Understanding the ins and outs of business structure types is an important step in your entrepreneurial journey. Leveraging the right business structure (aka “business entity”) can have a positive impact on growth, taxation, funding, and your personal liability as a business owner.
To help you choose the best legal structure for your business, let's dive into the pros and cons of every option and examine the types of companies that typically benefit from each business structure type.
What is a business structure?
A business structure is an organization formed by a single person or group to conduct business. Choosing the right business structure is a big deal, as it influences how you form, manage, and grow your business.
The business structure that you choose will directly impact:
- How your business is set up (formation requirements)
- How your business is taxed
- How business profits are shared
- Your legal liability as a business owner
- The size of your business and how it operates
- The funding options your business can seek out
The main types of business structures
The most commonly used business structures are:
- Sole Proprietorships
- Limited Liability Companies
Keep reading to understand the pros and cons of each structure and learn which businesses they suit best.
What is a sole proprietorship?
A sole proprietorship is the most common type of business structure and the easiest one to form. A Sole Proprietorship is not considered a separate structure, but an extension of a single owner. In the eyes of the law, you and your business are one and the same. All business-related activities from profit, employees, to liabilities, are attached to the sole proprietor. The only way a Sole Proprietorship can be owned by two people is when those two people are a legally married couple who file joint taxes.
Advantages of a sole proprietorship
- Easy and inexpensive to form. Most states will only require you to file a Doing Business As (DBA) in the county of primary operations if you want to operate under another name. The only fees you will need to consider are potential licensing costs for your DBA.
- Single taxation. Your business profits are only taxed as your personal income. This is known as “pass-through” taxation.
- Complete control. You will always have decision-making power and complete control of your business.
Disadvantages of a sole proprietorship
- Personal liability. There’s no separation between owner and business. As an owner, you're on the hook for any business debts and legal issues that may arise.
- Zero continuity. A sole proprietorship ends upon the owner’s death or incapacitation.
Who should form a sole proprietorship?
Sole proprietorships are typically best for people who want to start a small business with the intention of running it solo. A sole proprietorship is usually a popular option for personal trainers, makeup artists, writers, and home-cleaning services.
Partnerships are similar to sole proprietorships in many ways. The main difference is that the business has two or more owners. There are three kinds of partnerships: general partnerships (GPs), limited partnerships (LPs), and limited liability partnerships (LLPs).
What is a general partnership?
In a general partnership (GP), all partners actively manage the business and share in the profits and losses. This is the default mode of ownership for multiple-owner businesses, and there’s no need to register a general partnership with the state; when two or more people go into business together with the goal of earning a profit, a general partnership exists by default.
Advantages of a general partnership
- Easy to form. Most states will only require you to file a Doing Business As (DBA) in the county of primary operations if the owner chooses to operate under another name.
- Single taxation. Your business profits are only taxed as personal income of the partners (i.e. pass-through taxation).
- Shared risk. A single person doesn't need to absorb all the risk because partners divide losses as well as profit.
Disadvantages of a general partnership
- Personal liability. Partners are personally liable for business liabilities.
- Conflicts can arise. Partners don’t always agree on business decisions and operations. A detailed partnership agreement is the best way to avoid lengthy and potentially costly conflicts. If you need to create a partnership agreement, speed up the process with this free partnership agreement template from UpCounsel.
What is a limited partnership?
A limited partnership (LP) is like a general partnership with the addition of having limited partners. In a limited partnership, there will always have to be at least one general partner who has unlimited liability in the business and a limited partner who has limited liabilities. Like a general partnership, it’s important to have a partnership agreement with a detailed division of contributions, duties, profits, and losses in the business. Typically, general partners are more involved in the business's day-to-day operations, while limited partners take a backseat and usually just contribute capital.
Advantages of a limited partnership
- Easy and inexpensive to form. Similar to general partnerships, most states will only require you to file a Doing Business As (DBA) in the county of primary operations if the owner chooses to operate under another name.
- Pass-through taxation. Business profits are only taxed as personal income of the partners.
- Limited liability. Although general partners are exposed to personal risk, limited partners are protected from personal liability that the business may experience.
- Shared risk. With partners dividing losses and profit, the risk is shared by more than one person.
