How to Choose a Business Structure

Starting a business can be stressful, even overwhelming. The last thing you need is one more issue to think about, but you really should take the time to consider your options when it comes to the type of business structure or entity you choose.

This step-by-step guide aims to simplify this essential part of the startup process by walking you through the various options to help you understand how they differ, their benefits and drawbacks. Hopefully this will help you determine which is best for you and your business — leaving you with one less decision to worry about.

What is a Business Structure?

The structure of a business, or its legal entity, is a sort of template that governs how the company will operate and its obligations. The business structure you choose will determine how your business can raise investment capital, whether you need a board of directors, and your tax obligations.

When you register your business with your state, you’ll need to choose your legal structure — unless you opt for a basic structure. Basic structures, specifically a sole proprietorship or partnership, often don’t require formal registration. But you’ll still need to register a business name if you aren’t operating under your legal name.

The Most Common U.S. Business Structures

The US offers four main business structures: sole proprietorships, partnerships, LLCs, and corporations.

Let’s start with the simplest one.

1. Sole Proprietorship

Becoming a sole proprietor, also known as a sole trader, is the default for most small businesses. If you are the sole owner and register your business with the state without filing any addition forms, your business automatically becomes a sole proprietorship. In fact, if you’ve sold a product or received payment for services rendered without registering a business, you’ll automatically be classed a sole proprietor (unless you have a business partner).

Sole proprietorships are popular mainly due to their affordability and simple management. There are almost no setup costs associated with a sole proprietorship. Managing a sole proprietorship is very easy. No shareholder or board meetings or operating agreements are required. You, the owner, are in control of almost everything.

Besides your general business license (unless you need a specialized one) and registering a business name, your only non-operational cost is taxes. You’ll pay them through your personal income tax return and lodge the Schedule C and SE forms and the relevant 1040 form. These forms relate to business profits or losses and income and self-employment taxes. There may be other forms to lodge depending on whether you have employees or not, though.

The main downside to a sole proprietorship the lack of personal asset protection for you as the business owner. Since sole proprietorships are not separate entities from their owners, all business debt is shared. So, if your business goes bankrupt, you as the sole proprietor would be personally liable for its debts.

When to start a sole proprietorship:

• You want to get up and running as soon as possible
• Minimal paperwork and requirements is important
• Your business is low risk, or insurance covers liabilities
• You want to test your concept before formal registration

Pros and Cons of Sole Proprietorship

2. Partnerships

Partnership structures are a common choice for businesses with multiple owners, as they are also simple to set up and manage. However, not all partnership structures are the same. They range from the basic general partnership to more complex versions, like limited liability partnerships.

General Partnership

General partnerships function much like sole proprietorships, except with multiple owners. They are the default structure for businesses with more than one owner. Like a sole proprietorship, general partnerships are quick and cheap to set up, with some states not even requiring formal registration. But you will need to register a business name and pay for any relevant licenses.

Management-wise, partnerships are also simple and require no special meetings or documentation beyond standard business duties. Paying your taxes is a straightforward process as profits and losses are passed through to your personal tax return. You’ll need to submit form 1040 along with a Schedule K-1 and SE form which covers your individual income tax, business profits and losses, and self-employment taxes.

As with a sole proprietorship, partnerships offer no personal asset protections, which means you and your partners will be liable for the business’s debts, including those made by your partners.

This is why it’s crucial to thoroughly vet potential business partners before launch. You may be able to protect yourself further by putting in place a contractual agreement before forming the partnership, such as a partnership agreement.

When to start a general partnership:

• You and your partners want to start operating quickly
• You have few potential liabilities and risks
• You prefer minimal red tape
• You and your partners are testing viability of concept

Pros and Cons of a General Partnership

Limited partnership

Limited partnerships are a more complex partnership option that is used for partnerships with “silent investors.” Silent investors are partners that tend to only invest their money and take no part in day-to-day operations.

The silent partners within a limited partnership enjoy asset protection and limited liability and, therefore, typically only risk what they’ve invested in the business. Besides silent partners, limited partnerships need at least one general partner who assumes responsibility for business operations and has unlimited liability.

