The 5 Legal Structures of a Business: Which Is Right for You?

By Kathleen Garvin

 

Starting your own small business? Congratulations! Owning and operating a business can be an incredible growth opportunity — personally, professionally, and financially. You’re in good company, too: There are 30.2 million small businesses in the country, according to 2018 data from the U.S. Small Business Administration Office of Advocacy.

While you may be equipped with plenty of industry knowledge to run the show, picking a legal structure and registering your business can be confusing. When you create your company, you need to establish which type of business entity it is. This in turn determines which type of income tax return you will file, in addition to a number of other legal and tax considerations as well.

This article will help small business owners understand the legal jargon surrounding five recognized business structures: sole proprietorships, partnerships, corporations, S corporations, and limited liability companies (LLC).

 

What’s Considered a Small Business?

When people think of a small business, they might conjure images of a mom-and-pop grocery store or a dry cleaners, or other similar operations. While those are certainly examples of small businesses, you may be surprised to learn that a majority of companies of various sizes in a number of industries fall under the small business umbrella.

The definition of small business differs a bit depending on the agency or branch of government you consult. In this U.S. Census Bureau News press release, the U.S. Department of Commerce defines small and midsize companies as those with fewer than 500 employees. On HealthCare.gov, your business or nonprofit is usually considered “small” if you have between one and 50 employees.

The U.S. Small Business Administration (SBA) also has guidelines regarding what qualifies as a small business. SBA standards vary based on the number of employees, total gross income, and industry. This 39-page table details the current size standards, last defined in 2016.

To determine if you have a small business, talk to an expert. The U.S. Department of the Treasury states, “Because the body of definitions is complex and constantly changing, expert advice is essential to determine whether your business is ‘small.’" As your business grows, whether measured by employee count or average annual receipts, knowledgeable resources, including local SBA partners and business attorneys, can help you determine the correct designation for your company. They can also help you choose the business legal structure that works best for your company.

 

Here are the five primary legal structures a business can adopt:

  • Sole proprietorship

  • Partnership

  • Corporation

  • S corporation

  • Limited liability company (LLC)

Let’s take a look at how each one works, and some pros and cons of each, so you can determine which structure is right for you. You can refer to the IRS and SBA websites for more information.

 

1. Sole Proprietorship

This is the most common business structure. You are a sole proprietor if you own an unincorporated business by yourself. Note, however, that sole proprietorship does not extend to a domestic limited liability company you run on your own. A domestic LLC is “created under the laws of the state where it is operating.”

Please refer to this list of tax forms you may be responsible for as a sole proprietor.

Pros:

  • This business structure is relatively easy to form and dissolve.

  • It’s a good choice for new or low-risk business owners who are just getting started.

  • Under certain conditions, a married couple who own and operate a trade or business together can file as a qualified joint venture and each be treated as a sole proprietor.

Cons:

  • Sole proprietorships are not considered a separate business entity, so you are personally responsible for business debts and liabilities.

  • It can be hard to raise investment money because there is no “personal asset protection.”

  • Banks can be hesitant to lend you money because this type of business is considered “high risk.”

 

 

2. Partnership

A partnership is a business relationship between two or more people. Each person provides to the company — via money, labor, skills, and other assets — and expects to share in the business’ profits and losses. Two common types of partnerships are limited partnerships (LP) and limited liability partnerships (LLP).

Limited partnerships, according to the SBA, “have only one general partner with unlimited liability, and all other partners have limited liability.” The general partner must also pay self-employment taxes. Limited liability partnerships give all partners, as the designation suggests, limited liability. “An LLP protects each partner from debts against the partnership; they won't be responsible for the actions of other partners.”

Partnerships must file an annual tax return, but do not pay income tax; instead, profits and losses are passed through the company to the partners. They include their share of the income or loss on their personal tax returns.

Please refer to this list of tax forms you may be responsible for as a partnership.

Pros:

  • This structure is a straightforward way for two or more people to own a business together.

  • One type, an LLP, means each owner has limited liability, which protects them from debts against the business.

  • Partnerships can be a good choice for groups and businesses with multiple owners to test the waters.

Cons:

  • One partner in LPs, the other type of partnership, has unlimited liability.

  • Partners with limited liability usually have limited control in the company, too.

  • The partner with unlimited liability must pay self-employment taxes, since profits are funneled through to a personal tax return.

 

3. Corporation

A corporation is a more complex business structure that’s considered a separate legal entity from its owners. There are several different types of corporations, though the SBA, IRS, and other government sites primarily discuss C and S corporations.

In this type of structure, corporations can make a profit, but also be taxed and held liable legally. Prospective shareholders exchange money, property, or both for the capital stock. A corporation usually has the same deductions as a sole proprietorship when determining its taxable income.

Please refer to this list of tax forms you may be responsible for as a corporation.

Pros:

  • While corporations can be held legally liable, this structure offers firm protection against personal liability.

  • A corporation is considered a separate entity, so a shareholder can leave the company or the company can be sold, and business can continue on as usual.

  • Corporations are eligible for special tax deductions.

  • This business structure can be a good option for businesses looking to raise money because it’s preferred by outside investors and for IPO filings.

Cons:

  • It typically costs more money to form a corporation as compared to other business structures.

  • It requires stringent recordkeeping, reporting, and other corporate formalities to ensure full legal compliance.

Corporations pay income tax on profits, unlike sole proprietors, partnerships, and LLCs. Corporate profits are sometimes taxed twice — “first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns,” according to the SBA.

 

 

4. S Corporation

An S corporation, often referred to as an S corp, passes “corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes,” and the shareholders can then report the income and losses on their personal tax returns. As a result, shareholders are taxed at their individual tax rate. This is designed to avoid double taxation of corporate income.

Please refer to this list of tax forms you may be responsible for as an S corporation.

Pros:

  • An S corporation avoids double taxation.

  • As with C corps, S corps can continue doing business relatively unscathed if a shareholder leaves.

Cons:

  • A business must meet several requirements to qualify as an S corp, such as being a domestic corporation and having 100 or fewer shareholders.

  • State tax codes recognize S corps in a variety of ways, so S corporations, especially those operating in multiple states, should check with their state’s department of revenue.

 

5. Limited Liability Company (LLC)

An LLC is a business structure that has the benefits of both corporation and partnership frameworks. It can protect your personal assets, in most cases, if your LLC faces bankruptcy or lawsuits. Furthermore, “profits and losses can be passed through to your personal income without facing corporate taxes,” according to the SBA.

Please refer to this list of tax forms you may be responsible for as an LLC.

Pros:

  • An LLC can protect you from personal liability.

  • There’s no limit to the number of owners, or members, and many states allow single-member LLCs with just one owner.

  • This can be a good choice for higher-risk businesses and owners looking to protect valuable personal assets.

Cons:

  • Regulations vary by state, and an LLC may need to be dissolved or reformed if a member joins or leaves.

  • Members of an LLC are considered self-employed, and thus must make the appropriate contributions toward Medicare and Social Security.

  • Some businesses, such as banks, generally cannot be an LLC.

     

Final Thoughts

You should consider consulting with a CPA and a business attorney before launching your company. By discussing your current setup and future goals, a professional can help you figure out the appropriate legal business structure and any tax obligations.

 

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