Before you start a new business, you need to choose what legal structure it should use. It’s important to make the right decision — the structure you choose will affect virtually every detail of the company, from tax requirements and legal liability to ownership and management responsibilities. If you choose a structure that isn’t the optimal fit for your business, it can create legal and financial challenges that hinder the company’s ability to get off the ground and grow.
You can avoid this scenario and set your new business up for success by educating yourself about the features, pros, and cons of various legal structures. That’s why we developed this guide, which compares six different types of business structures for entrepreneurs to choose from. No matter what type of product or service your business offers, this guide will help you determine what structure would make the most suitable match.
What Are Business Structures?
In the United States, the collection of laws governing businesses is known as the Code of Federal Regulations, or CFR. The Code requires businesses to choose a type of “structure,” which is also commonly referred to as an “entity type” or “business entity.” So, what is a business structure, and what purpose does it serve?
Like a human skeleton, which provides a physical framework that determines how the body moves, a business structure provides a legal framework that determines how the business operates, from how many people can act as shareholders, to what tax documents need to be filed, to who can be held liable for business debts. Structure also impacts issues like:
- Who can make business decisions
- How you can raise funds and capital
- What types of forms you need to complete
- What types of taxes you must pay
- How much insurance coverage you need
Here’s how the Code officially defines business structures, or entities, under 26 CFR § 301.7701-2(a): “[A] business entity is any entity recognized for federal tax purposes…that is not properly classified as a trust under § 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code.” We’ll take a look at specific business structures, such as sole proprietorships and S corporations, in the next part of this guide.
What Are the 6 Types of Business Structures in the U.S.?
There are six main types of business structures in the United States:
- Sole proprietorships
- Partnerships, including general partnerships (GPs), limited partnerships (LPs), and limited liability partnerships (LLPs)
- Limited liability companies (LLCs)
- C Corporations
- S Corporations
- Nonprofit organizations
Read on for a quick overview of each business structure, including benefits, potential disadvantages, and what types of business scenarios each structure is best suited for.
Sole Proprietorship
A sole proprietorship is the simplest form of business ownership because the business and the owner are legally considered to be the same entity. Sole proprietorships are best suited for freelancers or contract workers, business consultants, and small businesses that have a low level of risk.
The chief advantages of sole proprietorships are that they’re fast, easy, and affordable to establish, while also giving the owner full control over all business decisions. The drawback is that the owner is personally liable for business debts and legal actions against the business. Additionally, sole proprietors have limited ability to raise capital compared to other structures like corporations.
To learn more about sole proprietorships, explore this IRS overview.
Partnership
A partnership involves two or more individuals sharing ownership of a business, which means they’re ideal for situations where multiple people want to share management responsibilities. There are several types of business partnerships to choose from, including:
- General Partnerships (GPs) — The simplest and most common form of partnership, where both partners make decisions equally
- Limited Partnerships (LPs) — Comprised of one General Partner, who has more decision-making power, and one or more Limited Partners, who have less authority
- Limited Liability Partnerships (LLPs) — All partners participate in management and enjoy protection from liability
Not only are partnerships easy to establish, they also offer pass-through taxation — an important advantage we’ll break down in the section on C corporations. Their main disadvantage is that if a conflict arises between partners, it can completely derail the business’s efficiency. Plus, general partners are personally liable for business debts.
Limited Liability Company (LLC)
An LLC combines the flexibility of a partnership with the liability protections of a corporation, offering the best of both worlds. In addition to limited liability, owners also enjoy a flexible management structure, plus the financial advantage of pass-through taxation. The drawback is that limited liability companies are more complex than a sole proprietorship or partnership, and typically have higher fees and more paperwork.
Generally speaking, the LLC structure is best-suited for small to mid-sized businesses that want liability protection without the formalities of a corporation.
C Corporation
The Internal Revenue Service (IRS) broadly defines a corporation as an organization “formed under state law by the filing of articles of incorporation with the state.” However, there are two main categories of corporations in the United States: S corporations, which we’ll cover in the next section, and C corporations, which are the more complex of the two.
A C corporation is a separate legal entity from its individual owners. On the one hand, this provides strong liability protection for shareholders. On the other hand, it also creates a more elaborate setup process.
There are also other pros and cons to the C corporation. One benefit is that C corporations provide the ability to raise capital through stock, which is critical for businesses in need of significant funding and investment. However, a major drawback is that — unlike other business structures — C corporations are subject to double taxation, meaning business income is taxed at both the corporate and personal levels. Finally, C corporations are subject to more intricate regulations than other structures, which increases the labor involved with tax filing, compliance, and recordkeeping.
Ultimately, the C corporation is best for enterprises and larger businesses, along with those planning to raise capital through investors. If you’re considering the C-corp structure, you may wish to read the IRS overview of forming a corporation.
