How to choose business structure?
Every 5 out of 10 companies start their journey as a home-based small business one day. Eventually, they grow, hire more employees, and reach the position where they have to pay taxes. So, at some point, every business comes to the moment when they identify their business types and structure and incorporate them into one.
The most common types of corporations include sole proprietorship, corporation, LLC, and partnership. Being aware of different kinds of corporate structures can make your job easier when incorporating your legal entity. Read further to know the different types of company ownerships and what your entity fits under.
To help you understand each business type better, we have included every business corporation out there.
When you choose the right kind of company ownership, you can make certain that the legal structure supports your business growth, helps you identify the correct tax and liability consequences, and understands and goes along with the complex business model.
The following are the eight most common types of corporations categorized based on business ownership and business structure types.
A sole proprietorship is the most simple and common type of business structure. The majority of the small business owners with zero employees prefer and fall under this category. Here the business owner is the only person controlling the operations and responsible for profit and loss as well as dues.
While it’s so simple to register a company under sole proprietorship, it still has a few drawbacks. As the business owner is the only shareholder, they are fully responsible for every business liability. It can also be challenging to scale the business due to limited resources and human resources.
Following are some of the advantages of choosing a sole proprietorship
Simplicity in operations: There won’t be any interventions from other partners, and they will make no compromise on privacy.
Easy to incorporate: The steps followed to incorporate as a sole proprietorship is very simple and fewer than the other categories. And the incorporation charges are inexpensive too.
Tax implications: As the business owner is the only earning person, their earnings are considered their salary. Hence, they are taxed only once.
A partnership is the business structure where multiple partners own a business, and the liabilities are shared equally among them.
Like sole proprietorships, partnerships can have tax advantages as each partner is considered a salaried member, which leads them to be taxed only once. However, the setup costs can shoot up as you might need an attorney to verify your partnership document.
There are three different types of partnerships based on how the liabilities are treated and shared among the partners.
General Partnership: General partnerships are a business entity where each owner is treated fully liable and has an equal say in the business operations and decisions. The profit, as well as shares, are shared equally between every partner. Imagine it like an entity formed by two family members or friends together. One noteworthy example is Warner Bros, which was started together by four brothers sharing equal responsibilities and liabilities.
Limited Partnership (LP): Limited partnership is when there is one general partner, and others act as limited partners. The general partner has control over the business and makes vital decisions, whereas limited partners don’t involve themselves in the company’s decision-making. They are there only to provide financial support to the business.
Limited Liability Partnership (LLP): this is almost the same as a Limited partnership, but in this category, both general and limited partners are involved in managerial decisions and take responsibility. Still, they are not liable for other partners’ actions and wrongdoings.
The corporation is one of the complicated business entity types based on how it is incorporated and functions. Here the legal entity is split between shareholders and not partners. So, each share is considered a separate legal entity under the same company. And all the shares work together towards a shared goal and objectives.
It is difficult to form, and it demands articles of incorporation documents that should specify the number of shares, shareholders’ information, business goals, and where its located. In the case of partnerships and a sole proprietorship, if the business owner is involved in any wrongdoings or goes broke or passes away, the business should be declared perished.
In contrast, a corporation can still function with the involvement of shareholders in such situations. A corporation is further divided into three, S and B corporations and non-profit organizations.
S corporations can hold up to 100 shareholders and not more than that. They don’t pay individual taxes. Instead, they elect and pass their income and profit to their shareholders, which they consider their own income. Later, individual shareholders report and pay taxes counting this as their income.
Criteria that can make a corporation eligible to register as an S corporation:
- A limited number of shareholders (less than 100)
- Shareholders must be individuals and not entities or corporations
- Shareholders must be the resident of the country
S corporations should have one class of stock. Each share carries one vote, and it must be distributed equally among the shareholders. The corporation must document the rights of each share in its articles of incorporation.
The significant advantage of the S corporation is single taxation, but it limits the future growth potential by limiting the number of shareholders.
C corporation business structure is more or less similar to an S corporation, but it can have any number of shareholders. These shareholders can be from any background, and they can be entities or even the employees of that same company.
These shareholders are there only to provide financial assistance. Hence, C corporation needs to form a board of directors who will be involved in decision making. C corporations are allowed to have multiple shareholders, and they can be from any location.
Here, they don’t have tax exemptions like S corporation, and the company is taxed separately. So, there is double taxation as both the corporation as well as the shareholders who take income from the profit pay taxes.
Most US organizations choose this corporation category if they plan to grow without any constraints. One of the drawbacks other than double taxation is that C corporation shareholders cannot claim the losses due to personal taxation. In contrast, it’s possible with an S corporation business structure.
These are charity organizations or non-business entities designed not to earn profit but to favor a social cause or the welfare of a specific community. The partners don’t take a share in profit but act as investors only. So the profit gets utilized for the operations and projects of the NPO only.
They are exempted from taxation, which means they don’t have to pay tax for whatever they earn/receive. The sources of their income include fundraising activities through volunteers targeted at the public or organizations.
