Types Of Business Structures: The Complete Guide

Your small business structure determines your taxes, paperwork requirements, ability to raise money, and personal financial liability. Every business is different; even within the same industry, certain businesses will benefit far more from one type of structure as opposed to others.

But how do you know which business type is right for you?

In this article, we’ll break down different business structures and the benefits and drawbacks of each to help you make the most informed decision for your business.

Types Of Business Structures

There are several ways a business can be structured, including:

• Sole proprietorship
• Partnership
• Corporation
• Limited Liability Corporation (LLC)
• Nonprofit
• Cooperative

Each type of business structure has huge implications for how the business operates, what level of liability and protection the business owner can expect, how the business and business owner are taxed, which tax deductions you’re eligible for, and more. These considerations are no small matter, so choosing the right business structure crucial to running a successful business.

Let’s dive into how each business type works and the pros and cons of each.

Sole Proprietorship

A sole proprietorship is an unincorporated business owned and operated by one person and is the simplest of the business structure.

You are legally considered a sole proprietor if you engage in business activities. There is no need to formally register your business. However, depending on your business type, you may still be required to get state and local licenses and permits to legally operate your business.

Under a sole proprietorship, you may operate under your own name or a fictitious name–also known as a DBA (doing business as) or trade name. This trade name does not create a legal entity separate from the owner.

The sole proprietorship owner records the business’s income and losses on their personal tax return by filing a Schedule C form.

Sole proprietors also file a Schedule SE for paying self-employment tax. These forms are filed with the standard Form 1040.

Many small business owners choose to operate as sole proprietors because of how quick, easy, and inexpensive it is to get started. However, this type of legal structure isn’t without its drawbacks.

One of the biggest downsides is that a sole proprietorship is indistinguishable from its owner; it’s not a separate legal entity. Hence, the business owner can be held personally liable for the debts and obligations of the business. So if your business is sued for negligence, your personal assets — such as your bank account and personal real estate — could be at risk. And if you default on a business loan, your personal assets could be seized to repay the debt.

Pros & Cons Of Sole Proprietorships

Is a sole proprietorship right for your business? Consider these pros and cons before deciding.

Pros

Cons

When To Choose A Sole Proprietorship

Sole proprietorships are best for low-risk and low-income businesses. Some entrepreneurs start as a sole proprietorship when testing a business idea before adopting another business structure. Most commonly, sole proprietorships are selected by service professionals, freelancers, and consultants.

Partnership

A partnership is the simplest business structure for businesses that have two or more owners. Like a sole proprietorship, it’s quick, easy, and inexpensive, and you aren’t required to register your partnership. Simply coming to an agreement with other owners and engaging in business activities is enough to establish a partnership.

You may still need to obtain the appropriate licenses and permits to operate your business legally. You may also be required to register your partnership with your state depending on the type of partnership you form.

When it’s tax time, a Form 1065 is filed with the IRS to report income, losses, gains, deductions, and credits. The partnership does not directly pay income taxes, but instead, “passes through” profits and losses to each partner, who report this information on their personal tax returns. Profits or losses are recorded on a Schedule K-1, filed with personal tax returns. All partners are also required to pay self-employment tax based on their share of the company’s profits.

Before establishing a partnership, it’s always important to ensure the right partners are selected. Disagreements between partners can hinder business growth and could even be the downfall of the business.

Types Of Partnerships

There are three different kinds of partnerships to consider. The primary difference between them lies in the personal liability of each partner.

Pros & Cons Of Business Partnerships

With the right people, a partnership can be very successful.

There are several benefits to forming a partnership. Before you get started, though, it’s also important to understand the risks and drawbacks associated with this business entity.

Pros

Cons

When To Choose A Partnership

While any business with two or more owners can form a partnership, this business structure is best for low-risk businesses and professional groups. Like sole proprietorships, this structure is also a good way to test a new business idea. If the business is successful, owners may take the next step to growth by reorganizing as a corporation.

Corporation

A corporation is the most expensive and complicated business structure.

If you plan to raise capital through the sale of common or preferred stock, your business will need to be set up as a corporation.

There are no limitations on how long a corporation can exist. The corporation does not have to be dissolved if an owner dies or retires.

