From developing your big idea and naming your brand to building a killer website and finding those first customers, starting a business is a thrilling journey. But something else also goes into the equation: establishing the proper foundation and structure for your business.
Incorporation may not be the sexiest part of entrepreneurship, but it’s a necessary step in setting up a legal entity recognizable by your state and the federal government. Think of it as the unglamorous but necessary grunt work of launching a successful new business venture.
In this post, you’ll learn about the different types of businesses and how to choose the best one for success.
Why your business structure matters
Your business’s legal structure has a significant impact on its taxation, liabilities, and access to funding and capital. Different structures apply depending on whether you are forming a business partnership, corporation, or limited liability company. Despite these variations, incorporating your business can provide numerous advantages, such as:
- Better chance to secure business funding
- Transferable business ownership
- Security of personal assets
- Limited liability in the case of legal issues related to the firm
- Potential for tax savings
- Distinct credit rating regardless of your personal credit score
- Earlier retirement
Each business structure comes with its unique ownership, legal, funding, liability, and tax considerations.
Types of business structures
Although each business structure offers benefits, certain types of businesses are more suitable for new entrepreneurs. Note that it’s possible to change the legal structure as your business evolves over time, though this adds to the administrative steps.
Sole proprietorship
A sole proprietorship is a basic business structure in which there’s no legal distinction between the company and the person who owns and runs it. It’s a straightforward option that’s easy to establish and maintain.
Some ecommerce startups with low liability risk and startup costs choose sole proprietorships. While a sole proprietorship can transform into other business structures later, it’s the quickest and simplest starting point.
Sole proprietorships fall under the non-employer business category, which means they have no paid staff. In the US, this type of business is the primary source of income for approximately 40% of small-business owners, whereas it’s a supplementary income stream for the remaining 60%.
Pros of sole proprietorship:
- Complete control of your business. As a sole proprietor, you can make all the decisions for your business, since there are no investors or partners to consider.
- Flexibility in future business structure changes. Starting with a sole proprietorship doesn’t mean you’re locked into that structure forever. You can easily transition to a different type of structure at a future date.
- Lower taxes. Filing taxes as a sole proprietor is generally simpler than with other business structures, and there’s only one tax filing to take care of.
Cons of sole proprietorship:
- Unlimited personal liability. In sole proprietorship, the owner and the business are seen as one entity. This means you have unlimited liability for everything your company does, putting your personal assets at risk. This exposure to personal liability is a deal breaker for many business owners.
Partnership
Partnerships are business entities owned by two or more individuals. Each partner or owner contributes to the business via capital, skill, labor, or property. Profits are shared between the partners.
Partnerships come in two forms:
- Limited partnership (LP). A limited partnership means specified partners are only personally liable for individual negligence, meaning their personal assets are somewhat protected. This type of partnership limits both liability and control for each partner.
- General partnership (GP). A general partnership involves dividing the business either evenly or into predetermined percentages that have been agreed upon and documented beforehand.
A pass-through taxation model is typically adopted in partnerships. With this approach, taxes are applied based on each partner’s personal income rather than the company’s revenue.
Pros of partnerships
- Shared responsibility. As the saying goes, there’s power in numbers, and this certainly applies to partnerships. You can share the burden with your partner, which can also give you more access to capital in many cases.
- Simple setup and management. Compared to other business structures, establishing a business partnership is relatively easy. Ongoing management also requires fewer tax forms.
Cons of partnerships:
- Partner conflicts. It’s common for both parties not to agree on every decision in most partnerships, and over time, this can cause conflict within the company. It’s crucial to ensure you and your partner are aligned when entering into this agreement.
- Personal liability. Owners assume more personal risk as taxes for partnerships don’t separate the business from the individual. Additionally, owners pay self-employment taxes instead of the business paying taxes, which can result in a greater amount owed.
Corporation
A corporation is a business structure that separates the business entity from individuals, protecting owners from personal liability. This structure assumes all the risk and ensures that business ownership can be transferred easily.
Corporations must be filed with the state, and each jurisdiction has specific requirements for corporations. Local, state, and federal taxes are paid separately from shareholders’ taxes, but whether corporations pay lower taxes than individuals depends on the state. A tax professional can help you identify the best option for your business.
Pros of a corporation:
- Sell shares to raise capital. Corporations allow owners to raise capital through shares. This makes them more attractive to some people because it offers reliable compensation, i.e., the corporation can always sell shares if it runs out of cash.
