A legal structure can make or break your small business. The right structure will minimize your risks and help cut your operating cost while the wrong structure can expose you to crippling liabilities and excessive costs.
As an entrepreneur, one of the most important decisions you have to make is choosing a structure for your business. This decision is made even more difficult by the fact that there are a handful of structures to choose from. Unless you’re an experienced entrepreneur who has set up multiple companies, it can be challenging to choose the right structure.
That’s the whole point of this article, though. Continue reading for a comprehensive guide on how to choose the best structure for your new enterprise.
What Are the Different Types of Business Structures?
The first step to choosing a legal structure that suits your business is to have a good understanding of the different types of structures.
Here’s a lowdown.
A sole proprietorship is very common business structure in the United States. In the actual sense of the word, it’s not a legal structure because there’s no legal distinction between the owner and their business.
A sole proprietorship is the cheapest and easiest structure to set up. Unfortunately, because it doesn’t offer any legal protections, the business owner has unlimited liability. If your business incurs a debt, creditors can come after your personal assets.
This type of business structure has pass-through taxation. The business itself doesn’t file any federal or state taxes, but the owner has to report the earnings or losses they made from the business — and pay taxes on profits.
A partnership occurs when two or more people come together to create a business. This structure is relatively simple to form, but the partners do need to draw up a partnership agreement that spells out, among other things, profit-sharing rations.
There are two types of partnerships:
- General partnership
- Limited liability partnership
In a general partnership, the partners have unlimited liability for the business. In a limited liability partnership, each partner is only liable to the extent of their investment or shareholding.
When it comes to taxes, partnerships have to report income or losses to the IRS. However, they don’t pay any taxes. This obligation is passed through to the partners, who have to pay taxes on the income earned from the business.
Limited Liability Company
Limited liability companies, or LLCs, are incredibly popular, and for good reason.
With an LLC, the owners (knows as members) are shielded from liability. If the company files for bankruptcy, creditors can only come after the business’ assets. The individual assets of the members are protected.
To set up an LLC, you have to pay a fee as well as file articles of organization and meet other requirements.
LLCs, like partnerships, are pass-through entities. Their only obligation is to report profits or losses, but the members will pay individual taxes on money earned from the company.
Think of any large company and you’ll find out that it’s a corporation.
Rightly so, corporations are complex business structures that result in the formation of legal entities that are separate from their owners. As such, shareholders have limited liability. They can’t lose more money than they invested in the company.
There are two types of corporations: S corporation and C corporation. They’re similar in many ways, with the only difference being how they are taxed. A C corp is a tax-paying entity, so there’s double taxation.
An S corp passes tax responsibility to its shareholders.
Forming a corporation requires expertise. You’ll probably need the help of a business lawyer when you want to create a corporation.
Choosing a Structure for Your Business
Now that you know the different types of business structures, how do you choose the right one for your upcoming business?
Here are a couple of factors to consider.
Size of the Business
The size of the business you want to create can dictate the structure you choose. If you want to set up a large organization, it’s a no-brainer, you need a corporation.
However, if you’re, like most entrepreneurs, creating a tiny business that you hope to grow into a big company one day, you can start out as a sole proprietorship. Just beware of the liability risk you’ll be exposed to.
Nature of Product/Service You’ll Be Selling
Selling a product or service comes with a number of risks. If it’s a product you manufacture, for instance, there’s a chance it could malfunction and injure a user. If it’s a widespread problem, a class-action lawsuit could emerge.
Do you want to be personally liable for the fines that the court might order? If you want to limit your liability, set up an LLC or a corporation.
However, if your business is low-risk, you can do with a sole proprietorship or even a general partnership.
Are You Starting the Business with Someone?
As a solo entrepreneur, you can start a sole proprietorship or a single-member LLC. But if you are more than two people looking to create one business, it’s clear your need to set up a partnership.
If you’re on a shoestring budget, you’ll want to create a sole proprietorship. It’s almost free to form. Partnerships are also cheap to start.
LLCs and corporations are complex and need a lot more money at startup.
The Legal Structure of Your Business Matters
You might not feel the importance of choosing the right legal structure right now, but once you start the business, you’ll know. With this helpful guide, you’re now in a good position to choose the best structure for your biz.
Keep reading our blog for more tips and insights.