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Business Structures

Introduction

If you’re thinking about starting a new business, you’ll have to select the proper business structure (also referred to as the business entity or business form). Choosing the best business structure for your new business is a big first step, and shouldn’t be taken too lightly. In fact, selecting the best business structure is essential to being a sophisticated business owner and will increase your likelihood of success.

While there are many books and articles on business formation, many fail to properly evaluate what business structure to properly select. It’s also easy to get confused with all the choices because businesses come in so many shapes, sizes, and varieties. However, this article aims to simplify your process a little, and get you thinking in broad terms before you get into some of the finer details.

In this article, we’ll go over the main considerations before choosing a business structure, types of business structures, and some of the pros and cons of each business form. We’ll briefly explore the business structures of sole proprietorships, partnerships, limited liability companies, and corporations.

NOTE: If you would like more detailed information on a particular business structure (e.g. partnership or limited liability company), please look for hyperlinks to articles that go into more detail on the different business structures.

Next, let’s take a general look at the different types of business structures out there.


Business Structure Overview & Diagram

For a new entrepreneur or business owner it can be difficult to even know where to begin when selecting the best business structure for your business. So, here, we’re going to take a look "from above the forest" at the different types of business structures you could select.

With that said, there are essentially 4 main business structures. The 4 main business structures listed generally from least to most sophisticated include:
  1. Sole proprietorships,
  2. Partnerships,
  3. Limited Liability Companies, and
  4. Corporations
The level of "sophistication" refers to the time and energy to create, maintain, and properly manage the legal aspects of the business structure. But keep in mind that situations can occur where a "less sophisticated business structure,”" is actually more sophisticated than a "more sophisticated business structure." What do we mean? Well, for example, a partnership may require more legal work than a limited liability company depending on specific facts of the business.

Additionally, we can break apart the above 4 types of business structures into a little more detail. Below is a diagram of the 4 main business entities broken down in a little more detail, again from the least to most sophisticated structures:



The Business Structure Spectrum:

  1. Sole Proprietorships
  2. Partnerships (i.e. General Partnerships)
    • Limited Partnership – with a "natural" general partner (e.g. individual)
    • Limited Partnership – with a corporation as a general partner
    • Limited Liability Partnership
  3. Limited Liability Companies
    • Limited Liability Company – member managed
    • Limited Liability Company – manager managed
  4. Corporations
    • S-Corporation
    • C-Corporation
Now, this is a "big picture" from "above the trees." This should give you a general idea about what types of business structures are available. There can be variations of these business structures (e.g. professional business structures like with law firms, accountant firms, etc.), but the above diagram represents the foundation for different types of business structures. Also, while this chart attempts to simplify which businesses are easier to maintain than others, the actual details of the business will determine its true level of sophistication.

Next, we’ll go over some main areas to take into consideration when selecting any business structure.


Fundamental Business Structure Concerns

There will be many concerns associated with the business structure you select. However, if we keep our view "above the trees" without getting into too much detail, there are essentially 3 main areas of concern in selecting a new business structure. The 3 main areas of concern in selecting any business structure include:
  1. Taxes,
  2. Liabilities, and
  3. Business Formalities
Let’s go into a little more detail on each of these 3 areas of concern.

1. Taxes


Many new business owners hate even hearing the word "taxes," but don’t let the word "taxes" intimate you. For starters, the reality is that businesses must pay taxes. The key is not to necessarily know everything about taxes. Rather, the key is to learn enough about taxes to spot issues that may affect your business. Then, hire an accountant and/or tax attorney to deal with the nitty-gritty details of tax law. If you know enough about taxes to spot major issues, you will stay ahead of your competition and help to save your business money (and maybe lots of money).

The business structure you create will alter how you pay your taxes. The Internal Revenue Service ("IRS") controls how businesses are taxes at the federal level, and your state and local governments control taxes at the state and local levels. New business owners always want to avoid any unnecessary taxes, i.e. taxes you can avoid. However, for most small business owners, setting up a business in a different state just to avoid a few bucks on taxes generally is not the best choice. But you’ll obviously want to consult an attorney for your particular situation.

With that said, there are 2 basic ways in which you can be taxed based on the selection of your business structure:
  1. personally, or
  2. as a corporation
Sole proprietorships and partnerships are generally taxed personally. That means that the profits made are taxed at the individual’s tax bracket rate, which usually varies around 15% to 35%. You can take a look at what you paid in taxes last year for a general idea about what you might expect to pay (while also taking into consideration what you expect your business to generate in profits).

