How to Choose a Business Structure
The first step in choosing a business structure is determining if you need personal liability protection.
What is personal liability protection? When a business owner has personal liability protection, they cannot be held personally responsible if the business suffers a loss. This means personal assets (car, house, and bank account) are protected.
Business Structure Types
Informal Business Structures do not offer personal liability protection. Informal business structure types include:
- Sole Proprietorships
- General Partnerships
Formal Business Structures offer personal liability protection. Formal business structure types include:
Informal Business Structures: No Personal Liability Protection
Informal business structures do not offer taxation benefits or personal liability protection. There are two main types of informal business structures:
Sole proprietorship. A business owned by an individual that isn't formally organized. A sole proprietor files taxes under his or her own name and is personally iable for any actions taken against the business.
General partnerhship. A business owned by more than one individual that isn't formally organized. A general partnership files taxes under the partners' names and the partners are liable for any actions taken against the business.
Informal business structures like sole proprietorships and general partnerships are best for businesses with the following characteristics:
- They MUST be low profit and low risk (low chance of liability or financial loss)
- They have a smaller customer base; often friends, family, and neighbors
- They sometimes start as hobbies like photography, blogging, or video streaming
Advantages and Disadvantages of Informal Structures
The biggest advantage of starting a sole proprietorship is simplicity; it couldn't be any easier or less expensive to get a business up and running. But, less output up-front might not lead to the best outcome later.
Disadvantages of Informal Business Structures:
- No Personal Liability Protection. Informal business structures do not offer personal liability protection. This means your personal assets (car, house, bank account) are at risk in the event your business is sued or if it defaults on a debt. ONLY low profit/low-risk businesses should operate as informal businesses.
- Zero Tax Benefits. Sole proprietors pay taxes on their profits and also pay full FICA taxes (Medicaid and Social Security taxes). When a business becomes profitable, it will be very expensive to be taxed as an informal business structure.
- Limited Growth Potential. When a business becomes more profitable, risk increases. When risk and profit increase, so does the need for a legal formal business structure.
- Reduced Credibility and Branding Opportunities. A sole proprietor must invoice, receive payment, open a bank account, and market with their surname unless their state allows them to register and maintain a doing business as (DBA) name.
Formal Business Structures: Personal Liability Protection
Formal business structures offer taxation benefits, increased credibility, and most importantly, personal liability protection. There are two main types of formal business structures:
Limited Liability Company (LLC). An LLC is a formal legal business structure that is owned by its members. An LLC is the simplest way of structuring your business to protect your personal assets in the event your business suffers a loss. LLCs also offer unique tax benefits.
Corporation. A corporation is a formal legal business structure that is owned by shareholders. A corporation offers personal liability protection and is more complex to maintain than an LLC. Corporations offer their own set of tax benefits and investor opportunities.
When To Use A Formal Business Structure
Formal business structures like LLCs and corporations are recommended for businesses with the following characteristics:
- Larger customer base
- Potential for immediate and sustainable profit
- Increased risk of liability or loss
- Would benefit from unique tax options
Advantages and Disadvantages of Formal Business Structures
The only disadvantages of forming a formal legal structure are cost and maintenance. For a profitable business, these disadvantages are outweighed by financial and legal advantages.
Advantages of Formal Business Structures:
- Personal Liability Protection. Formal business structures like LLCs and corporations provide personal liability protection. This means your personal assets (car, house, bank account) are protected in the event your business is sued or if it defaults on a debt.
- Tax Benefits. Formal business structures like LLCs and corporations have options to customize their tax structure. This allows businesses to use the best tax strategy for their circumstances.
- Growth Potential. Formal business structures like LLCs and corporations can grow in profit and risk because they provide personal liability protection and tax benefits.
- Credibility and Consumer Trust. LLCs and corporations generally earn more trust from both banks and consumers than do informal business structures like sole proprietorships. This can impact a business's ability to take out loans and can affect marketability.
Make Your Choice and Take the Next Step
Personal liability protection is the primary factor to consider when choosing a business structure. Luckily, it's fairly simple to tell if you need it.
If you expect to make a profit: and/or there could be business liability or risk, you must have personal liability protection.
Next Steps for Informal Business Structures
Sole Proprietors and General Partnerships
Stop Here. If you don't expect to earn much of a profit or be held liable for an injury etc., you can form your business simply by operating it. In most states, a sole proprietorship doesn't require any type of registration with the government.
Some states require general partnerships to register their business names. To research whether this applies in your state, visit our How to File a DBA guide and choose your state from the drop-down.
