The United States is known as the land of opportunities. This is evident in the large number of small businesses that exist in the country. Each year,
What is the importance of choosing the right business structure?
Although business structures are primarily about paperwork and formalities they can have far more impact than the information on your state files. Your business structure can have a significant impact on your day-to-day business life and long-term obligations.
The business structure you choose will have an impact on three areas.
Each state has its own administrative responsibility for business formation applications. These are often known as Articles of Organization and Articles of Incorporation. However, the Internal Revenue Service uses this information to file federal taxes. Some business structures can be considered pass-through entities for tax purposes. This means that profits are passed directly onto the owners of the business and reported on their personal tax returns.
Other structures are treated as separate entities, each with its own tax rate and structure. How and when you file your taxes will depend on the type of business entity that you choose.
You, as a business owner are responsible for the actions of your company. This can sometimes lead to personal risk. If a person and their company are one legal structure, that means that the person can be held liable for any liability the business may have.
This protection is not always available and owners may be held responsible for any obligations or debts that they incur. Some structures provide some protection from this liability, while others offer different degrees of protection.
Some business structures require that the organization has detailed and well-documented plans for managing the business. This information can include information about how to settle disputes and who makes decisions. It also includes information about how money is managed and how it is reported to the state. More stringent requirements for operations can often lead to more reporting, as well as the administrative overhead required to maintain it.
Different types of businesses to choose
1. Sole proprietorship
The business and its owner are treated as one legal entity in a sole proprietorship. Even if they don’t file for sole proprietorship, anyone who runs a business technically is a sole proprietor. This allows owners to claim all profits or losses on their personal tax returns, but it also means that they are responsible for all the obligations of the business.
Who’s it good for
If you want to have full control over your business, and are willing to take on the responsibility, a sole proprietorship may be the best option.
- It is easy to set up and requires very little administrative work.
- Individual tax filings avoid corporate tax rates, and allow for special deductions
- The business’s owners retain total control over its operation and operations
- The owners are liable for all debts, lawsuits and other obligations that the business may have.
- Fundraising for sole proprietorships can be more challenging.
Learn more: What is sole proprietorship? >>
2. Limited liability company (LLC).
An LLC (or Limited Liability Company) is a hybrid of sole proprietorships or a formal corporation. An LLC, or Limited Liability Company, has a formal management structure which includes members. The members are protected by a good deal of personal assets, so they aren’t liable for any business obligations.
Members can also claim their profits directly from their tax returns and not have to pay corporate taxes.
Who’s it good for
Anyone who wishes to retain control of a business but not assume total liability can choose LLCs.
- Easy to set up and minimal reporting requirements.
- Protect your personal assets from creditors and other people who might be able to take over the business
- Tax treatment is done on a pass-through basis. Individual tax returns are used instead of corporate returns.
- The business can be managed by members without the need to have a separate board.
- Members are subject to some liability, particularly if they are found to be operating a business in an unethical manner
- Additional self-employment taxes may apply to new business owners
- The LLC must be disbanded if any member dies or leaves.
A business partnership is a great way to make sure everyone is treated fairly when you are entering into a business. You can form partnerships in a variety of ways, including limited partnerships (LLP), limited partnerships (LLP), or general partnerships. However, the core idea will still be divided.
You will usually be required to sign a formal partnership agreement when you start these businesses. This agreement will outline how disputes will be resolved and how profits, ownership, and responsibilities will be shared.
Who’s it good for
When people have different business experience and want to work together to make a business succeed, partnerships are often the best option. They are also a great choice when there is no need for emotional involvement.
- Partnering means that you have an additional set of hands to help with daily operations and more knowledge.
- It’s easy to start a partnership.
- Both you and your partner can decide the management structure and terms of operation
- You must make all decisions together, so it is likely that you will disagree.
- Profits will be split, and each person will be taxed separately
- Partnerships are not separate legal entities. This means that you and your partner share the responsibility for the business’ legal and financial affairs.
4. C Corporation
If someone speaks of a corporation they most likely mean a C corporation. These legal entities provide total asset protection to owners and can have unlimited stock owners.
Taxes are charged at the corporate level. Therefore, C corp must follow many regulations to keep its status.
Who’s it good for
A C corp is the best choice for companies that plan to issue stock, or want legal separation from their owners.
- The business is an independent legal entity and its owners are not responsible for any legal or financial obligations.
- Shares can be held by anyone, and can easily be transferred.
- Stock options can also be offered in multiple classes.
- Venture capitalists, as well as other investors, are very familiar with C Corps and will back them.
