What Is a Business Structure?
A business structure is a government classification of an enterprise that is intended to regulate certain aspects of a company.
When looking at your startup from a federal government perspective, the legal business structure of your company will determine how your taxes are structured. From a state perspective, the legal structure of your company is used to determine liability.
In the next few sections, we’re going to go over why your business structure is important and what ramifications choosing one structure over another will have.
In case your business gets sued, business structures such as a limited liability company (LLC) can protect your personal assets. If your business or industry has any potential for personal liability, it is highly recommended that you look into a business structure that offers liability protection.
For example, if you develop a product and one of your customers gets injured while using that product, a potential liability case arises. Similarly, if your company owns property that allows outside visitors and a visitor happens to get injured as a result of something present on that land, there is also the potential for a liability lawsuit. If you’d like to ask specific questions regarding liability, consulting an attorney is the ideal way to go.
The tax implications of your business structure are one of the most important considerations to make. Business owners who are taxed as sole proprietors, partnerships, or S corporations have their business income “pass-through” to themselves as personal income. They then pay taxes on the income that passes through the business. C corporations, on the other hand, completely separate the income of the business from the owner.
The significant differences between personal tax rates and business tax rates make choosing a tax-friendly business structure a priority for startups. Take the time to think through your company’s situation, and consider consulting a tax lawyer for additional guidance.
The hierarchy of your business will depend on the type of legal structure your company was incorporated under. For instance, corporations must decide on a board of directors, and under certain state laws, the board must convene a minimum number of times every year.
In case of a transfer of ownership, if the owner dies, or if the owner exits the company, corporate hierarchies also determine share transfer rules and offer contingency protections. Note that this type of hierarchical protection is only offered under corporate structures, not LLCs, partnerships, or sole proprietorships.
Registration and Paperwork
The paperwork and registration processes for corporations compared to more simplistic structures, such as LLCs, differ significantly. For example, starting a corporation requires you to submit articles of incorporation and submit government reports on a regular basis. Additionally, you’ll need a legal business structure before you can open bank accounts on behalf of your business or file for an EIN used for tax purposes.
Depending on the business structure you’ve chosen for your startup, how you do fundraising or take on outside capital will differ. If you have a sole proprietorship, you won’t be able to offer equity or shares in your business as a corporation could. If you’ll be seeking outside investment and funding, it’s important to structure your business in order to make this process as easy as possible for investors.
Most Common Business Structures
Choosing a business structure for your startup can be daunting in the beginning, but once you know about the types of structures that exist and their purposes, you’ll be able to make an informed decision.
Here are some of the most common business structures founders and explanations for why a certain structure should be used over another:
Sole proprietorships are enabled by “default.” If you don’t register a business officially and operate under your own name, you’re automatically considered to be a sole proprietor.
There is no officially registered business entity with a sole proprietor, and your business is not separate from your personal liabilities and personal assets. If there are any debts, obligations, or lawsuits that befall your business, you will be personally liable and responsible for them.
For low-risk businesses, this can be the ideal choice. If you want more protections under the law, it is recommended to form a business under one of the officially registered entities.
If two or more people would like to form a business together, partnerships are the ideal choice. When forming a partnership, you can choose to make your business a limited liability partnership (LLP) or a limited partnership (LP).
In a limited partnership (LP), you generally have one partner who has unlimited liability, and then the remaining partners within your legal entity are considered to have limited liability. These limited liability partners also generally have limited control over the company. Similar to LLCs, any profits that are generated in an LP structure are passed through to the partners on their taxes, and the partner without limited liability (the general partner) is also required to pay self-employment taxes.
Limited liability partnerships (LLP), on the other hand, provide limited liability for every partner within the business. If there are any debts that arise within a partnership, for instance, none of the partners will be responsible for the actions of the other partners in an LLP.
In a limited liability company (LLC), you get the benefits of a partnership and corporation combined into one entity. If you form an LLC for your startup, it’ll protect you from any personal liability, and in most instances, it’ll also protect your personal assets such as your bank accounts, vehicles, and home. In case your business declares bankruptcy, your personal assets will still be kept safe – this is one of the primary benefits of a limited liability company.
For all profits and losses generated by your business, they will be “passed through” into your personal tax returns. Additionally, you’ll be considered self-employed and will be required to pay self-employment taxes.
Corporations come in different shapes and sizes, and all have different purposes based on the type of business you wish to run.
C corporations are a legal entity that is completely separate from the owners of the business. Any profits or losses within a corporation are taxed as a separate entity and not passed through to the owners or partners. For the strongest liability protections, corporations are the ideal business structure.
B corporations are different from C corps in their transparency, accountability, and purpose but are taxed identically. If you form a B corp, the shareholders will hold the company accountable for producing a financial profit as well as a public benefit of some sort. In some states, a B corporation will be required to submit an annual report that demonstrates the benefit the corporation provided to the common good.
Selecting a Business Structure for Your Startup
Now that you know all of the different types of business structures available, it’s time to make a decision and determine the right business structure for your startup. We’re going to walk through the thought process for making this determination.
For most small businesses, the ideal business structure is an LLC. This is primarily due to their simplicity and the personal liability protection they provide. Due to the complexities of corporations, including filing paperwork, annual reports, and selecting a board of directors, LLCs are a much simpler choice for small enterprises. Additionally, if you plan on reinvesting most of your profits back into the business and don’t need to attract any investors, this would be the ideal business structure for you.
If your startup is planning on taking on venture capital funding or looping in an angel investor, you’ll likely want to consider a corporation over an LLC. In a corporation, you’ll be able to give your investors shares and company equity in a quick and straightforward manner.
Many small businesses begin their journey as an LLC and then later transition into a corporation once it makes sense for their business. However, if you need to attract outside investment or plan to carry profit over from tax year to tax year, then forming a corporation from the get-go may be ideal.
It’s also important to note that you can elect S corporation tax status in order to save on the distributions you bring in as income. If your startup generates a large net profit, it may make sense to file taxes as an S corporation, where you could potentially save up to 17%. Discussing this with an accountant or attorney is the ideal course of action, as every startup is different.
Which Is Best for Your Startup?
We’ve walked through the most common types of business structures, what they do, and what the benefits of each might be for your startup company.
C corporations are generally preferred for startups due to their ability to take on outside investment with ease, but your decision will depend solely on your company’s goals and vision.
The ball is now in your court – it’s up to you to decide which business structure makes the most sense for how your startup operates and your eventual goals. It should be clear that businesses that plan to receive outside investment should prefer corporations, whereas smaller businesses that would ideally reinvest their profits back into the business could start simply with an LLC.
We recommend consulting with an accountant and attorney to ensure that your business structure makes the most sense for your goals.
Frequently Asked Questions
What is the best business structure for a startup?
For a startup looking to receive funding, a C corporation is generally preferred. Unlike LLCs or partnerships, a C corp can easily take on outside investment and give shares and equity of the company to investors. C corporations also have the best liability protections out of all business structure types. For a startup looking to form something quick and easy to obtain liability protection, an LLC may be ideal.
What are the three types of business structures?
The three most common types of business structures include the sole proprietorship, limited liability company (LLC), and C corporation. Out of all of the businesses formed today, most businesses are created with one of these four structures.