S Corporation
Unlike C corporations, which are subject to double taxation, S corporations are pass-through entities, meaning they allow profits to “pass through” to the business owners’ personal income tax returns. This distinction is highlighted by the IRS, which defines S corporations as “corporations that…pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” In addition to offering tax advantages, another benefit of the S-Corp structure is that it provides personal liability protection for owners.
The drawback is that S corporations can only have a maximum of 100 shareholders, which can pose challenges when it comes to raising capital. Additionally, S corporations are subject to more regulations than most other business structures, including LLCs. Ultimately, the S corporation is best-suited for small businesses that want to limit both taxation and liability.
Nonprofit Organization
A nonprofit organization operates to serve a public good and is exempt from certain taxes. Most nonprofit organizations are some type of 501(c)(3) organization, a broad category which includes:
- Charitable organizations for “religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes”
- Churches and religious organizations
- Private foundations
While less common than the 501(c)(3) categorization, there are also many additional types of nonprofit organizations to consider, including 501(c)(4) organizations, 501(c)(5) organizations, and so on — all the way through 501(c)(27). You can view a complete list here.
The benefits of a nonprofit organization include eligibility for certain grants, limited protection against liability, and the ability to qualify for tax exemptions. However, nonprofits are subject to strict regulations and need to maintain extensive financial documentation. Additionally, profits must be reinvested in the organization.
Key Factors to Consider When Choosing a Business Structure
There are numerous factors to think about when deciding on a business structure. Here are four of the most important:
- Liability
- Taxation
- Management
- Funding
Liability Protection
Different business structures provide varying levels of liability protection for business owners, from extensive protection to none at all. For example, if a general partnership accrues tax debt or business debt, the partners are considered to be personally liable for the amount, which also applies to sole proprietorships. Structures that offer more robust liability protection include the LLC, the limited partnership, the S corporation, and the C corporation.
Taxation
Different business structures are subject to different tax regulations, which can have major financial impacts on the company — and its owners. A perfect example is double taxation, which exclusively impacts C corporations. Other types of business structures — including S corporations, partnerships, and LLCs — are considered “pass-through” or “flow-through” entities, which means that the business is not taxed at the entity level.
Control and Management
Corporations are overseen and controlled by boards of directors, who represent company shareholders and have authority over business decisions. In comparison, other structures like general partnerships and sole proprietorships give business owners more influence and direct control over everyday procedures and decision-making.
Likewise, corporations are more tightly regulated and are subject to more formal management systems. For example, most states have laws requiring S and C corporations to keep comprehensive meeting minutes that record the details of board and shareholder meetings.
Funding Needs
When choosing a business structure, it’s crucial to consider how much funding you’ll realistically need to get off the ground. For example, if you’re aiming to raise significant capital from investors, you may benefit from forming a corporation to issue stock.
Administrative Complexity
Some business structures are more heavily regulated than others, which directly impacts the type and amount of administrative work required of your team. The most straightforward structure is the sole proprietorship, while C corporations are at the opposite end of the spectrum. Structures like LLCs or S corporations fall in the middle. There are no costs, fees, or paperwork necessary to launch a sole proprietorship, whereas C corporations require articles of incorporation and state filing fees, along with the costs of retaining legal experts or business consultants — an optional but strongly recommended step, as we’ll explore in the next section.
Steps to Choose the Right Legal Structure for Your Business
There are four key steps to choosing the best business structure for your new company:
- Identify your long-term business goals, objectives, and targets.
- Determine how much financial risk you’re personally willing to take on.
- Educate yourself about local, state, and federal business tax regulations.
- Seek expert advice from trusted legal and financial professionals.
Step 1: Assess Your Business Goals
It’s impossible to achieve business goals without first identifying them. Therefore, your first step should be to determine your long-term vision for the business, including its growth targets, funding needs, and management structure.
Step 2: Evaluate Your Risk Tolerance
Some business structures, like C corporations and LLCs, offer extensive personal liability protection. Others, like sole proprietorships and general partnerships, offer little or no protection in the absence of insurance. For that reason, it’s important to assess how much risk you feel comfortable taking on. Depending on the degree of physical or financial risk involved in your industry, you may want to consider choosing a structure that will help protect your personal assets in the event of a bankruptcy or lawsuit.
Step 3: Understand Tax Implications
Make time to thoroughly research the state and federal tax treatment of each business structure. Taking this step will enable you to make an informed decision about which type of entity best aligns with your financial goals.
The IRS website is an excellent resource for small business owners who are looking for federal tax forms or filing information. Some topics of particular interest may include:
Step 4: Seek Legal and Financial Advice
It’s strongly recommended to consult with a legal professional, like a business attorney, or a financial professional like a certified public accountant (CPA), to guide your decision. CPAs, business lawyers, financial consultants, and other experts can help ensure that you choose the most suitable structure for your specific vision and needs.
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Choosing the right legal structure will help position your business for long-term sustainability and success. When deciding which entity type to select, it’s critically important to consider issues like personal liability for debt, compliance with tax regulations, and long-term as well as immediate funding needs.
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