Next Steps for Formal Business Structures
LLCs and Corporations
Keep Reading. If you expect to earn a profit or if there is any potential risk in operating your business, you must operate under a formal legal structure to protect your personal assets.
We will guide you through the next stage of choosing between an LLC vs a corporation. Then, we will discuss when it makes sense to opt for the S corp tax designation.
Choosing a Business Structure Step 2: LLC vs Corporation
A limited liability company (LLC) is usually the best business structure for most small businesses. LLCs are taxed as pass-through entities which allows business owners to reinvest profit back into the business and not pay taxes on those expenses.
A corporation might be a good choice for a small business if the following is true:
- You expect to carry a relatively large sum of profit from tax year to tax year.
- You will rely on investors or venture capitalists, or list on the stock exchange.
- Your time and effort will be well spent on complex operational procedures.
When To Form an LLC
Most small businesses start as limited liability companies (LLCs). An LLC is most likely the best structure for your business if:
- you plan to invest most of your profit back into the business each year
- you would benefit most from an easy to maintain business structure
Reinvesting LLC Profit and Pass-Through Taxation
If you expect to reinvest most of the profit back into your small business, an LLC is the right choice.
Small businesses usually carry very little profit from one tax year to the next. This is because small businesses usually spend most of their income on expenses like marketing, software, and office equipment to help the business grow. But, why does this matter?
Pass-through taxation means the net income (profit minus expenses) of the business passes through to the LLC member(s) individual tax returns. This means the business itself will not be taxed and you will only be taxed on the business's net income on your individual tax return.
Corporate income is taxed twice and one of those times occurs prior to expenses being deducted. This is not a good scenario for a small business that is reinvesting its profits to promote growth.
To learn more, read our LLC vs. Corporation Taxes guide.
LLCs are Easy to Start and Maintain
Limited liability companies (LLC) are a simple business structure: they require less paperwork, less administrative overhead, and are much easier to start and maintain than a corporation.
LLCs are also adaptable, and can elect to become corporations at a later date. This makes LLCs a great starting point for your business to grow.
When to Form a Corporation
Most small businesses start as limited liability companies (LLCs) but there are some instances when starting as a corporation makes sense.
Your small business would benefit from a corporate structure if:
- you need to carry significant profit over from tax year to tax year
- you need to attract venture capitalist and investors
- there is benefit in managing a complex business structure
Profit Carryover from Year to Year
If a small business is unable to spend a significant amount of its profit during a tax year on expenses to grow the business, it could make sense to structure the business as a corporation rather than an LLC. This is because of the difference in the way the two business entities are taxed.
A corporation is taxed at about 15% for all profits that carry over to the next tax year. In this same scenario, an LLC members tax burden would be greater because they pay FICA taxes and federal and state income taxes, which are higher than the 15% corporate rate.
That said, a business owner who anticipates needing to carry profit into the next tax year should look closely at the financial benefits of forming a corporation.
Venture Capital and Investors
If you need to attract investors, starting a corporation could be the best choice for your small business.
An investor in a corporation pays taxes on dividends only when they receive them whereas an investor in an LLC would have to pay taxes regardless if they received a distribution or not. The LLC investor might never see a return on their investment but might have to pay taxes every year regardless.
Managing a Complex Business Structure
If the benefits of managing a complex business structure outweigh the costs, starting a corporation could make sense for your small business.
Corporations are more complex organizations compared to LLCs, with increased administrative overhead, more paperwork, and complex compliance requirements. Managing a corporation may require help from an attorney or accountant which can increase overall business costs.
To learn more about the complexities of running a corporation, visit our How to Start a Corporation guide.
Take the Next Step: LLC vs Corporation
Most small business owners choose to form an LLC vs a corporation. Follow the steps below to get started with the best option for your business.
Next Steps for Starting a Corporation
If your business will benefit most from a corporate structure, visit our How to Start a Corporation page and select your state from the drop-down menu. We provide easy to follow steps for starting (and running) a corporation yourself.
Next Steps for Starting an LLC
Small businesses often benefit most from forming an LLC vs a corporation. We offer easy to follow guides for starting an LLC in every state. Visit our How to Form an LLC page and select your state from the drop-down menu to get started today.
Recommended: Continue reading below for more information about the S corporation tax designation for LLCs.
Most small businesses file taxes under the default LLC tax classification. This is because small businesses don't usually carry over the amount of profit that would make the S corp tax designation beneficial.