- Protect personal property. Another benefit of forming a corporation is it protects the personal property of the shareholder. For instance, if a customer sues a retail corporation and the court decides in their favor, the corporation will have to pay. In case it doesn’t have enough money to pay, the shareholder won’t be forced to cover the difference.
Cons of a corporation:
- Personal liability is still there. If a corporation’s records are not managed properly, you may face more personal liability than you had anticipated. This can occur when attorneys prove that the corporation was not acting as a separate legal entity and “pierce the corporate veil,” resulting in the loss of liability protection for personal assets.
- More effort to set up and maintain. Unlike other business entities, forming and managing a corporation requires more effort. From the initial setup to ongoing maintenance, corporations must be carefully managed as a separate legal entity every step of the way.
Limited liability company (LLC)
Limited liability companies (LLCs) are the perfect mix of partnership ease and corporate liability protection. They provide a middle ground between the two and are technically a type of corporation, with limited liability partnerships falling under the same umbrella.
Owners of an LLC, known as members, directly pay taxes on the LLC’s profits. This means the business structure doesn’t file taxes as a separate legal entity. Additionally, LLCs with more than one member can choose to be taxed like partnerships or corporations, which eliminates the separation of personal and business taxes.
Since their creation, LLCs have been steadily gaining popularity. According to IRS data, while other corporate structures have declined since the 1980s, LLCs have experienced significant growth.
The duration of LLCs varies depending on the state, with some dissolving when a member leaves. Overall, they are an excellent business structure option for solo founders just starting out.
Pros of an LLC:
- Personal protection: The advantage of having an LLC is that it shields your personal assets from business liabilities. If the LLC faces a lawsuit or other legal issue, creditors won’t seize the owner’s assets to cover the resulting financial damages.
- Simple management: Compared to other business structures like corporations, LLCs have less paperwork and fewer profit-sharing requirements. This simplicity makes LLCs an attractive option for small to medium-sized businesses, and early stage startups.
Cons of an LLC:
- Limited availability: LLCs may not be available to all types of businesses. Depending on your state, there may be laws around which industries are eligible to form an LLC, as well as any additional requirements or limitations.
- Taxes: LLC members may need to file additional forms for both state and federal taxes. Additionally, depending on the number of members in the LLC, local laws, or even the LLC’s articles of organization, members may need to pay payroll taxes.
How to choose the right business structure
Selecting a business structure isn’t straightforward. Many online retailers start as sole proprietorships or partnerships before incorporating, but unlimited personal liability can be concerning. Ultimately, the business entity you choose depends on various factors. It’s essential to consult an attorney to determine the best structure for your business.
Typical considerations include:
Personal liability
Business incorporation creates a separate entity from you, reducing personal risk for some businesses. Some structures offer stronger protection, such as a corporation, while others, like partnerships, offer less. Analyze your personal situation to determine the appropriate level of personal liability for your individual self.
Bringing on partners
If you plan to have a partner in your business, you’ll need to choose a business structure that can support a business partnership. Some options to consider include a general partnership, an LLC with multiple members, or a corporation.
Hiring employees
The legal structure of your business plays a vital role in staffing decisions. Sole proprietors can’t hire employees, so if you plan to onboard staff, you’ll need to change your structure. Starting as a sole proprietor may give you more autonomy and flexibility, but it’s crucial to consider your future staffing needs.
Business funding
Incorporating can help you build credit and a financial history for your business, making it more eligible for financing from potential lenders or investors. Consider Shopify Capital for funding to help you take your business to the next level.
Ready to take the next step?
Incorporating your business has numerous advantages, from protecting your personal assets to building credit and history for your company. In some instances, it may even minimize your income tax. However, the most significant benefits of business incorporation are less tangible.
By officially incorporating your business, you’re taking the first step towards transforming your idea into a successful and legitimate enterprise, but the success that follows will depend on your continued efforts.
Types of businesses FAQ
What are 4 types of business structures?
When incorporating a business, you can choose from the following four structures:
- Sole proprietorship
- Partnership
- Corporation
- Limited liability company (LLC)
Which types of businesses are best for taxes?
Each business type has distinct advantages and disadvantages concerning taxes. Sole proprietorships, for instance, are subject to self-employment taxes, but can reduce their tax load through itemized deductions. In contrast, corporations are not subject to self-employment taxes. It’s essential to consider the tax implications of each business structure carefully and evaluate which option will work best for your particular circumstances.
Is it better to have a corporation or LLC?
While both corporations and LLCs offer limited liability to businesses, an LLC is more suitable for owner-operated SMBs looking for less red tape and greater flexibility. A company looking to raise funds and scale, on the other hand, should structure itself as a corporation.