Corporations are independent legal entities separate from their owners, providing the owners with the best liability protection. However, this type of legal structure has more regulations and tax requirements. Most corporations hire an attorney to ensure the corporation is set up and maintained according to state regulations.

Depending on the type of corporation, double taxation may also be a concern. This means that corporations pay federal and state corporate income tax, while shareholders also report dividends on their personal tax returns. Many corporations enlist a tax preparer or hire an accountant to ensure returns are filed correctly, which adds an additional business expense.

Types Of Corporations

There are a few different types of corporations. Let’s explore the differences between each type.

Pros & Cons Of Corporations

Big benefits come along with forming a corporation, but like other entities, there are also negative aspects to consider before choosing a corporation as your business structure.

Pros

Cons

When To Choose A Corporation

If you plan to grow your business in the future and want to raise large amounts of capital to fund that growth, a corporation could be the best legal structure for your business.

Limited Liability Company (LLC)

Business owners who want the best of both worlds may consider forming a limited liability company, also known as an LLC. An LLC combines the benefits of other business entities to keep taxes and business requirements lower than corporations while also offering personal liability protection for its owners. All members of the LLC can fully participate in the operations of the business.

LLCs must be registered with the secretary of state in the state where the business will operate. In some states, an operating agreement will also need to be filed.

In an LLC, owners have limited liability, in most cases protecting their personal assets from being taken to pay off business debts and obligations, just like a corporation. Personal assets will also be protected in the event that the business files for bankruptcy.

Owners can select how an LLC is taxed by the IRS. LLCs can be taxed like a corporation, or the profits and losses can be passed through to the LLC members and filed on personal tax returns. Members must file a Form SE to pay self-employment taxes.

Pros & Cons Of LLCs

Will forming an LLC best meet the needs of your business? Only you can answer this question, but make sure to fully evaluate the pros and cons of forming an LLC before making your decision.

Pros

Cons

When To Choose A Limited Liability Corporation

An LLC is best for any business that wants to protect the personal assets of its members. It’s also a good choice for businesses that want the benefits of a corporation without paying corporate tax rates.

Nonprofit

Most businesses have one primary goal: to make a profit. One business structure is the exception: nonprofits. A nonprofit — or 501(c)(3) — is a business that is beneficial to the public.

Nonprofit corporations follow rules and regulations similar to other types of corporations. However, nonprofits also have additional rules governing how profits are used. For example, profits can’t be distributed to members of the corporation.

Another difference between nonprofits and other corporations is that this type of business entity may be exempt from state and federal income taxes. However, nonprofits must register with the IRS to receive this exemption and register with the state.

Religious, educational, literary, and scientific organizations may be eligible for nonprofit status. Charities are also businesses that are formed as nonprofits.

Pros & Cons Of Nonprofits

Before you make your decision, weigh out these pros and cons:

Pros

Cons

When To Choose A Nonprofit

If the goal of your business is to benefit the public, choosing a nonprofit structure may be the right choice for you. However, if your goal is to profit, consider another business structure.

Cooperative

A cooperative, or co-op, is a type of business that operates for the benefit of its members. Members of a co-op are known as user-owners and have the right to vote on important decisions surrounding the growth and direction of the business. Officers and a board of directors are responsible for running the co-op.

Pros & Cons Of Cooperatives

If you’ve thought about your goals and think a cooperative may work for your business, read through these pros and cons before making your final decision.

Pros

Cons

When To Choose A Cooperative

Any business can become a cooperative if the goal of the business is to benefit the user-owners. Businesses that aim to sell their products or services to consumers for a profit would be better suited to form another type of business entity.

How To Choose The Right Business Structure

Ultimately, the type of business structure you select is based on your business’s current and future goals. You should consider the long-term plan before choosing your business structure. While you can always reorganize if needed, this process can be lengthy and expensive. Ask yourself:

• What is the goal of my business?
• How long do I plan on being in business?
• How much business growth do I anticipate?
• How many key decision-makers does my business have?
• What level of liability am I comfortable with?
• How do I want my business to be taxed?

If you’re still having difficulties choosing the right business structure, consider consulting with an accountant, business consultant, and/or attorney to weigh out the pros and cons of each and make the decision that’s best for your business.

Once you’re ready to get your business off the ground, check out our beginner guides for business to get started on the right track.