Under an S corp, business owner(s) can save about 17 percent on the distribution portion of their income if the following statements are true:
- The business can pay the owner(s) a "reasonable salary".
- There are substantial distributions year over year.
- There is a positive return on investment for payroll service costs.
- The business meets S Corp requirements.
When To Elect S Corp Classification
The S corp tax classification allows business owners to be taxed as employees of an LLC. Under an S corp, the LLC business owner pays FICA (Medicare and Social Security Tax) and federal income tax on only their salary.
S Corp Tax Benefit: When a reasonable salary is present, the owner pays FICA and income taxes on salary only. LLC distributions are then only subject to income taxes.
The following criteria determine whether electing the S corp tax classification makes sense for an LLC:
- The LLC business owners must earn a "reasonable salary".
- The business should consistently earn a profit and pay distributions.
- There should be a positive tax advantage to offset the cost of maintaining S corp upkeep.
- The business must meet IRS S corp requirements.
When To Use The Default LLC Classification
Many LLCs will benefit most from the default LLC tax classification. LLC owners often put any profit right back into their small businesses each year to promote growth. And without profit and distributions, there's no basis for electing an S corp.
Default LLC Tax Benefit: Business owners can choose to invest as much of the businesses profit as they see fit in any given tax year.
The default LLC tax structure is best suited for businesses with these characteristics:
- Their owners reinvest profit back into the business to promote growth
- The cost of bookkeeping and payroll services would outweigh the tax benefit of an S corp
To learn more about the difference and benefits of default LLC vs S Corp classifications, read our LLC vs. S Corp article.
Business Structure FAQ
How do you start a business?
The steps to starting a business vary depending on the type of business you plan to start and the state in which it will operate. You can find detailed information in our How to Start a Business, How to Start a Corporation, and How to Form an LLC guides. Simply select your state from the drop-down menu to see its specific steps and requirements.
What are the types of business structures?
There are four main types of business structures:
Several additional types exist within these main groups, such as nonprofit corporations, benefit corporations, single-member, and multi-member LLCs, limited partnerships, general partnerships, and more.
Can I change my business structure?
Yes. The process for changing your business structure varies depending on the type of change and the state in which your business is located.
What is an informal business structure?
An informal business structure is a category that includes sole proprietorships and general partnerships. In these structures, there’s no legal separation between the business and the owners.
What is a formal business structure?
A formal business structure is a category that includes corporations and LLCs. In these structures, the businesses are separate legal entities from their owners.
What is the best business structure for a small business?
The best business structure for a small business will depend on that business’s particular characteristics and needs. There is no single answer for all small businesses. However, small businesses use the LLC, partnership, and sole proprietorship structures more often than a corporate structure.
What is pass-through taxation?
Pass-through taxation is a system of taxation that generally applies to sole proprietorships, partnerships, LLCs, and S corps. In this system, a business’s profits or losses are not taxed at the business level. Instead, they pass through to the owners’ personal tax returns and are taxed at each owner’s personal income tax rate.
What does limited liability mean?
Limited liability protection means that a business owner’s personal assets are protected in the event that the company goes into debt or faces a lawsuit. Corporations, LLCs, and LLPs each offer limited liability protection. Sole proprietorships and partnerships do not.
What is an S corp?
An S corporation (S corp) is a tax designation applicable to either an LLC or a corporation. Under this tax structure, the Internal Revenue Service treats owners as employees. The owner-employee then pays FICA taxes and income taxes on only their reasonable salary. Distributions are subject to only federal and state income taxes.
S corps can have additional advantages as well as disadvantages, which you can read about in our What is an S Corporation article.
What is the best business structure for a rental property?
The best structure will depend on your business’s particular characteristics and needs. However, it’s generally a good idea to choose a structure with limited liability protection when the business involves rental properties. This includes LLCs and corporations.
Do I need an attorney to start a business?
Hiring an attorney may or may not be necessary when starting a business. It depends on the type of business structure you choose and your level of comfort with the process. Starting a sole proprietorship is quite simple. Forming an LLC is a bit more complicated, but can typically be done without the help of an attorney. Starting a corporation is a more complex process than starting an LLC so hiring an attorney is often advised.
What is double taxation?
With corporations, income is taxed at the corporate level and then the owners must pay personal income tax on the dividends they receive. Because profits are effectively taxed twice, this is often referred to as double taxation.
Do I need a business license?
Different states and localities have their own rules regarding business licenses. Check with your state and local government offices to determine the specific requirements for your business.