NPO examples can be hospitals, educational institutions, health, and social well-being awareness-raising organizations. If your business is set up in the US, contact IRS and gain 501(c) (3) status to be claimed as tax-exempt. But to achieve this status, all of the members involved should be organizations.
To manage the NPO and take decisions, they have a board of directors whose number can go up to 50. And then they have staff to take care of administration and accounting. To take care of programs and implementation, they hire volunteers.
A limited liability company is a type of business entity that protects its members from incurring personal losses when the business faces loss or debts. The owners are called members of this type, and there are no limitations in the total number of members. Members can be corporations, individuals, or even foreign entities.
Business owners prefer LLC for its flexibility, as LLC allows the owners to choose the tax system of any corporation (S, C, Partnership, or sole proprietorship). So, the LLC business structure is eligible to bypass double taxation, but the owner must pay self-employment taxes as the owner is also an employee.
A significant drawback of this business entity is when a member dies or leaves the company, the LLC must be dissolved and formed again.
Also known as a co-op, this is a jointly organized venture that is supposed to serve people who own and maintain it. They are called user owners, and they elect the cooperative's mission and goals.
To explain in plain terms, imagine a group of employees forming together a cooperative union to fulfill their socio, economic and cultural needs, and expectations. The members get the right to vote and elect their director, who will guide them and approve decisions.
So it’s a user-owned and managed business whose profits would be distributed equally among themselves and cannot be sold outside. Each member will contribute equally and accept responsibilities while enjoying the benefits and services.
Cooperative corporations do not have to pay taxes on their profits as they are considered self-help organizations. But they do pay taxes for the services they use like payroll, license, and property taxes.
How can you find which type of business structure is suitable for your business? You will rely on various factors to come to a conclusion. To enjoy the expected level of growth and tax benefits while keeping the risk away, you have to choose the right business type. Some factors you can consider are:
Are you okay with being the only person responsible and liable for debts, legal actions, and losses? The odds of facing loss or going bankrupt are high during the early days of business. Do you need more financial backup to expand and grow your business? If yes, then choosing a limited liability structure will eliminate the fear of losing your personal assets while helping you attain growth and give more control over your entity.
How comfortable are you with giving power and control to your other partners? If the business owner wants more control and says in every decision, the sole proprietorship is the best option. At the same time, if you feel that your partner should equally put effort and knowledge, then business structures like partnerships can fit well.
A business structure should allow the company to prosper and grow and not hold back its potential. Check and review the goals and business plans to see where you plan to see your business in the near future. Then, choose the proper structure best aligned with these goals and make them happen.
When it comes to taxes, as a new business owner, you have two options; you can either file them on your own, considering the business expenses as personal expenses. Or you can view the business as a separate entity and pay its taxes alone. A majority of small businesses go for the first option and consider their earnings as income. However, choosing the second option can keep your business and personal finances separate.
Capital is required to set off a smooth sailing. Are you equipped with the proper finance to run a business without interruptions? You can secure a bank loan or get help from investors, venture capitalists, or partners. Turn to your business plan again, make an estimate on the capital requirement and choose wisely.
Each type of business structure comes with its own advantages and restrictions. Choosing the format that precisely suits your business and its model takes time; but is achievable. You will have to ask yourself the following questions to arrive at a conclusion.
Let’s start with an important aspect: liabilities - Are you okay to be liable for your business debts and financial obligations?
If your answer is yes, what do you think about filing business taxes on personal returns? Or do you want to pay them separately from your individual tax returns?
Considering that you say yes to filing business taxes on personal returns, do you wish to start separately or with a partner?
Let’s split into two categories based on liabilities.
So if you are okay with facing liabilities on your own, here are some options.
● If you are starting alone, managing finances independently, filing taxes under personal returns, then the business type is a sole proprietorship.
● If you are starting with an active partner who is equally invested in the business and filing taxes personally (considering the profit share as income), then a partnership business structure would work for you.
● But if you just want a partner for investment sake when you take major decisions, and all partners choose to file taxes alone, then you can go for a limited partnership.
● If you want a limited partnership but want to file business taxes separately, choose a Limited liability partnership.
You don’t want to take sole liability for debts and lawsuits.
● Are you going to list your company for stocks, then the corporation is the perfect business type.
● Want to file taxes alone, and start it with limited shareholders, then go for an S corporation.
● Want unlimited stockholders but okay with double taxation where both owner and corporation pay taxes? A C-corporation will be the answer.
● Not going for stock listing, and starting without any partners, then a Limited liability company would be the right choice.
● Starting for a public cause and going to have partners or managing it alone, choose the Non-profit organization.
Based on your business goals, expansion policies, demographics, and capital, you can choose one among the types mentioned above of corporations. Identifying the fitting business entity can be challenging at first, but it ensures the right start needed for your business.
Choosing the incorrect types of corporate structure can make you feel that you have set your foot at the wrong place. But people make wrong decisions all the time. You can always restructure your business structure and re-register the business entity.
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