When it comes to partnership taxation, general partners pay the same taxes as the general partnership structure above. While limited partners avoid paying self-employment taxes, profits and losses are passed through to their personal tax returns.

When to start a limited partnership:

• Silent partner wants to stay out of operations
• You’re okay with a decent level of paperwork
• General partner accepts unlimited liability
• Company is relatively low-risk

Pros and Cons of a Limited Partnership

Limited liability partnership

Limited liability partnerships are the final variation within the partnership structure, blending the simplicity of a partnership with the protections of more formal business structures like LLCs and corporations.

Since LLPs are a partnership variation, you’ll need to register your business formally. Otherwise, it’ll default to the general partnership structure. LLPs are simple to run and manage and provide flexibility when changing partners as you can modify remuneration and partnership agreements whenever needed.

The best part about limited liability partnerships may be the asset protection they provide to all general partners. Not only do partners enjoy limited liability, but they’re also protected against negative repercussions through the actions of another partner. These features make LLPs safer than other partnership options without the formality of running an LLC or corporation.

However, one drawback to LLPs is the narrow criteria for who can and cannot register as an LLP. They are typically reserved for partnerships within professional sectors, such as accountants, doctors, architects, and lawyers.

When to start a limited liability partnership:

• You want few duties and asset protection
• Partners want to be protected from each other’s actions
• Outstanding liabilities will be likely
• You meet the criteria to register an LLP

3. Corporations

Any business that is publicly traded will fall under the category of a corporation. Most entrepreneurs use a corporate structure to easily raise capital while protecting the owners if the business happens to go bust. But, not all corporate structures are equal. In fact, nonprofits and other private companies use variations of the traditional corporate structure.

C Corporation

C corporations are the typical business structure used for large companies that trade on U.S. stock exchanges. Corporations are the most complex and most expensive business structures to set up and maintain as they have additional requirements compared to other structures.

C corporations require at least one appointed director and officer and need to formally incorporate with the state. After that, you’ll need to write the company bylaws (operational guidelines) and hold necessary meetings, such as the board of director meetings. But, if your company only has one director, your meetings will consist of producing written resolutions to topics typically addressed during a formal meeting.

Another drawback of C corporations is that they are subject to corporate tax, meaning they’re taxed twice. Corporate taxation happens once as a separate business entity and again when shareholder distributions are paid. There are two ways to get around this, though, by paying distributions as salaries and bonuses (tax-deductible for the business) or retaining earnings for future business expenses.

While corporations are complicated to set up and maintain, they do come with benefits. Namely, C corporations are considered their own legal entity. This separation means they can continue operation even after you (or any other shareholders) decide to sell your stock. C Corps also provide all owners with liability protection, which is important when dealing with large sums of money.  

However, one of the main reasons for using a C corporation is how easy it makes raising investment capital or selling a business. Many corporations are taken public through IPOs (Initial Public Offerings) to raise money or are sold to VC (Venture Capital) firms as an exit strategy.

When to start a C corporation:

• You want to protect your personal assets
• Large sums of money involved
• You plan to raise capital by selling stock
• Accept stringent record-keeping and meeting requirements

C Corporation Pros and Cons

S Corporation

S corporations are one of the more common corporation structures, but they can also be thought of as a tax structure, which you’ll learn about a bit later.

One of the main benefits of starting an S corporation is that they avoid the double taxation of the standard corporate structure. S Corps are considered “pass-through” entities, like sole proprietorships and partnerships, which means income passes through the company and is taxed on the owners’ individual returns.

Since S corps are less common than their C Corp counterparts, S Corp taxation varies between states. However, most states use the taxation guidelines created by the federal government. For states that use alternative tax rules, you may find yourself paying taxes on earnings above a certain threshold or being taxed as a C corporation.

Like C corporations, S Corps must abide by strict management duties and require annual reporting and meetings to maintain incorporation status. On top of this, there are additional criteria that you must meet besides the basic C Corp requirements. One example is that S Corps can have no more than 100 shareholders.