Limited liability companies ("LLCs") can be taxed personally like a sole proprietorship or partnership, or elect to be taxed as a corporation. Corporations’ profits are taxed twice – (i) at the corporate tax rate and (ii) personally at the individual’s tax bracket for the profits received.

Now, this is just the bare, bare bones of taxes. But understand that sole proprietorships and partnerships are generally taxed at the personal level. LLCs can be taxed at the personal level or corporate level (i.e. taxed twice), and corporations are taxed twice at the corporate level and personal level.

2. Liabilities


The next main area of concern in selecting a business structure deals with liability. Liabilities are all the potential things that a business could "get in trouble for" or "be accountable for." Businesses can be liable for both acts, i.e. things done, and/or omissions, i.e. things that were not done. If you’re wondering how a business could be liable for an omission (something it did not do), consider a business owner that hires a minor worker, i.e. under age 18, without determining the youth’s age. You can probably imagine, that depending on the type of work and hours performed by the minor, that business owner could be liable for failing to check the minor’s age (this is an omission).

There are many, many types of liabilities that can arise with every business. With that said, the 2 fundamental ways in which liability is assessed include: (1) personal liability and (2) limited liability.

Personal liability means that you will be personally liable for the acts and/or omission of your business. For example, if you’re personally liable for your business and you take out a loan with a bank and fail to pay the bank, that bank may file a claim against not only all of your business assets (e.g. cash, materials, buildings, vehicles, accounts receivable – money that people owe you), but also all of your personal assets including your car, house, personal bank accounts, right down to the pennies in your piggy bank. It is generally best to try to avoid personal liability as much as possible.

Limited Liability means that you will generally only be liable for the amount of money you invested in the business. This means creditors and others (e.g. plaintiffs) generally can only go after your business assets. They generally cannot touch your personal assets, unless you act in a way that would allow the creditors or others to pierce the corporate veil, i.e. to pierce your limited liability (and get to your personal assets). Please read "Pierce the Corporate Veil, If You Dare" for further details on how this works.

3. Business Formalities


Business formalities generally refer to the amount of legal paperwork, filings, and other legal requirements that you must follow. The further you move down the business structure diagram [link] from sole proprietor to corporation the more business formalities you’ll generally have. Sole proprietorships don’t really have many business formalities, while corporations generally have their fair share of business formalities. The formalities involved with partnerships and LLCs will generally relate to how the business structure is set up.

Next, let’s take a brief look at the business structure of sole proprietorships.


Sole Proprietorships

A sole proprietorship is a business operated by 1 person in his or her name or in a fictitious name, i.e. made up name, without filing any paperwork with any government body. In essence, a sole proprietorship is the default structure for any individual who simply begins working one day and does nothing else. It’s the easiest business structure to choose because there are hardly any legal requirements to set it up.

However, there are many drawbacks in operating as a sole proprietorship. Perhaps the biggest drawback is that sole proprietors are personally liable for all the acts and or omissions of the business. In general, it is best to avoid personal liability and so the vast majority of individuals are better off in selecting a different business structure than a sole proprietorship.

The general taxes and liabilities for sole proprietorships are as follows:
  1. Taxes – taxed at your personal income rate level
  2. Liability – personal liability
Next, we’ll go over the basics of the partnership business structure.


Partnerships

Partnerships can come in many different forms, but the most basic partnership is a general partnership. A general partnership is essentially the same form as a sole proprietorship, except that it involves 2 or more persons. A general partnership involves 2 or more people carrying on business in their names or a fictitious name. A general partnership does not require any paperwork to be filed with any government body. So, a general partnership is the default structure for any 2 or more individuals who simply begin working together one day. Also, general partners split profits and losses equally depending on the number of partners (e.g. 2 partners would split 50/50, while 4 partners would split 25/25/25/25), unless the partners explicitly agree to split profits and losses in a different manner (which should be put in written contract agreement).

Now, keep in mind that a general partnership is the default form of partnerships. That means that if you simply start working with 2 or more individuals in a business, and take no other legal actions, the default general partnership rules will apply to you. Check your state’s statutes for general partnership law and the default general partnership rules.

While general partnerships are easy to form, there are many drawbacks to forming a general partnership. Like sole proprietorships, partners in a partnership are personally liable for all acts and omissions of the business. This is a key point to remember. In general partnerships partners are personally liable for the acts and/or omissions of other partners! If you think about it, this actually creates more liability than in a sole proprietorship. In a sole proprietorship, you’re only liable for your acts and/or omissions, not for your partner’s acts and/or omissions too. So, keep this key concept in mind if you join with someone else to form a business and take no legal steps to limit your liability – you could be personally liable for the acts and/or omissions of your partner.

