Look Before you Leap: Which Business Structure is Best?

It’s time.

You’ve decided to take the leap: you’re ready to start your own business.

But before you do, it's crucial to select the best legal structure. Skipping this step could have massive tax and legal implications. So, our goal for this article is simple: to help you make the best decision given your unique situation.

To accomplish that goal, we'll explore the differences between the four most common types of business entities: sole proprietorships, partnerships, LLCs, and corporations. We'll provide an overview of each structure, discuss the legal and financial implications of each option, and weigh various pros and cons. By the end of this article, you'll have a better understanding of the different structures available. This will allow you to make a more informed decision about which one is right for your business.

Let’s jump right in.

Sole Proprietorship

A sole proprietorship is by far the easiest business structure to operate. In fact, according to the SBA, 87% of non-employer small businesses (freelancers or self-employed individuals) operate as sole proprietorships. In this structure, the business is typically owned and operated by a single person. The owner is directly liable for company activities, and business income “flows through” to the individual for tax purposes.

How do you form one? By performing business activities. There is no need to set up a separate legal entity – you’re automatically considered a sole proprietor by default if no other structure is chosen. You can still operate under a trade name by filing a “doing business as” form with your local government. Requirements vary by state, so be sure to check your state’s specific instructions.

The primary benefits of a sole proprietorship are the easy and inexpensive setup, simple tax filing process, and complete control over the business. The primary drawbacks are the absence of liability protection, limited tax strategy flexibility, and difficulty raising capital for business expansion.

A sole proprietorship can be a great choice for small, low-risk businesses. They can also work well for testing a new idea before investing in a more formalized structure.

Partnership

A general partnership is like a sole proprietorship, except it involves more than one owner. If you go into business with a friend, for example, by default the business would be considered a general partnership. In a general partnership, no separate legal entity is set up and, as a result, the partners are directly liable for company activities. Also, like a sole proprietorship, business income “flows through” to the partners for tax purposes.

It is also possible to set up a separate legal entity for the partnership. In this case, the two most common types of partnerships are limited partnerships (LPs) and limited liability partnerships (LLPs). In a limited partnership, there is typically one general partner (GP) who bears unlimited liability, while all other partners have limited liability. The GP will generally have more control over the day-to-day operations of the business, while the LPs do not. In contrast, with a limited liability partnership, all partners enjoy limited liability protection.

Given the wide variety in partnership types and structures, they are commonly used for a variety of businesses and investments ranging from small, low-risk businesses with multiple owners, to complex real-estate development and other investment projects, to professional services organizations such as accounting or law firms.

Limited Liability Company (LLC)

LLCs, or limited liability companies, are a popular hybrid business structure. They offer some of the benefits of both partnerships and corporations. LLCs provide limited liability protection for owners, meaning personal assets are shielded from business liabilities and legal actions. They also offer flexible management options, with the ability to be managed either by the owners themselves (member-managed) or by one or more designated managers (manager-managed). Another advantage of LLCs is that they can choose to be taxed as either a partnership or as a corporation, depending upon the needs of the business. This provides more flexibility in tax planning.

However, LLCs can be more expensive and complicated to setup and maintain than sole-proprietorships or general partnerships. LLCs must file a variety of forms and reports with the government. This can involve extra administrative burden as compared to a sole proprietorship or general partnership.

LLCs can be a great choice for higher-risk businesses, for owners with significant personal assets to protect, and for owners who value flexibility in tax planning.

Corporation

A corporation, sometimes referred to as a C corp, is a completely separate entity from its owners. These entities provide the strongest personal liability protection. A C Corp is particularly well suited for businesses that expect to raise large amounts of capital since they’re able to readily sell shares of stock to new investors.

The tradeoff for these benefits, however, is that corporations are much more complex to create and maintain. Formation and management costs are higher as a result. In addition, corporations are generally subject to a higher level of reporting. Additionally, many corporations are subject to double taxation. Double taxation occurs when the corporation’s profits are taxed at the company level, and then taxed again when dividends are paid to shareholders on their personal returns.

Corporations are excellent choices for high-risk businesses that expect to raise outside funds or that intend to go public or be acquired by another company.

Final Thoughts

Considering the various business structures available before making the jump is a prudent step every business owner should take. Each option comes with its benefits and drawbacks, so it’s critical to ensure that the structure is optimized to align with the goals of the business. The good news is that the company's legal structure can adjust over time. Many business owners choose to update their business structure one or more times over the life of the business.

Have more questions, or still find yourself unsure what structure is best for your business? We completely understand - there is a tremendous amount of nuance to every situation. Involving professional legal counsel early and often may be a wise investment and can help avoid costly mistakes. Our team specializes in supporting new business owners, so feel free to reach out and we'll be happy to help.

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