When to start an S corporation:

• You want to avoid double taxation of C Corps
• Your C corporation meets IRS requirements
• High-risk business involving large amounts of money
• Your state recognizes S corporation tax status

S Corporation Pros and Cons

Benefit Corporation

Benefit corporations (not to be confused with the B Corp certification) are businesses driven by financial profits and making a difference in society. Leading outfitter Patagonia is an example of a benefit corporation, as they regularly promote activism and give back to society through different programs such as their “Earth Tax.”

Benefit corporations come under even more scrutiny than typical corporations. They are held accountable for their societal goals—and their profits—by their shareholders. On top of this, benefit corporations usually need to submit annual reports that detail their contributions to the public.

While the high levels of transparency needed to run a benefit corporation may seem invasive, your public contributions can become a unique selling point for clients and customers. If your mission resonates with investors and clients, you may find that they become fiercely loyal to your business, at the exclusion of all others.

When to start a benefit corporation:

• Your business aims to improve society
• You can detail this impact through annual reports
• Limited liability protection is important to you

Benefit Corporation Pros and Cons

Close Corporation

Close corporations are similar to C corporations but are less formal structures and require much less transparency. These corporations are private companies that cannot be publicly traded on the stock market. They are also typically run by a small group of shareholders rather than a large board of directors.

As a default, close corporations are taxed like C corps, which means your business will be vulnerable to double-taxation. However, you do have the option to be taxed as an S corp if you meet the criteria, or you can use the strategies mentioned in the C corp section.

One drawback of close corps, though, is their limitations for raising capital. Since they can’t sell stock to the public, close corporations need to be funded by shareholders, loans, and other less common options.

When to start a close corporation:

• You want liability protections of a corporation
• Your business only has a few key shareholders
• You don’t want to issue stock to the public
• You prefer more relaxed operations and management

Close Corporation Pros and Cons

Nonprofit Corporation

Nonprofit corporations are a corporate structure variation that operates much differently from their profit-focused counterparts. Nonprofits usually aim to solve a pressing issue within society, such as providing low-cost education to underprivileged people or solving health crises.

Charities and other nonprofits function similarly to C corporations in regards to their management and reporting duties. However, one key difference is that nonprofits must use the profits they generate. Instead of paying out profits to shareholders, nonprofits put this income towards operations and new initiatives.

One of the main benefits of starting a nonprofit is that they’re eligible for tax exemptions—if they pass the IRS application. With tax exemptions, you’ll be able to put more of your revenue towards your charitable programs and effect greater change in the world. Also, since nonprofit corporations are a formal structure, they protect your personal assets if you cannot pay your nonprofit’s debts.

When to start a nonprofit corporation:

• You’re interested in making change
• Your business addresses a pressing issue
• You want your personal assets to be protected
• You’re willing to abide by management requirements

Nonprofit Corporation Pros and Cons

Cooperative

Cooperatives are a lesser-known structure that varies from corporations in a few different ways. One of the most significant ways is who owns and benefits from the business and its services—its members. Members of a cooperative are known as user-owners rather than shareholders because of this unique ownership twist.

Cooperative businesses usually have a board of directors and officers who oversee the management and daily duties of the company. There are also regular members who can vote on important business decisions.

The criteria for becoming a member can be anything deemed valuable to the business, such as a certain number of labor hours, an investment, or even a particular set of skills. Typically, though, members join co-ops by purchasing shares and making ongoing purchases of its products or services.

One key factor of co-op structures is that every member has equal voting rights, no matter their prior contribution to the business. For example, if one member invests $100,000 while another invests $1,000, as long as both meet the user-owner criteria, they will have the same voting power.

Co-ops are taxed at the same rates as a C corporation. However, this is calculated after certain deductions. Cooperatives are usually taxed at either the cooperative level or patron level and are allowed to deduct certain types of refunds, thus avoiding the double-taxation of C corps.

While cooperatives differ from corporations in quite a few ways, they still retain the benefits of limited liability. Therefore, you and any other user-owners will be safe from any debts and obligations accrued by the business.

