start. Setting one up is inexpensive, and usually, license fees and business taxes are the only associated costs. Generally, there is minimal or no paperwork to file, and minimal or no special regulations and rules apply.
- Self-employed taxpayers may be able to take advantage of certain tax deductions, such as health insurance premium deductions; the Small Business Health Care Tax Credit, which provides a credit for up to 50% of certain healthcare premiums paid by certain small businesses for any employees; and the self-employment tax deduction, which permits deduction of half of Social Security and Medicare taxes.
- It can be relatively easy to terminate a sole proprietorship. Depending on the jurisdiction, the owner may need to notify the secretary of state, local tax authorities and any licensing entities who have issued the business license.
- The owner is personally responsible for the company’s debts and liabilities, which can put their personal assets, such as their home, at risk. When the owner dies, the business becomes part of their estate.
Partnership
If a person starts a business with one or several other people and all the partners have personal liability for the debts of the partnership, that is considered a general partnership. A general partnership is generally designed for situations where one or more partners are actively involved in the business.
If someone invests in the business but doesn’t want personal liability beyond that investment, a limited partnership can be formed instead of a general partnership. The investor could be a limited partner. There must be at least one general partner. This type of partnership may be more complicated to form and maintain than a general partnership because of the administrative complexities and required filings. Both general and limited partnerships feature pass-through taxation, which means that the partnership itself generally is not subject to tax, but each partner must include their share of partnership income, gain, loss, deductions, etc., on their own tax returns via Schedule K-1 to Form 1040.
The cost of maintaining a partnership may generally be higher than that of maintaining a sole proprietorship because of the fees associated with creating a partnership agreement and other filings with the state that may be required.
Key considerations
- Generally, partnerships require little to no paperwork filing (depending on the type of partnership and the jurisdiction), and the partnership may be able to continue if one of the partners retires or dies.
- Beyond this, a partnership may potentially have improved access to loans because the partnership would be drawing on the personal credit and collateral of more than one partner. And there is a potential tax benefit from partnerships because partners report their share of income or losses on their individual tax returns, creating one level of taxation.
- The general partners are personally liable for the company’s debts and liabilities. (However, the limited partner’s responsibility is typically limited to their investment in the business.)
Learn more: What’s needed to apply for a bank account as a limited partnership or general partnership
Limited liability company (LLC)
A limited liability company (LLC) is a type of business entity whereby the members of the company generally are not held personally liable for the company’s debts or liabilities (beyond the members’ investment in the LLC). LLCs are generally hybrid entities that combine the asset protection characteristics of a corporation with the tax characteristics of a partnership or sole proprietorship. The costs of setting up an LLC may vary, depending on whether outside help is used. The state filing fee may range from $50 to several hundred dollars or more. Online LLC formation services will charge additional fees, though these fees typically cover additional activities required to set up the business. An attorney can also assist with formation services.
Key considerations
- An LLC offers some benefits of the corporate structure, such as protecting the business owner’s personal assets, and generally may require less paperwork to establish. When the LLC is taxed as a partnership, This form of business offers more flexibility in how profits are distributed, compared with S and C corporations.
- Depending on state law, there are generally no restrictions on how many members the business can have. Some state laws may not require LLCs to have annual meetings or a board of directors, which may make them relatively easy to maintain.
- An LLC may not offer liability protection if the business owner does not keep their business and personal finances separate. Members of LLCs generally must pay self-employment taxes along with income and other taxes.
Cooperative
A cooperative is a member-owned structure that is designed to meet the social, economic and cultural needs of those who belong to it. Common types of co-ops include housing co-ops, credit unions, retail co-ops and consumer co-ops. They are typically made up of at least five members. Co-ops may have special tax rules, depending on the type of co-op.
Key considerations
- A co-op is a separate legal entity from its members, and members, employees and directors are generally not personally liable for its debts. Co-ops are generally egalitarian: All members get equal voting rights, no matter how many shares they own.
- Because co-ops depend on cooperation, they can struggle to make decisions if members don’t see eye to eye.
Corporations
C corporation
A C corporation is a separate legal entity from its owners, and it generally protects the owners from personal liability. Instead of pass-through taxation, the business may be subject to double taxation since the C corporation is subject to tax and its shareholders may be subject to tax on distributions from the C corporation. An LLC may in certain circumstances elect to be treated as a C corporation for tax purposes.
Key considerations
- In some ways, a C corporation enjoys the greatest flexibility of any business structure. There’s generally no limit on the number of owners, unlike S corporations or partnerships that elect to be taxed as an S corporation, which have a limit of 100 shareholders.
- If a business owner has big plans for their business, a C corporation may, initially or at some later time, be a viable option since it can sell shares to more than 100 investors. In fact, if a business owner plans to go public someday, they may have to incorporate as a C corporation either when established or at a later time.
