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Start QuizTypes Of Business Structures: The Complete Guide
Business structures determine several important factors like taxes and the ability to raise money. Which business structure is right for you?
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Key Takeaways
- There most common business structure types are sole proprietor, partnership, corporation, limited liability corporation, nonprofit, and cooperation.
- The type of business structure you choose has a huge impact on your business's liability, taxes, revenue structure, and more.
- Many businesses choose a sole proprietorship for its simplicity, but an LLC gives business owners more liability protection.
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.
Table of Contents
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
- Easy & Inexpensive: No costly fees are associated with setting up a sole proprietorship. In fact, you don’t even have to register at all. Simply buying and selling goods or performing other business activities classifies your business as a sole proprietorship.
- No Ongoing Requirements: Unlike other business structures, a sole proprietorship does not have requirements such as meetings or voting.
- Simplified Taxes: You do not have to file a separate tax return for your sole proprietorship. Instead, you attach your Schedule C and Schedule SE to your personal income tax return. You will also have your earnings taxed once, and you can write off your business losses on your personal return.
Cons
- Unlimited Personal Liability: As a sole proprietor, you would be responsible for the debts, obligations, and liabilities of your business. Your personal assets could be put at risk, and lawsuits can be filed against you.
- Financing Difficulties: As a sole proprietor, getting extra capital when you need it can be difficult. Banks, credit unions, and even some alternative lenders are hesitant to loan money to sole proprietors. You also will be unable to sell stock to raise money.
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
- Minimum Requirements For GPs: General partnerships have minimum requirements and do not require filing with the state. Partnerships are also not subject to the same requirements as corporations, such as holding meetings, recording meeting minutes, and establishing bylaws.
- Tax Requirements: Partnerships are not required to pay taxes on income, and partners can report their share of profits or losses on their personal income tax returns. Business losses can also be deducted on personal tax returns.
- Raising Capital For LPs & LLPs: Businesses that choose to form an LP or LLP may be able to raise capital from their investors.
Cons
- Personal Liability: General partners are liable for the business’s debts, obligations, and liabilities. Each partner may also be held accountable for the actions of other partners.
- Financing Challenges For GPs: General partnerships may have difficulties getting loans, or other business financing, if the business is not registered.
- Costs: While forming a general partnership is easy and inexpensive, a limited partnership or limited liability partnership may be more expensive and require filing with the state.
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
- Ability To Raise Capital: Corporations give you the biggest opportunities for raising large amounts of capital through the sale of stock.
- Limited Personal Liability: Corporations offer the most protection against personal liability for shareholders.
- Some Tax Benefits: C-corporations offer more tax deductions than other business entities, as well as lower self-employment taxes. S-corporations also offer the additional benefit of no corporate tax rates or double taxation.
Cons
- Higher Cost To Form: It is more expensive to form a corporation than any other business structure.
- More Requirements: Corporations have more ongoing requirements, including holding meetings, recording meeting minutes, and establishing bylaws.
- Shareholder Restrictions: The number of shareholders is restricted to 100 or less if you create an S-corp.
- Higher Taxes: C-corps face double taxation. Business losses also can’t be deducted on personal income tax returns.
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
- Limited Liability: One of the biggest benefits of an LLC is that all members have limited liability, meaning personal assets aren’t at risk in most cases. (You can also give yourself extra protection with insurance for your LLC.)
- Tax Benefits: With an LLC, you have the option to choose how your business is taxed.
- Fewer Requirements: There is less paperwork and fewer ongoing requirements for an LLC when compared to a corporation.
- No Shareholder Limits: An LLC has no limits to its number of shareholders.
Cons
- Expensive & Time-Consuming To Set Up: Because you will have to register with the state where you conduct operations, setting up an LLC is more expensive and time-consuming than forming a general partnership or sole proprietorship. You may also need to hire an accountant to help ensure you’re complying with the rules and regulations of your state — adding an additional expense to your list.
- Limited Life: If a member quits, dies, or retires, the LLC may be dissolved. Some states even have laws in place that require an LLC to dissolve after a set number of years.
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
- Tax Exemption: Qualifying organizations may be exempt from paying corporate income tax, as well as state and local taxes.
- Tax Deductions: Charitable contributions by a nonprofit may be tax-deductible.
- Limited Liability: All founders, directors, employees, and members of the nonprofit are not liable for the debts and obligations of the nonprofit…in most cases. There are, however, some exceptions, such as when the organization is engaged in illegal activity.
- Grant Opportunities: Nonprofits may be eligible for public and private grants not available to for-profit businesses.
Cons
- Paperwork Requirements: Nonprofits must submit annual reports to state agencies and the IRS in order to maintain tax-exempt status.
- Costs: Starting a nonprofit can be expensive in terms of time and money. Nonprofits must pay fees, and most organizations opt to hire attorneys, accountants, and/or consultants to make sure records are kept up-to-date and all regulations are followed.
- Stricter Policies: In addition to following state laws and regulations, nonprofits are also required to follow their own bylaws and articles of incorporation.
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
- Everyone Has A Voice: Member-owners get to weigh in on key issues and decisions of the business. Regardless of how many shares a member-owner holds, all votes are weighed equally.
- Member Investments: Member-owners buy into a cooperative, providing a source of capital that can be used for operational expenses or expanding the business.
Cons
- Funding Challenges: Finding startup loans and other types of funding through traditional lenders may be difficult. Cooperatives have to get creative with other funding sources, such as launching a crowdfunding campaign or applying for small business grants.
- Slow Decision-Making: Voting and making decisions can be a lengthy process. This can put the cooperative at a disadvantage if a critical decision must be made immediately.
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.
Chelsea Krause
Lead Staff Writer
Chelsea Krause is a writer who specializes in accounting, payroll, and small business loans. She has been with Merchant Maverick helping small business owners manage their finances since 2016. She is a QuickBooks Certified User and former eCommerce store owner. Her accounting expertise has been quoted in Forbes and her work appears in Startup Nation, Small Business Bonfire, and Women on Business. Chelsea graduated summa cum laude with a BA in English & Creative Writing from George Fox University and studied abroad at the University of Oxford as well. She currently resides in Boise, Idaho.
View Chelsea Krause's professional experience on LinkedIn.
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