When to start a cooperative:

• You’re OK with equal voting rights for all
• Multiple points of view are welcome
• You want to share business risks among many people
• You want to limit your liability

Cooperative Pros and Cons

4. Limited Liability Company (LLC)

Last but not least, we have LLCs. Starting a limited liability company is our main recommendation for U.S. entrepreneurs—particularly in the beginning.

LLCs provide a middle-ground between simple structures like sole proprietorships and partnerships and more complex ones like corporations. They aren’t as formal as corporations (although you still need to register them), yet still provide personal asset protections through limited liability, meaning you aren’t liable for any business debt.

These structures still require you to have an operating agreement, file annual reports and have a registered agent. But they do avoid annual meetings, having a board of directors, and the need to issue stock to shareholders.

One caveat related to having a board of directors, though, is that you can appoint one or more external managers to oversee your business if you deem it necessary. Otherwise, you and other members (if any) can manage the LLC.

As a default, LLCs are taxed as “pass-through” entities, like sole proprietorships, partnerships, and S Corps, so they avoid double-taxation. However, if you plan to retain earnings between financial years, choosing the C Corp designation is also possible.

On top of this flexibility, LLCs are also easier to set up as there are fewer regulatory requirements.

When to start an LLC:

• You want asset protection without too much red tape
• You don’t plan on selling stock
• You want to be able to change your tax designation
• You’re looking for middle-ground between simple and complex

LLC Pros and Cons

Can I Combine Different Business Structures?

As you probably noticed with the structures above, mixing certain structures with different tax designations is possible. For example, LLCs can be taxed as C corps, S corps, nonprofits, sole proprietorships, or partnerships.

While C corps can also be combined with other taxation structures, they aren’t as flexible—or simple—as LLCs. This flexibility allows LLCs to change and adapt to better fit your business at different stages of its lifecycle. This is why we recommend LLCs as the best overall structure for start-ups and small businesses.

Why Your Business Structure Choice Matters

To put it simply, the way you structure your business affects your taxation, administrative duties, asset protection, and how you receive funding. So choosing the right business structure is essential. It’s best to choose a business structure that balances the benefits you receive and any drawbacks that the structure entails.

For example, a preference of yours may be simplicity. In that case, you may want to forgo other benefits like asset protection.

To help you decide which benefits are important to you, answer the questions below.

1. Complex or simple?

In general, there are two business structure categories, basic and formal. On the basic side, you have sole proprietorship and general partnership, and on the formal, corporate variations and limited liability companies.

Basic structures such as sole proprietorships are super simple to set up and manage, requiring little more than paying your taxes and ensuring any permits and licenses are valid. You may also need to register a DBA (Doing Business As) if you want to operate under a name other than your legal name.

Formal structures, however, require formal registration, specific documentation, annual reporting, board meetings, and stringent record-keeping and transparency. But, they are also typically considered separate legal entities, which provides liability protection and some other key benefits.

If you choose to go with a C, nonprofit, or benefit corporation, you’ll need to meet high transparency standards and deal with many administrative duties. LLCs and close corporations, on the other hand, are a bit less strict and only require some of these duties.

2. How much time do you have for admin?

While you may be capable of tackling all the administrative aspects of your business, you have to ask yourself whether you have the time. On the other hand, you could also pass those duties to an employee, freelancer, or outside business to take care of them.

However, as the business owner, you’ll still have some part to play in administration. You’ll still need to supervise, review, and ensure all documents and duties have been completed correctly.

As a rule of thumb, the more time you can devote to administration (or be willing to outsource it), the more complex your business structure can be.

3. How do you want to be taxed?

A significant factor to consider when choosing a business structure is taxes. There are a wide variety of tax structures that can either benefit or detract from your business. If you prefer simplicity, you might prefer pass-through entities, which are sole proprietorships, partnerships, LLCs and S corporations.

Some business owners prefer this tax structure as it negates the double-taxation of corporate structures like C corporations. C Corporations (and a few other structures) are taxed as separate entities and taxed again when shareholders receive distributions.