- The flexibility of a C corporation often comes with the costs of processes and fees. C corporations file state paperwork and pay fees upon incorporation and every year thereafter.
- A C corporation also must have a board of directors, hold annual meetings of shareholders and file annual reports with the state and other governmental regulators.
Learn more: What’s needed to apply for a bank account as a corporation
S corporation
Forming an S corporation or electing for an LLC to be taxed as an S corporation may potentially reduce self-employment taxes. An S corporation generally cannot have more than 100 shareholders, must have only one class of stock and can only have U.S. residents and certain trusts as shareholders.
Key considerations
- Any distributions the S corporation makes to an individual shareholder are generally not subject to payroll taxes, such as Social Security, Medicare and unemployment.
- The earnings of an S corporation generally may be taxed only once, at the shareholder level; by comparison, in a C corporation, the earnings generally are taxed twice — when the corporation is taxed and when earnings are distributed to shareholders.
- An S corporation also may shield shareholders from the debts of a corporation.
- The number and types of owners are more limited for S corporations as compared with many other types of entities.
- S corporations often must pay taxes if they sell or distribute to any shareholders any assets that have appreciated in value before the conversion to an S corporation. And S corporation shareholders who directly or indirectly own more than 2% of the stock in the S corporation (at any time during the year) or who own stock with more than 2% voting power in the S corporation are generally not eligible for certain tax-advantaged benefits, such as company-paid health insurance premiums.
- These benefits are generally treated as Form W-2 wages for federal tax purposes.
B corporation
A benefit corporation or B corporation is a business entity that has two purposes: turning a profit — like a for-profit corporation — and promoting the public good, like a nonprofit. The directors of a B corporation are responsible for reporting how they are supporting the public good to their shareholders.
Key considerations
- A B corporation allows the shareholders to do well by doing good, generating profits while contributing to society.
- The purpose-driven nature of a B corporation may help in building a strong culture that attracts employees and customers who believe in its mission.
- B corporations are not available in every state.
Closed corporation
A closed corporation, also known as a privately held company, is one with a small number of shareholders, who are typically managers, owners and families closely associated with a business.
Key considerations
- Businesses that structure themselves as a closed corporation gain the liability protection that comes with a corporate structure. Because these corporations are not publicly traded, they may offer flexibility that publicly traded companies do not have, without the same reporting requirements to shareholders.
- It may be harder to raise funds in a closed corporation than in a publicly traded one because they cannot sell shares to the public.
- Since a closed corporation is not publicly traded, if a shareholder wants to cash out, they generally must sell the shares to the remaining shareholders. This can pose a challenge if those shareholders are not ready or willing to buy them out.
Open corporation
This is a type of corporation that sells its shares on a public stock exchange, such as the New York Stock Exchange or Nasdaq. Some open corporations sell their shares through private, over-the-counter transactions. Generally, small businesses are not structured as open corporations, but if a small startup scales up, it can become a publicly traded corporation one day.
Key considerations
- The ability to raise funds from the public on a large scale makes open corporations attractive to small companies with a big vision for growth. Because the shares are publicly traded, shareholders have a lot of liquidity.
- There are steep compliance and reporting requirements for open corporations.
Nonprofit
A nonprofit organization is a structure for organizations whose purpose is promoting social causes or advocating for a group that needs help. A nonprofit organization may be eligible for tax-exempt status under section 501 of the Internal Revenue Code. It is different from a nongovernmental organization (NGO), which has a similar purpose but operates outside of the borders of the U.S.
Key considerations
- The tax exemptions that may come with nonprofit status generally make them less costly to run.
- While laws governing nonprofit corporations vary from state to state, a nonprofit generally cannot be owned by its founders and cannot be sold. If it is dissolved, it must give its assets to another like-minded nonprofit organization.
- Even if an entity has tax-exempt status, annual IRS as well as state reporting requirements may apply depending on the entity’s annual gross receipts.
Choosing a business structure
Clearly, there’s a lot to consider when an aspiring business owner is choosing a form of business. That owner will need to think ahead and choose a business structure that can grow with their business, or consider whether they should change their business structure as they grow. This is a big decision that can greatly affect a business, and business owners should consult with a qualified attorney as well as a qualified tax advisor to choose the best business structure for their needs and goals. When making a decision, business owners should consider factors such as flexibility, complexity, liability protection, implications for their taxes, and permits and licensing requirements.
Once a business owner is ready to get started and has identified the best structure for their business, third-party providers specializing in business formation can help streamline the process and get them the documentation they need, depending on the business structure they choose.
To learn more about the steps to launch a new business, including how to form your business with an exclusive offer from Bizee, visit The Bank of America Start a Business Center.
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