When starting a new business, the structure you choose will determine how your business functions, the way it pays taxes, and the legal liability you may carry as the owner.
You may start your business as a sole proprietorship or partnership. But it may eventually evolve into a larger entity and a different structure may better suit your need to expand and raise capital.
Every business structure has its pros and cons, so it’s important to consider your options before launching your start-up. To help you make a decision, we’ll go through several business types: sole proprietorships, partnerships, corporations, and LLCs.
Related documents: Business and Employment Forms
What is a sole proprietorship?
A sole proprietorship is an unincorporated business that you run and own yourself. It’s often the default structure if you’re just starting to work as a self-employed person.
As a sole proprietor, you’re responsible for your company’s debts, mistakes, and agreements. So, if the business goes bankrupt with outstanding debt, you’re personally responsible for paying back the money owed. If you fail to repay a loan, a creditor may sue and seize your personal assets or garnish your income to settle the score.
As a sole trader, you only have to file your personal income tax return. Include your income from your business, along with any other income you may have.
You may also be subject to self-employment tax because you’re working for yourself. If needed, consult with an accountant before filing your annual return in your business’s first fiscal year.
Advantages of a sole proprietorship:
- Straightforward legal structure
- Low formation costs and little paperwork
- The owner has full control over company management
- Pay taxes at a personal income level (low rates)
- Focus on your core business
Disadvantages of a sole proprietorship
- The business dissolves if the owner dies
- The owner is liable for all business obligations, contracts, debts, violations, and more
- Investors may consider the business a high-risk investment, as there is no equity to give as collateral
- May be subject to self-employment taxation
What is a business partnership?
A partnership is when two or more individuals form a business together to generate a profit. Partnerships can occur in different forms: general partnerships, limited partnerships, or joint ventures.
What is a general partnership?
In general partnerships, each partner owns either an equal amount of equity or an amount relative to their investment and contribution. Each partner also shares liability regarding the partnership.
Like sole proprietorships, each partner pays taxes on their individual income tax returns (so the income from the partnership itself isn’t taxed). This is called pass-through taxation because the taxes pass through the business to the people that operate it. However, partnerships must report their earnings, losses, and deductions in an annual information return.
A partnership is another default structure, like a sole trader, but with two or more people involved. If there is a dispute, courts will look at the terms of the partnership. So, it’s best to have a written agreement. Use a Partnership Agreement to define the responsibilities of each partner and outline the distribution of income and losses.
Advantages of a general partnership:
- A simple business structure
- Partners combine resources, cash, and skills
- Partners often share responsibilities
- Pay taxes at a personal income level (low rates)
Disadvantages of a general partnership:
- Partners are liable for the actions taken on behalf of the business
- Partners may disagree on business decisions
- If one of two partners withdraws from the agreement, the business dissolves
- Partners may be subject to self-employment taxes
What is a limited business partnership?
In a limited partnership, partners are only liable for their share of the business.
For instance, if you contribute $10,000 into a company worth $200,000, you’d only own a 5% stake in the business. Therefore, you’re only responsible for the 5% stake and not accountable for the company’s entire debt.
Usually, limited partners are investors who don’t partake in the daily operations of a business. Instead, the general partner handles day-to-day management.
Advantages of a limited partnership:
- Limited partner liabilities are equal to their contributions
- Limited partners often avoid management duties
- Pay taxes on your investment at a personal level
Disadvantages of a limited partnership:
- General partners are mainly liable for the company
- Limited partners often require periodic updates on the business
- Only suits certain ventures, such as small businesses that operate as sole proprietors or partners already
What is a joint venture in business?
A joint venture is similar to a partnership but is a more temporary arrangement in which two or more members collaborate on a project for mutual benefit.
This structure involves sharing costs, risks, strategies, and resources. Often there is no profit realized by the joint venture. Instead, the members will separately make use of whatever the venture built, discovered, or negotiated.
Generally, joint ventures occur between established businesses. If your company lacks resources to expand, but another company with an established distribution network sees an advantage in pairing your products with its own, this type of enterprise can be a fast and effective way to build your business and access new markets.
Advantages of a joint venture:
- Pooled resources and capital contributions
- Diversification of skills, services, or products
- Access to new markets and distribution channels
- Pay taxes at a personal income level (low rates)
Disadvantages of a joint venture:
- Members may be liable for each other’s actions
- Potential for conflict when making business decisions
- Imbalanced levels of investment
- High confidentiality requirements are needed in the Joint Venture Agreement if the members are competitors in the marketplace
Want to write a joint venture proposal?
