By Trent Derrick, CMT®
Starting a small business is no easy feat. Considering 45% of small businesses fail within the first five years, (1) starting on the right foot is crucial. An ideal way to set yourself up for success is to start with the best corporate structure for your business needs. Whether you’re looking for pass-through income, limited liability, or minimal startup costs, there is a business structure for you. In this guide, we’ll explore the 5 most common types of business structures and how they can be utilized for small business owners.
A sole proprietorship is the simplest business structure. It consists of one owner, and no paperwork, legal filings, or fees are required to get started. A person who runs a business is automatically considered a sole proprietor if they do not choose to incorporate as another business entity. This structure works well for someone who’s just starting out and would like to test their business before adopting a more formal structure.
Since a sole proprietorship is not considered a separate business entity, the owner will be held personally liable for any debts or obligations of the business. This makes sole proprietorships risky in the eyes of potential lenders and you may find it difficult to raise business capital with this structure.
Sole proprietorships are easy to start and just as easy to end. Your business can be dissolved at any time, again without paperwork, legal filings, or fees. But this also means that the business will not continue in your absence if you were to become incapacitated or pass away.
A partnership is formed when two or more people own a business together. Partnerships are more complicated than sole proprietorships and require registration with the State as well as an official partnership agreement outlining the rights and responsibilities of each partner. There are three main types of partnerships:
- General partnership: In this partnership, all partners share equal responsibility and unlimited liability.
- Limited partnership (LP): In this type, there is one general partner who has unlimited liability. All other partners are considered limited partners with limited liability and also limited control over the day-to-day operations of the business.
- Limited liability partnerships (LLP): In this case, every partner is granted limited liability and no partner can be held liable for the actions of another partner. This structure is commonly used with professional groups like doctors or lawyers.
Partnerships are considered pass-through entities, meaning both profits and losses are passed through to the partners’ personal tax returns based on their proportional share of the business. General partners are also required to pay self-employment taxes.
Depending on the specific structure of the partnership, it may have the added benefit of business continuity. Generally, if a limited partner were to die, the business would continue, but if the general partner dies or becomes incapacitated, the business would dissolve. This issue can be avoided with a solid buy–sell agreement.
Limited Liability Company
A limited liability company (LLC) is a hybrid business structure that provides limited liability and pass-through taxation. An LLC is considered a separate legal entity apart from its members and it does require paperwork and filing fees in order to be recognized. Like a partnership, members of an LLC will recognize pass-through income and losses at their personal income tax rate. All members are also subject to self-employment tax.
Most LLCs consist of two or more members, but they can also be structured with a single member. In this case, the single-member LLC functions exactly as a sole proprietorship but without the personal liability. Compared to sole proprietorships and partnerships, LLCs have more administrative complexity, but the members are exposed to much less personal risk.
LLCs do not have continuity of life since many states require that the company be dissolved and re-formed if an existing member dies, retires, or becomes incapacitated. LLCs can work well for businesses with a high degree of risk or owners who have substantial personal assets to protect.
A C corp is the typical business structure you think of when you hear the word corporation. It is a separate legal entity from its owners and it does not provide pass-through taxation. Instead, the corporation itself will be taxed at the flat corporate tax rate of 21%. Members of a corporation are called shareholders and they receive dividends in return for buying stock in the company. This can create double taxation since profits are taxed at the corporate level and then again at the shareholder level when dividends are paid.
C corps provide the greatest protection from personal liability, but they have a high degree of administrative complexity and require a greater up-front cost to incorporate. Corporations also have the highest level of business continuity since they exist independently from the shareholders. If a shareholder dies or becomes incapacitated, it will not affect the corporation’s legal ability to operate.
This structure is commonly used for large businesses or owners who want to keep their personal finances separate from the business and maintain the lowest level of personal liability.
An S corp is a type of corporation created specifically for small businesses as a way to avoid the double taxation caused by a C corp. This is done by allowing the shareholders to recognize pass-through profits and losses, instead of taxing the income to the corporation first.
The shareholder still receives limited liability benefits, but they are required to meet strict eligibility requirements and file with the IRS in order to obtain S corp status. (2) Like a C corp, an S corp also has continuity of life and will not be dissolved due to changes in shareholder status. This structure is commonly used for businesses that meet the eligibility criteria and would otherwise choose a C corporation structure.
Which Business Structure Is Right for You?
As a small business owner, choosing the right business structure is one of the most important decisions you will make. If you would like help sorting through all the details, I would love to hear from you! Together, we can analyze your financial needs and make the best decision for you and your business. Book a consultation with me here or email me at firstname.lastname@example.org to get started today.
Trent Derrick is a financial advisor and Chief Market Technician at Legacy Wealth Management. Trent is passionate about the value small businesses bring to their communities and specializes in serving small business owners by providing seamless financial advisory services tailored to their financial needs, including tax planning, cash flow management, retirement planning, and bookkeeping. Trent has a bachelor’s degree from the College of Charleston and studied economics at the University of South Carolina, Columbia. He is a Chartered Market Technician® (CMT®) professional. Trent serves as a guest lecturer for the College of Charleston’s MBA program and acts as chairman of the Market Technician Association’s Charleston chapter. When he’s not working, Trent, a proud Eagle Scout, enjoys volunteering with the Charleston Animal Shelter’s outreach program. Trent and his wife love to cook international cuisines and host dinner parties with their friends. To learn more about Trent, connect with him on LinkedIn.