A Quick Guide to Business Structures
Starting a new business can be an exciting time. It is often the culmination of careful planning and preparation over a significant period. For entrepreneurs, bringing one’s passions and ideas to life while managing to earn a living can be very fulfilling.
New businesses pop up all the time. In March 2022, around 1.1 million new businesses were established in the United States. Amidst the excitement, new companies must learn to stand out among their competitors in their specific fields.
Before considering attracting customers and keeping up with your competitors, it’s essential to cover registrations and legal requirements, such as your business structure. Here is a quick guide on the different types of structures and how they work.
What is a business structure?
A business structure is the legal framework within which a business operates. Choosing the proper framework for your business is critical, as it affects various aspects of your day-to-day operations.
Your business structure can determine your legal and tax obligations, management and decision-making processes, and the extent of personal liability for the owners. Carefully assess your current resources and your desired management structure for your business before choosing a structure. Transitioning from one structure to another is doable but might be more difficult for specific types of companies, like corporations. Some factors you should consider before choosing your business structure include the following:
- Potential business size;
- Desired liability protection;
- Tax considerations;
- Funding and credit needs;
- Flexibility;
- Complexity;
- Permits and licensing requirements.
Types of Business Structures
It’s vital to study each type carefully to pick one that suits your preferences, providing you with enough legal protections and benefits. Here are the types of business structures to consider:
Sole proprietorship
A sole proprietorship is a business structure where one individual owns and operates the business. It is the simplest and the most common structure for small businesses.
It is also the most straightforward, as it only involves one person handling business activities. Whether or not you register as another formal business type, your business automatically becomes a sole proprietorship.
A sole proprietorship makes no distinction between your business and personal finances. Therefore, the assets and liabilities of your business are lumped together with your assets and liabilities.
As a result, any debts you may incur while running your business become your responsibility. However, this business structure also gives you complete control over your finances and business operations.
Sole proprietorships can be an excellent option for low-risk businesses or new entrepreneurs who want to test their business idea on a smaller scale.
Partnership
A partnership is a business structure where two or more people are responsible for running the business. It is the simplest business structure for ventures with more than one owner. It also shares several similarities with sole proprietorships. Like sole proprietorships, partnerships create no distinction between business assets and liabilities and personal ones.
The income generated from the business will flow into each partner’s accounts, and they will pay taxes according to their share of the business’s revenue. Each partner will also be liable for any debts the company may incur through its operations.
There are two types of business partnerships: limited partnerships (LP) and limited liability partnerships (LLP). Establishing a partnership involves drafting a partnership agreement outlining each partner’s rights and responsibilities.
In an LP, one general partner has unlimited liability, while the rest have limited liability. Since they might incur the most risk, the partner with unlimited liability often has greater control over the business.
In an LLP, each partner enjoys limited liability. This partnership type protects each partner from potential debts against the business, and they won’t become responsible for other partners’ actions.
Limited liability company (LLC)
An LLC is a hybrid of some elements of partnerships and corporations. It protects owners from personal liability while reducing tax rates and other requirements. This structure has become increasingly popular for small to medium-sized businesses due to its flexibility and protection.
Establishing an LLC involves creating an operating agreement, which outlines the structure, rules, and regulations governing the company. It covers the roles and responsibilities of members, the distribution of profits and losses, and the process for admitting or removing members.
By providing limited liability protection, the owners or members of the company do not become personally responsible for the company’s debts or liabilities. In most cases, each member’s assets become protected from business debts and lawsuits.
One of the most significant advantages of an LLC is its tax flexibility. When paying taxes, the LLC becomes a pass-through entity.
The profits and losses of the business pass through to the individual members, and the LLC itself is not subject to federal income tax. Instead, members report their share of profits or losses on their personal tax returns.
Establishing an LLC is also a lot simpler than a corporation. Most states allow for a straightforward formation process. For example, accomplishing the requirements to start an LLC in Pennsylvania is much easier than starting a corporation. You can quickly check your state’s requirements for forming an LLC and request assistance.
Corporation
A corporation is a business structure that creates a separate legal entity for your company. It is one of the most complex and formal business structures, usually found in large companies with more extensive organizational structures.
State and federal laws consider a corporation as a separate legal entity. Should you choose this structure, your business can enter into contracts, own property, sue other parties, and receive lawsuits in return.
Since a corporation’s shareholders have limited liability, the company’s debts and liabilities won’t generally affect their personal assets. The most they can lose is the amount they invested in the corporation.
Corporations have the advantage of being able to raise capital by issuing stocks. This process makes it easier for them to attract investors and accumulate funds for expansion. Owning stocks then makes a person a shareholder of that corporation.
These businesses have a formal structure with a board of directors elected by the shareholders. The board oversees major decisions and appoints officers responsible for the company’s operations.
One of the notable drawbacks of a corporation is the potential for double taxation. The company’s profits get taxed at the corporate level, and the dividends paid to shareholders also get taxed on their personal income tax returns.
Establishing a corporation is also more complex than other business structures. These companies are subject to more formal requirements and government regulations. Some of these requirements include holding regular meetings, maintaining detailed records, and filing annual reports.
Set Up Your Business the Right Way
Choosing a business structure is critical to establishing and managing a business. Entrepreneurs must carefully consider various factors, like the advantages and disadvantages of each framework, when making this decision.
You can always seek professional advice when taking this step. Understanding the distinctions between each type is essential for making informed decisions and setting your new business up for success.
References:
- https://corporatefinanceinstitute.com/resources/management/business-structure/
- https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
- https://www.bankofamerica.com/smallbusiness/resources/post/choosing-the-best-business-structure-for-your-small-business/
