Deciding how to structure your business is a seemingly simple task that has far-reaching consequences. The legal structure of your business will determine your personal liability, your tax liability, the regulatory oversight and reporting requirements imposed on your business, how scalable your business is, and the type of business ownership and control that you have.
We can help simplify the decision: in this article, we provide a concise overview of all the different type of business structures out there, and the pros and cons of each.
A sole proprietorship is the most basic business structure. For that reason, it is also the default business structure: if you don’t specifically set up the legal structure of you business, it will be considered a sole proprietorship by law.
In a sole proprietorship, the business is owned by a single person, and the law draws no distinction between the assets and liabilities of the business and that of the owner.
A sole proprietorship offers simplicity and no costs. You do not need to file for, or register, the business entity, and you don’t have to file its taxes separately. As part of this simple structure, you can also deduct business expenses from your personal income tax.
The biggest disadvantage of a sole proprietorship is a direct result of its simple structure. As the only owner, you are personally responsible for the business’s liabilities. If the business fails to satisfy a debt, your personal assets can be seized. For this reason, it is also much more difficult to get a business loan and to build business credit.
The General Partnership
The general partnership business structure is exactly the same type of business entity as a sole proprietorship, with only one difference: instead of having one owner, the business has several owners (partners) who are all joint and severally liable for the liabilities and obligations of the business.
The benefits of a general partnership are the same as those of a sole proprietorship, with the additional advantage that partners can help you absorb business losses if they should arise. The disadvantages are also similar to those of a sole proprietorship.
The Limited Partnership
Unlike the previous two business entities, a limited partnership (LP) is a formal legal structure for a business, and to create an LLP you need to file paperwork with the state. An LP has two kinds of partners: those who own, operate and assume liability for the business; and those who only act as investors. The former partners are general partners in the same sense as seen with a general partnership above. The latter are limited partners, or so-called “silent partners.”
Limited partners do not have direct control over the business and its day-to-day operations. Accordingly, they also face fewer liabilities for the business’s debts. Because they act as investors, they also pay lower taxes than general partners.
Creating an LP can be an attractive way of raising capital. It offers investors some protection: they can serve as limited partners and not incur personal liability. Another aspect of this business structure that makes it an attractive way to raise capital is that general partners maintain authority over all business operations. A final advantage is that limited partners can leave the partnership without it having to be dissolved. This increases the potential continuity of the business, even if its investors change.
Under an LP, general partners are still personally responsible for all the business’s debts and liabilities. In addition, this entity is more expensive to create than a general partnership because it requires filing an application with your state. Finally, this business structure does not completely exempt limited partners from personal liability: if they take too active a role in the business, they can be held personally liable for business debts.
The Limited Liability Partnership
A limited liability partnership (LLP) is a business structure in which all of the partners are the joint owners of the business, and they all share in the profits and losses of the business. In this regard, it is very similar to a general partnership.
There is one big difference, however: in the case of LLPs, none of the partners have personal liability for the losses and debts of the business. Each partner is only directly liable for any damages or losses arising out of his or her own negligence and misconduct. However, this business structure is only available to partnerships offering professional services (doctors, lawyers, and accounting firms, for example).
The Limited Liability Company
A limited liability company (LLC) is a form of business that is jointly owned by all the members of the LLC. The exact structure and proportion of ownership is determined in a membership agreement. If an LLC is correctly incorporated and legally operated, each of the members of the LLC are shielded from personal liability for the debts and obligations of the LLC. There is a complete separation between the assets and liabilities of the company and those of its members, in other words. The income generated by the LLC flows directly to its members, in whose hands it is taxed.
An LLC is relatively easy and inexpensive to form. This is a very big advantage when compared with the other business structures (corporations) that offer similar protection to the personal assets of the business owners. In addition, the actual operation of an LLC is very flexible and much can be determined in the LLC operating agreement: how profits are shared, how tax liabilities are divided among members, and how the day-to-day operations of the LLC are run, for example.
The fact that an LLC is a pass-through entity for tax purposes makes it an unattractive investment prospect. The structure does not allow for investor protections (such as those offered by preferred shares in the case of corporations) and pose increased tax liabilities to potential investors. If you are looking to raise funds, therefore, an LLC is not an advisable option.
The C Corporation
A Corporation (the C Corporation being the default type) is a legal entity that has a completely separate legal existence from its owners. The business entity is owned by shareholders, and managed by a board of directors.
The C Corporation is the first business structure on this list that is, as an entity, liable for corporate income tax. This means that its owners (shareholders) are not taxed on the business income generated by the C Corp.
A C Corp is the ideal structure for businesses looking to raise funds. The fact that its ownership is attached to shareholding makes it easy and simple to distribute equity in exchange for investments. Shareholding and shareholders’ rights also allow for the creation of preferred shares (and different classes of shares) that can carry specific rights and protections. Some examples of this includes anti-dilution protection, the right to appoint board members, enhanced voting rights, and limits on the transferability of shares. In short: a corporation’s ownership is complex enough to allow for a multitude of different business realities.
Another great advantage of the C Corp is that it is subject to federal income tax. This means that the shareholders are not taxed on business income. This is another reason why investors prefer to invest in corporations. A corporation’s separate existence from its owners and managers also ensures its continuity.
The benefits of a C Corp comes at the cost of increased regulatory scrutiny. It is much more complex and expensive to form a corporation, and the reporting requirements that corporations face are much more extensive than those imposed on simpler business structures. This means increased requirements for how the business is run, including board meetings, shareholder meetings, keeping meeting minutes, and creating bylaws.
A Variation on the Standard Corporation Structure: S-Corps
All corporations share the same basic structure set out above for C Corps. There is one further refinement on the corporations structure: S-Corps.
S-Corps are essentially C-Corps that are owned by a relatively small number of investors, all of them natural persons. An S-Corp can function as a corporation whilst being taxed as a partnership.
Any C Corp can file IRS Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (IRS). If the corporation meets the requirements, it will be taxed as a partnership. The most important requirements are that all shareholders are natural persons (i.e. not business entities) and that there are no more than 100 shareholders.
If you are a relatively small business, an S-Corp allows the benefit of simplified tax returns (you are taxed on the income in your own hands, and the business is not subject to income tax).
S-Corps are, by nature, not very scalable. You cannot have more than 100 shareholders. In addition, the fact that those shareholders must be natural persons excludes any potential commercial investors and VC funds from investing in your company.
Talk to a Business Formation Lawyer Before Starting Your Business
Your business structure should reflect not only your current commercial reality, but also your aspirations and future goals. Consult with a legal expert today to get strategic advice about your ideal business structure and how to make the most of the legal opportunities offered by your choice. Our business formation lawyers are experts at helping business owners transform their dreams into reality.