How do I choose the right business structure?
The "right" company structure for you may not be the same as for other businesses. What works for the flooring business down the street may not work for the consulting service you are creating.
Information is power—and doing your research when it comes to business entities will help you make an informed and accurate decision that is tailored to what you and your company need to thrive for years to come.
Below are just a few questions that you should consider as you start this process.
- How many people will be involved in the ownership?
- How do I want to attract investors? Do I need to attract investors?
- Will the business own substantial assets?
- Is a physical location necessary?
- What kind of clients do you want to attract? Are those clients expecting an "Inc." at the end of your company name?
- Are you planning to keep the profits from the company? Or is your goal more focused on serving the community at large?
Answering some of these basic questions will point you in a general direction toward one type of entity over another.
What are the most common types of business structures for small businesses?
When many people think about choosing a business entity, their first thought is about huge corporations, many of which are publicly traded. These are traditional C corporations.
While that type of business structure works great for some companies, many entrepreneurs who are just getting started simply might not need that structure to hit the ground running. That type of business structure may make sense in the future, but it is often a good idea to explore other options when you are just starting out.
Entrepreneurs may want to consider all of their options, many of which offer excellent protection and benefits. Here are some of the most common entities.
Sole Proprietorships and Partnerships
A sole proprietorship is by far the most common type of business entity. In fact, there are over 23 million sole proprietorships in operation in the United States today.
Part of the reason they are so common is that you do not have to take any extra steps to form this type of business. Instead, you simply file your taxes slightly differently; there are no formal requirements to start a sole proprietorship.
It is typically the easiest type of business entity to run because the filing and formal requirements are minimal. However, that does not mean it is the best option for every business. Sole proprietorships do not give some of the many benefits that other entities offer, such as limited liability, the ability to have more than one owner, or any feasible means to attract investors.
Partnerships operate very similarly to sole proprietorships, but there is more than one person involved. Forming them is often just as easy as creating a sole proprietorship. However, general partnerships are arguably even riskier because someone other than you could bind the partnership and put your personal assets at risk if the partnership does not pay its bills or gets sued.
For many entrepreneurs, having a sole proprietorship or partnership may be a good starting point, but it may not make sense for the long term in most situations.
Limited Liability Company (LLC)
A limited liability company, or LLC, is a hybrid business type that incorporates some of the best features of both a sole proprietorship (or partnership) and a corporation. The benefits of an LLC include:
- Limited liability. An LLC allows each owner to limit their liability to just the assets that the company holds. That means that, as long as certain conditions are met, each owner's personal assets, like their house or car, are not at risk if the LLC does not pay its bills or gets sued.
- No limit to membership. You can have virtually an unlimited number of members of your LLC. You can even break down membership into classes, where certain members have more rights (such as to vote) than others. This can be a helpful way to attract investors.
- Fewer formalities than corporations. Compared to a corporation, there is far less paperwork and required annual or bi-annual filings and fees associated with starting an LLC. Starting an LLC is also often less expensive and time consuming compared to a corporation.
In a traditional C corporation, the company is taxed at the corporate level first. Then, when income is divided up among the owners, that money is taxed again at their individual tax rates. This is sometimes referred to as "double taxation." While this may not make sense for some businesses, there are some pluses to starting a C-corp. These include the ability for anyone to be an investor and for the corporation to have unlimited number of shareholders and multiple share classes. There are typically more formalities (or "red tape") involved in starting and maintaining a C-corp, but many mature companies choose this structure for its investor flexibility.
In an S corporation, the "double taxation" issue is completely avoided because the corporation is only taxed at the individual owner's rates—there is no separate corporate tax rate that applies.
This structure is similar to an LLC, except that any funds paid to owners (that are not wages) are generally taxed at a lower rate as "distributions" rather than income.
Unlike an LLC, however, an S-corp has strict legal guidelines for formation and maintenance. There are some limitations on how you can generate income, too. For example, those who own an S-corp can only have up to 25% of their receipts from passive activities, like real estate investing.
Many entrepreneurs overlook the possibility of creating a nonprofit organization. However, if your goal is to help the community, creating a nonprofit can be a great option. You are often better able to raise funds and ensure that your civil and social goals are met when you create a tax-favored nonprofit compared to a for-profit company.
Where can I get help choosing the right entity for my business?
Only you can decide which benefits are the most important for your situation, but Rocket Lawyer can help. You can get tailored legal advice about which entity is right for your business from a Rocket Lawyer network attorney. It's affordable and straightforward.
If you decide on an LLC, S-Corp, C-Corp, or nonprofit as your business entity, Rocket Lawyer can help get your name checked and your paperwork filed with our business formation services. Plus, your first formation is FREE (excluding state fees) and you get up to HALF OFF business services when you purchase a Rocket Legal+ membership - The membership that pays for itself! So level up your business game now to jumpstart a successful new year.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.