But you can also negate double-taxation by paying shareholders a salary instead of dividends (which is tax-deductible for the business). Still, this strategy only applies to “reasonable salaries.”

Specific corporate structures can also retain earnings to avoid taxation, but you can only use these earnings for particular purposes. These include future expenses, tax purposes, or business investments.

Pass-through entities also have their own set of taxes. Sole proprietorships, partnerships, and LLCs (under certain conditions) are subject to self-employment taxes. LLCs can negate these taxes by choosing an S Corporation tax structure. However, you will still pay taxes on your “reasonable salary,” which is linked to industry and location averages.

Therefore, the tax benefit only kicks in once your business earns a substantial profit above your salary.

4. Will you need to raise funds?

The business structure you choose will have a substantial impact on how you can raise funds for your business. For example, sole proprietors may struggle to secure bank loans as banks generally view them as high risk.

But there are ways around bank loans, such as alternative sources like SmartBiz, crowdfunding, and loans from family, friends, or acquaintances.

If you plan to secure more traditional funding, you’re better off with a more complex business structure. In particular, C corporations have the most funding options since, in addition to various loans, you can sell stock to the public or receive VC investment.

On the other hand, LLCs can also navigate the usual loan market, invite new members (owners) in exchange for capital, or tap into the current owners’ capital sources.

5. How important is flexibility?

Flexibility is vital in business as you never know when you’ll have to make a decision that alters your business forever. Having a flexible business structure will ensure you can pivot your company without much hassle.

Basic entities such as sole proprietorships and partnerships offer flexibility in the way of simplicity. These structures allow you to focus on your business without the hassle of formal reporting, meetings, record-keeping, and stringent transparency. However, you cannot optimize your business for tax purposes and restrict your funding options.

On the other hand, you have corporate entities such as C corporations, nonprofit corporations, and benefit corporations. These structures lack administrative flexibility as they require high levels of transparency to maintain their corporate status. But, they do provide the ability to grow to a significant size, as you won’t be personally liable for your business’s debts or obligations.

Finally, LLCs are essentially a middle-ground between the primary and corporate business structure, and if flexibility is a priority, an LLC should be your choice. This structure provides you with almost as many funding options as corporations while allowing you to optimize your business for tax purposes.

6. What product or service are you offering?

The product or service you provide will determine how risky your business is. For example, a photography business can be relatively low-risk as long as insurance covers your equipment. However, a consulting business can be hazardous if you’re working with multinationals and your input can undercut millions of dollars in revenue.

In general, high-risk businesses deal with large contracts or expensive services and products (or cheap ones with scale), or have the potential for large lawsuits. If you operate a high-risk business, you should choose a company structure with limited liability to protect your personal assets if your business goes bankrupt.

You can opt for a structure with unlimited personal liability if your insurance policies cover all your bases. However, this leaves a potential risk if your insurer can avoid paying your claim.

If you operate a low-risk business, you’re free to choose whichever structure you like based on other benefits. But, we do always suggest a structure with personal asset protection as you never know when you’ll need it.

7. Are you a licensed professional?

Licensed professionals include doctors, lawyers, accountants, and more. Typically, companies based on these occupations have special business structures, such as professional corporations (PCs) and professional LLCs (PLLCs).

The main difference between professional and standard structures is the way limited liability works. Even though professional business owners have incorporated or set up an LLC, they’re still liable for malpractice claims that result from their own advice or actions. However, they do have liability protection against claims that result from other owners’ lawsuits.

So, Which is the Best Business Structure?

There isn’t one best business structure for everyone out there. If you’re planning on going public or acquiring venture capital early on, then choosing a C corporation is likely best. But if you plan on operating a simple labor-for-hire business, you should probably go with a sole proprietorship.

Yet for the majority of start-ups and small businesses we recommend choosing LLC.

The main advantage is that LLCs grow with your company and can be modified to better fit your business’s current development stage. And they protect your personal assets, so you have one less worry on your mind when getting your new business off the ground!