However, if you recall from earlier in this article, a general partnership is only 1 type of partnership. In fact, there are many different forms of partnerships including limited partnerships and limited liability partnerships. These types of partnerships require some kind of contract or agreement between the partners which limit liability of the partners in different ways.

The general taxes and liabilities for general partnerships are as follows:
  1. Taxes – taxed at your personal income level rate
  2. Liability – personal liability
Next, we’ll go over the basics of the limited liability company business structure.


Limited Liability Companies

A Limited liability company ("LLC") is a fairly new and adaptable business structure. It’s also one of the most popular business structures for many small businesses. That’s because an LLC offers many of the benefits of sole proprietorships, partnerships, and corporations, while reducing many of the drawbacks from these different business structures. In essence, an LLC is a hybrid between a partnership and corporation.

To form an LLC, however, you must actually file paperwork in the form of articles of organization (or other similar name) with your state’s agency like the secretary of state. You’ll also have to create an operating agreement to dictate how the LLC will run. So, as you can see, you’ll have more business formalities to deal with in setting up an LLC than in setting up a sole proprietorship or general partnership.

However, there are many benefits of setting up an LLC. Perhaps the 2 best benefits include (i) limiting your personal liability and (ii) paying taxes like a partnership, i.e. only once.

When you file paperwork to set up an LLC, you’re telling the government that your LLC is a separate "legal person." The "legal person" concept comes from corporations (LLCs are a much newer form of entity than a corporation). This means that the state treats the LLC like a separate individual in many respects. An LLC can buy and sell property, sue and be sued, pay taxes, etc. It also means that if a creditor or plaintiff sues the LLC, you as an individual owner of the LLC will generally not be personally liable for the LLC. This is a big difference from sole proprietorships and general partnerships, where the individuals are personally liable. So, when you form an LLC, you limit your personal liability.

As an LLC, you can also be taxed as either a partnership or a corporation. It’s up to you. It’s often a good idea to be taxed as a partnership because you’re only taxed once – at your personal tax rate. However, sometimes for strategic reasons, LLC owners elect to be taxed as corporations. Corporation’s profits are taxed 2 times – (i) at the corporate tax rate and (ii) at the individual’s tax rate (which we’ll discuss in the next page). If you do want to be taxed like a corporation, you must actually make that election on Form 8832 with the IRS.

The general taxes and liabilities for LLCs are as follows:
  1. Taxes – taxed personally or like a corporation (if you elect to be taxed as a corporation)
  2. Liability – limited liability
Next, we’ll briefly go over the corporation business structure.


Corporations

Corporations are generally the most sophisticated business structures and offer many unique advantages that other business structures do not. But you’ll likely need an experienced attorney to create corporation that suits your particular business needs.

To form a corporation you must file paperwork in the form of the articles of incorporation (or other similar name) with your state’s agency like the secretary of state. You’ll also have to create the bylaws to dictate how the corporation will run. (Please read "Bylaws of Corporations" for more details.) Additionally, there are other business formalities you must deal with in corporations, such as keeping track of the corporation’s minutes, maintaining a share ledger, etc.

NOTE: The Articles of Incorporation of corporations are fairly similar to the Articles of Organization with LLCs – that’s because LLCs use many similar legal concepts as corporations. Also, the bylaws of a corporation are similar in some respects to the operating agreement of an LLC.

There are many benefits to creating a corporation, one of which is to limit your personal liability. However, a main drawback of a corporation is that their profits are taxed twice! There are legal ways to avoid some of the double taxation, but if your corporation distributes dividends to its shareholders the profits must first be taxed at the corporate tax rate and then at each individual’s personal tax rate.

The general taxes and liabilities for corporations are as follows:
  1. Taxes – taxed twice on profits at the (i) corporate tax rate, and your (ii) personal tax rate
  2. Liability – limited liability
Finally, we’ll wrap up this article with some main points to keep in mind.


Conclusion

In this article, we covered a lot of ground in short amount of time. We explored the main considerations before choosing a business structure and some of the pros and cons of each business form. We took a look at the 4 main types of business structures, including sole proprietorships, partnerships, limited liability companies, and corporations.

With this general overview of business structures you should now at least have a better understanding of what types of structures are available to you – from an "above the forest level." We encourage you to read the other articles on the particular business structures, and take a look at many of the other business law articles to learn more about some of the details.


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