- The entity is independent from its owners. If one dies or leaves, the business will continue.
- Corporations can be more difficult to manage. There are formalities to be met, such as annual reporting, the creation of bylaws, and regulatory compliance.
- Corporation profits and losses must be taxed, while dividends earned by shareholders must be taxed. Double taxation is a term that describes this phenomenon.
5. B Corp
If they are committed to social causes, certain corporations may be eligible for B Corp status. These businesses pledge to transparency and accountability by committing to implementing strict social and environmental standards.
This certification is issued by B Lab, a nonprofit that requires strict compliance to their guidelines.
Who’s it good for
Any type of business can become a B corporation if the organization is environmentally-minded. This certification is only for those owners who are willing to put in the effort and sacrifice profits for sustainability.
- B Corp is a commitment to doing good in the global community.
- The B corp status is valued by potential employees and clients as well as public relations agencies.
- To become a B Corp, you must meet strict standards and maintain them throughout your certification period.
- B Corp is not recognized by every state as a business category
- There are no liability or tax benefits
Continue reading: What is a B Corp and how does it work? >>
A business that serves a social purpose and does not seek to make a profit can be considered a nonprofit organization. Nonprofits may be exempt from tax by being subject to different state laws. Some nonprofits are exempted entirely from the business income tax for tax purposes.
Who’s it good for
Nonprofits are not for everyone. Nonprofit status is a good option if you want to help others.
- Nonprofits are motivated to serve the greater community. This is a rewarding endeavor for both professional and personal satisfaction.
- Nonprofits have lower taxes than other businesses, and may be eligible for discounts on rent.
- Nonprofit founders and employees are protected against personal liability for things such as fines or lawsuits
- While it is possible to set up a nonprofit without expecting to make a lot of money, it can be expensive.
- Nonprofits need to keep up with regulatory guidelines and annual reporting
- Funding for non-profits can be competitive and difficult to secure.
A business cooperative is one that employees own, rather than having separate owners. Each member is given equal rights in the business regardless of how many shares they own. Profits are split equally among members.
This is different from a partnership which is still centered around designated owners. Each member of a cooperative is subject to individual tax, but they are protected by the structure from liability.
Who’s it good for
If a company plans to give every employee a share of the business, it will be called a “share and say” company.
- Cooperative employees tend to be highly invested in the company and are dedicated.
- Equal distribution means that the liability is equally distributed amongst large numbers of people
- Often, overhead costs are low
- Owners pay only one tax, and not as a business entity or as personal profit.
- Some states do not allow businesses to be formed in this manner.
- Due to equal distribution of funds, founders will see a decrease in profits
- It can be hard to make decisions when there are many stakeholders.
Considerations when choosing a business type
Your preferences will determine the best business structure for you business. This is an important decision that you need to make.
1. Setup is easy
The state manages business structures. They will have a process to approve any business. Some structures, such as sole proprietorships and partnerships, do not require paperwork or approval from the secretary. You can begin working immediately on your business without waiting for approvals or processing time. Complex structures, such as corporations, will take more effort and cost more money to get up and running.
2. Protection from liability
The core question about the business structure is whether owners and business are legally distinct entities. If they aren’t, liability is shared. This means that the owners can be held liable if their business is sued, insolvent, owes money or is found to have been involved in any other legal proceedings. These cases can lead to the seizing of personal assets such as cars, homes, or money. Your risk tolerance in regards to personal assets is part of choosing a business structure. Your work history and potential lawsuits or debts may influence this decision.
To determine the tax treatment of businesses, the IRS looks at their business structure. The IRS uses business structure to determine how businesses are taxed. Corporations that are taxed as an entity can be subject to higher corporate taxes and other taxes. However, members of the corporation must still pay personal income taxes. Many people find this double taxation disadvantageous. They will choose a pass-through structure, which skips corporate taxes and allows profit and loss to be reflected in individual returns.
4. Number of owners
There are some structures that limit the number of owners. A sole proprietorship may have one owner, while a partnership must at least have two. Different structures may be available depending on whether you plan to issue stock and what type, or if your company plans to go public.
Many businesses are designed to be small and profitable over their entire lives. An LLC is a good option if you don’t plan on transferring ownership or bringing in new owners. An LLC may be the best option if there is potential for large companies. However, a corporation allows stock to be issued and ownership can be transferred. This could help facilitate company growth.
6. Your commitment level
It may not be worthwhile to run a small business just to make extra money. Even the most casual business can benefit from a simple LLC or sole proprietorship. If you’re a dedicated worker for a large company, it might be worthwhile to opting for a formal structure.
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