Draft a sample Joint Venture Agreement to get an idea of the terms you’re willing (or unwilling) to compromise on.
What is a corporation?
A corporation is a separate legal entity with its own rights and liabilities that are distinct from its owners, members, and shareholders.
Corporations can be private or public. In public corporations, people buy and sell shares on the stock exchange. Private corporations, however, don’t issue shares for public trading.
To create a corporation, you must file Articles of Incorporation in the state where your business operates. Your articles should include details about your business, the share structure, and the directors of the company. Your corporation also needs to obtain the necessary permits and licenses.
While procedures vary by state and business, the general steps to take for incorporating your business are as follows:
- Hold an organizational meeting to develop corporate bylaws
- Determine internal management structures
- Elect directors and officers
- Issue stock certificates
- Record everything in a corporate minute book
Read more: Startup Founders: 5 Steps for Success
What is a C corporation?
A C corporation is a business entity that may have numerous shareholders—owners of your company’s shares (also known as stock or equity). Shareholders of C corporations may include foreign and local citizens.
C corporations can issue different classes of shares to attract investment without diluting the controlling interests of the original shareholders. This is done by limiting or eliminating voting rights in the new share class.
Another distinguishing feature of this type of business entity is that it’s subject to corporate taxation: the corporation pays taxes based on its profits, and shareholders also pay taxes on any income (dividends) they earn from the business.
Advantages of C corporations:
- Prestige and credibility attracts investors
- Flexibility of ownership and transferability of shares
- Corporations can continue to exist if one shareholder decides to sell their shares
- Ability to address shareholders’ rights and responsibilities in a Shareholders’ Agreement
- Different classes of stock for investors, shareholders, and employees
- Unlimited amount of owners
Disadvantages of C corporations:
- Qualifies for corporate taxation
- A startup requires a fair amount of paperwork (with associated filing costs)
- Corporations must appoint directors, who in turn must ensure they abide by directors’ duties to the corporation
What is an S corporation?
An S corporation is any type of corporation that files taxes under Subchapter S after meeting Internal Revenue Code requirements. This allows the corporation to qualify for pass-through taxation, where shareholders pay taxes on their individual tax returns at normal rates.
Some requirements for being an S corporation include having no more than 100 shareholders and no more than one class of stock. Plus, only human persons (not partnerships, corporations, or non-residents) can be shareholders.
Advantages of an S corporation:
- No personal liability for shareholders
- Ability to avoid double taxation
- The corporation continues to operate if one partner dissolves their shares
Disadvantages of an S corporation:
- The startup requires a fair amount of paperwork (must set up an LLC or C corp before applying for S corp status)
- Strict requirements for qualifying as an S corp
- Must hold regular meetings and record minutes
What is a limited liability company?
A limited liability company (LLC) is a type of hybrid legal structure that combines the limited liability of a corporation with the personal tax structure of a partnership.
To form an LLC, you must file Articles of Organization within your state. This document includes your business name and the names of each member.
Draft an LLC Operating Agreement to define how your business operates. This contract includes your company’s purpose, member information, capital contributions, profit and loss distribution, and more.
You’ll also need to obtain state-specific permits or licenses to operate. Be sure to check the LLC formation requirements in your jurisdiction. Some states, like New York, require you to publish a notice of your company’s formation in a daily and a weekly newspaper approved by the local county clerk.
Advantages of a limited liability company:
- An LLC operates as a separate legal entity
- Members are not personally liable for business debts, obligations, or wrongdoings
- Avail of pass-through taxation
- Members determine the distribution of profits and losses
- Able to seek outside funding (unless the company goes public)
- Members don’t have to hold annual meetings or take minutes
Disadvantages of a limited liability company:
- The startup requires a fair amount of paperwork
- Cannot issue stock or shares in exchange for funding
- Cannot have more than one class of shares
- If the LLC decides to pay taxes individually, there are self-employment taxes
- The LLC may dissolve if a certain member withdraws ownership (avoid this by specifying continuation in your operating agreement)
What structure is best for your company?
There is no one-size-fits-all approach to choosing a legal business structure. It depends on your situation and your business.
The needs of your business may change over time, which is why it is important to review what’s working for your business and what could improve. If necessary, adjust your business structure accordingly.
Whichever you decide, you can always consult other business owners about their experience choosing a business structure or consult with a lawyer on the best course of action for your company.