Business Structure Basics

When you start a business, one of the first decisions you should make is how to structure your business.

Before making the decision, you will need to consider both the legal and tax consequences of each business structure. In other words, each business structure will dictate what you owe in taxes and what your exposure for liability could be. The business structure you select will also determine what tax forms will be required annually.

Types of Business Structures

  • Sole Proprietorships: The simplest structure, where one person runs their business, which has not been incorporated in any manner under state laws. You can file the business taxes when you do your personal income taxes. However, you are fully liable for the actions of your business - even your personal assets. That is because this structure is not considered to be a separate entity from that of its owner. This does not require a state filing fee to form - so it’s inexpensive.

  • General Partnerships: when two or more persons join forces to form a business they have formed a partnership. Generally, there is an agreement called a partnership agreement used to define each partner's role in the business and their investment. General partnerships are not required to have any formal business filings; these can occur when two people have an agreement to work together. General partners assume liability for the business. These kinds of partnerships are easier to form than limited ones. Partnerships also do not require a state filing fee.

  • Limited Partnerships: when there are two business partners (known as "general partners"), they normally seek to get other partners (called "limited partners") to join them in a business venture. The general partners accept all liability; limited partners have no liability outside of their investments (unless they otherwise agree) and minimal, if any, management rights. Limited partners simply provide much of the cash. These partnerships are more costly to set up and are often used for projects that are considered "one-time" projects.

    • For all kinds of partnerships, there is no tax on its income. Rather, profits or losses are ‘passed through’ to the individual partners.

  • Corporations: These structures are separate entities, which makes the formation more complex. When something of value, money or property is exchanged for stock in a company, a corporation exists. This enables corporation to raise its own money, which can be appealing for entrepreneurs. Corporations also must file specific legal documents with state agencies. Many entrepreneurs like corporations due to the liability protection - only the assets of the corporation are at risk, and not personal income or assets. There’s always a price for such benefits: owners of corporations are taxed double on any business earnings: the corporations is subject to state and federal income taxes, and earning distributed to shareholders (via dividends) are also taxed at individual tax rates on their personal returns.

  • S Corporations: These structures are the best of both worlds - a more favorable tax rate and the benefit of liability protection. In S Corporations, all income and losses get ‘passed through’ to shareholders, who then include it on their individual tax returns (only getting taxed once at the federal level). This allows shareholders to report income and losses on personal tax returns and pay tax only at their personal tax rates. However, there is a lot of paperwork with these kinds of businesses, which can mean higher overhead costs.

  • Limited Liability Company (LLC): These structures are hybrids, combining some of the best features of a partnership with a corporation. Each state governs LLC’s, meaning each company considering an LLC must verify their state rules on formation. LLC’s enjoy the same kind of liability protection as corporations, and do so without the double taxation. Ownership is not restricted; there may be unlimited number of shareholders including corporations and foreign companies or persons (S corporations are limited to 100 shareholders). These members also get to fully participate in the operations of the business. There are fewer operational rules that LLC’s have to comply with, too - at least as compared with corporations. Most states prohibit insurance companies and banks from forming LLCs.

  • Limited Liability Partnerships: General partners have limited liability; therefore, each partner is liable for his or her own malpractice, and not their partners. These kinds of structures are usually found with doctors and lawyers, or other professional practices.

  • Non-Profit Corporation: companies formed for the sole purpose of soliciting donations to further charitable, educational, literary, religious, or scientific goals. In most cases, non-profit corporations are exempt from both state and federal taxes and the members of the board govern the entity and determine how to collect and distribute donations based on their charter. Because it benefits the public, it gets special treatment under the law. However, they are also restricted by the IRS in some of their activities (such as not being able to contribute to or intervene in political campaigns).

  • Cooperatives, or Co-Ops: These businesses are owned by and operated for the benefit of the people using its services. Profits that are earned are distributed between the members. They do not work very well for many type of business, but often, agricultural businesses, arts and some restaurants use this type of formation. In effect, everyone contributes to the success and everyone shares in the profits (and losses). Some states have stringent guidelines regarding cooperative business structures.

Choosing Your Business Structure

Before determining which business structure works best with you it is important to evaluate your overall goals for your business. Several factors, including income projections, the need to hire employees and the need to protect personal assets should be considered before determining what type of business structure you should use for your business. Additional factors to consider include:

  • Long term income goals

  • Long term goals for securing financing

  • Likelihood of failure (protecting your personal assets)

  • Current/Future employee count (tax benefits)

  • Business Assets

  • Tax filing status

Some other thing to think about are the complexity and cost of forming the business structure, or if your business is inherently risk (like construction), you might want a more protective business. It will all depend on the type of business you want to have, as well as the industry you are in.

Legal Structure of a Business

The legal structure of a business determines the tax status and the liability of the owners. According to the Internal Revenue Service (IRS) sole proprietorship, partnership, corporation, and S corporation are the most common forms of business ownership.

Business structures offer certain benefits and require certain responsibilities, depending on which structure you choose. An attorney with UpCounsel will be able to guide you in the right direction, as well as create the legal documents required to form whatever structure you choose.

Helpful Resources

SBA: Choose Your Business Structure

IRS: Business Structures

1040, U.S. Individual Income Tax Return

Schedule C (Form 1040), Profit or Loss from Business

Schedule C-EZ (Form 1040), Net Profit from Business

1065,U.S. Return of Partnership Income(PDF)

1120, U.S. Corporation Income Tax Return (PDF)

1120S (PDF)

1120S Sch. K-1 (PDF)

Limited Liability Company (LLC)

Tax Information for Charities & Other Non-Profits