Disadvantages of a limited partnership
- Personal liability. Any general partners are personally liable for business liabilities.
- Partner conflicts can arise. Partners might not always agree on business decisions and operations.
What is a limited liability partnership?
Limited liability partnerships (LLPs) allow some or all of the partners the benefit of having limited liability. These partnerships, however, can only be entered into by licensed professionals of certain industries. Only some states recognize LLPs. And in most of those cases, only lawyers, accountants, and architects are permitted to form limited liability partnerships. Before you move ahead with this business structure, remember that states have different rules and regulations so it is important to check the rules in your area.
Advantages of a limited liability partnership
- Single taxation. Similar to other partnership business structures, profits are only taxed as personal income of the partners (pass-through taxation).
- No personal liability. Limited partners are protected from personal liability that the business may incur.
- Separate accountability. Partners in a limited liability partnership are not liable for the negligence or malpractice of a single partner in their business. Each partner is only accountable for their own negligence and malpractice.
Disadvantages of a limited liability partnership
- Pricey insurance policies for partners and the LLP. Each partner must have individual malpractice insurance, because they are responsible for their own liability. Some professions, like medical specialties in some states, are also known to have hefty insurance premiums that can exceed $100,000 a year.
- Different rules and regulations per state. Each state allows different professions to enter into an LLP, so working or expanding your business and partners from other states may be difficult.
Who should form a partnership?
General partnerships and limited partnerships are a good choice for those looking for an easy and cost-effective way to start a business with multiple people. It is a good way to minimize the risk and cost of starting a business because more than one person will be taking on these responsibilities. A general partnership is a good option for bands, tattoo artists, or any business that wants to be started by more than one person.
Licensed professionals from certain industries should form a limited liability partnership if they have a group of fellow professionals who will find it beneficial to form a business together. A good example would be a law firm of attorneys with different specializations. A law firm that is an LLP can attract a bigger number of clients because they offer more than one specialization.
What is a corporation?
A corporation is a business structure that is legally separate from its owners. Shareholders, therefore, are not liable for the corporation’s debts and liabilities. Although forming a corporation has the benefit of being a separate structure from the shareholders, there are some disadvantages as well.
For example, forming a corporation requires more paperwork and admin. A corporation must follow the article of incorporation bylaws, must hold shareholder and board meetings, and prepare minutes of those meetings. If the bylaws are not followed, the corporation risks the limited liability protection of the shareholders.
C corporation vs S corporation: what’s the difference?
A C corporation is the traditional and default type of corporation, wherein there can be any number of shareholders, the corporation pays its own taxes and the shareholders receive dividends that they need to pay taxes on.
An S corporation on the other hand can only have a maximum of 100 shareholders, one class of stock available, and all shareholders must be US citizens or residents. The biggest benefit of an S corporation, especially for small businesses, is that an S corporation is only taxed once, at the level of the business owners or shareholders.
Advantages of corporations
- Personal liability protection. Corporate shareholders do not risk personal liability when the business incurs losses and liabilities.
- More funding options. It is easier for corporations to gather more funding from investors because they are able to sell shares.
- Business perpituity. The corporation can continue running indefinitely because it can pass through many generations of investors.
- Pass-through taxation (S corporation only). S corporation profits are only taxed once, because the corporation itself is not taxed on its income. The incorporators are only taxed on the dividends they receive.
Disadvantages of corporations
- You may be hit by double taxation. C corporations will be taxed on business profits first and then the investors will also be taxed on dividends earned.
- They can be complex and expensive to form. Corporations need to adhere to the rules and regulations at a local, state, and federal level. Corporations will need to deal with the IRS and their local Secretary of State office to form and maintain their structure. This usually means hefty filing and legal fees.
Who should form a corporation?
A corporation is often best for those looking to start a long-standing business with plans for high growth and expansion. Incorporated businesses can also gain credibility in the eyes of investors and consumers, tax rates can be lower, and financing and grants will likely be easier to obtain compared to other business entities. If you’re interested in incorporation, talk to a licensed professional to discuss the best option for your business.
Limited Liability Companies
What is a Limited Liability Company?
A limited liability company (LLC) is a hybrid business structure for private companies that combines the aspects of a partnership and a corporation. An LLC benefits from the flexibility and pass-through taxation of a partnership while maintaining the limited liability of a corporation. Owners, known as “members” in LLCs, can opt for the business’s profits, losses, credits, or deductions to be processed on their tax returns, just like in sole proprietorships, partnerships, and S corporations. Or they can elect to be taxed like C corporations.
Advantages of a limited liability corporation
- Personal liability protection. LLC members do not risk personal liability when the business incurs losses and liabilities.
- Flexible taxation options. Members can choose how they will be taxed—as a sole proprietorship, general partnership, S corporation, or C corporation.
- Flexible ownership. You can be an owner operator and register as an individual or as a group.
Disadvantages of a limited liability corporation
- Can’t receive wages. You cannot pay yourself wages from the business even if you participate in day-to-day operations.
- Franchising fees. Many states have franchise and/or capital values tax on LLCs.
- Self-employment tax. LLC members that are not taxed like corporations will need to pay self-employment taxes on their income.
- No ownership changes. If any partner in an LLC decides to leave the business, the LLC is dissolved.
Who should form an LLC?
LLCs can be advantageous for entrepreneurs who want to have an easier-to-manage business structure that comes with the added perk of limited personal liability. Typically, an LLC is a popular choice for newer operations that are still figuring out what business structure best suits their business.
How to choose the right business structure for your service business
So what’s the best business structure for your business? Unfortunately, there’s no one-size-fits-all answer to this question. Ultimately, working with an attorney is the best way to determine which legal structure makes the most sense for your business.
Before you book in with a pro, ask yourself the following questions:
- How much personal liability are you willing to take on? Certain business structures (e.g. a corporation) can reduce your level of personal risk.
- Do you want to work with partners? You’ll want to set up a partnership, an LLC with multiple members, or a corporation.
- Do you want to hire employees? Note that sole proprietorships can’t hire employees but they can work with independent contractors.
- Will you need to take on funding? Incorporating will help you build credit and credibility for your business—you’ll need both when you work with potential investors and lenders.
- Do you want to sell your business one day? Sole proprietorships can’t be sold or transferred in the same way that other business entities can be sold.
Frequently Asked Questions
Can you change business structure types?
Yes, it is possible to change business structure types. Many service businesses begin as sole proprietorships or partnerships, and incorporate when it makes sense to do so. Switching can be a tedious process, but it is generally straightforward. Just be prepared to deal with the paperwork and be sure to outsource the process to a licensed pro.
What is pass-through taxation?
Pass-through taxation (also known as flow-through taxation) is a way of taxing a business structure by allowing the taxable income from business operations to “pass through” from the business to the owner(s). Both sole proprietorships and partnerships use pass-through taxation, and the owners of these business types pay all business taxes on their personal tax returns (i.e. there are no additional tax forms for the business itself).
What is double taxation?
Double taxation is when income tax is paid twice on the same income. For example, an incorporated business will pay income taxes on profits. And then shareholders will also have to pay personal income tax for that same income they receive as dividends from the business.
Is double taxation always a bad thing?
Not always. Depending on the amount of income and allowable deductions, personal income tax rates alone may still be higher than corporate tax rates plus income tax rates combined. Working with a CPA is the best way to know whether incorporating—and taking on double taxation—is the right move for your business.
What is a B Corporation?
A B corporation (aka “B corp”) is not an official type of Corporation, but a special certification awarded to businesses that go above and beyond to meet specific high standards of operation. For businesses to be certified B-Corporations, they must meet the following criteria:
- Demonstrate a high social and environmental performance by scoring an 80 or above on the B Impact assessment and a risk review.
- Make a legal commitment to change their corporate governance to be accountable to all stakeholders, not just shareholders.
- Exhibit transparency by providing information about their performance that can be measured against B Lab’s standards, which can then be publicly available on their B corp profile.
There are several benefits to being a certified B-corp company. The most beneficial thing is that it brings positive awareness to your business. Aggregate awareness of B Corps in the US is 43% and in Canada it's 32%, and there's been a 488% increase in news attention given to B Corps in 2020 compared to 2019. Popular companies that are B-corp certified are Nespresso, The Body Shop, and Patagonia.
Want to get your B corporation certification? Visit the Guide to B corporation certification for processing fees and requirements.