Starting a business involves a lot of decisions, and one of the most important ones is choosing between the different types of businesses to establish your entity. Which type best suits your operations will depend on factors like who’s involved in the business, how simple you want it to be, and more.
Your business structure helps determine how much you pay in taxes, your personal liability, and what paperwork you need to file. Choosing the right business type can help you save when tax season arrives.
Not sure which business structure is right for your small business? Let’s take a closer look at your options and how they affect your business taxes.
5 Main Types of Business Structures
There are five main types of businesses to choose from. For some, there may be clear advantages of one business type over another, but before making a decision, you should have as much information as possible.
1. Sole proprietorship: The simplest business type
A sole proprietorship is the simplest business structure. If you’re just getting started or you’re self-employed, you’ll typically operate as a sole proprietorship.
When you form a sole proprietorship, you’re the only owner. That means you’re personally responsible for any debts against your sole proprietorship, and your personal assets can be used to collect debts.
With a sole proprietorship, you’re responsible for paying your personal taxes and self-employment taxes. The self-employment tax rate is 15.3%, which includes Social Security and Medicare taxes.
When you file small business taxes as a sole proprietor, you can attach Schedule C to your individual tax return. You also need to complete Schedule SE and submit it with your individual tax return to pay your self-employment taxes.
Sole proprietorships are simple because taxes are straightforward, and there’s less paperwork involved. However, it can be difficult to secure funding because you may not have the business credit a corporation has.
2. Exploring partnerships: General, limited, and limited liability
Partnerships involve two or more people, so partnerships are only an option if you’re planning on starting a small business with someone(s). There are several different types of partnerships you can enter, and your tax obligations and personal liability can vary depending on the type of partnership you choose.
General partnerships
General partnerships (GPs) are easy to form because you don’t technically have to file anything with the state. However, you still need to get your business license and any required permits. While it might not be required, it’s a good idea to have a partnership agreement that outlines important items like profit shares, liabilities, how to handle disputes and so forth.
While general partnerships are a simple option with fewer hoops to jump through, they offer little protection. You and your partner have unlimited personal liability unless you form a limited partnership or limited liability partnership.
Limited partnership
In a limited partnership (LP), at least one partner has unlimited personal liability. This party is considered the general partner(s). The other limited partners have limited liability and play a smaller role in day-to-day operations.
LPs are commonly used for short-term business ventures instead of standard businesses. To register your business as an LP, you’ll need to file formation documents and pay the related fees with your respective state.
Limited liability partnership
An LLP offers protection for your personal assets. In an LLP, your assets can’t be used to cover business debts, but you can still be held responsible for malpractice.
In many states, only certain types of professional services businesses can create a limited liability partnership (LLP). This includes professions like accountants, dentists, and doctors. In some states, any business with at least two partners can form an LLP. When forming an LLP, all proper forms must be filed.
Partnerships are a simple way to form a business with two or more owners. All three types of partnerships are taxed similarly, must file an annual federal return, and require an EIN.
3. Limited Liability Company (LLC): Flexibility and protection
A limited liability company (LLC) can have one or multiple owners, but those owners aren’t personally liable like they are in a sole proprietorship or general partnership. Each owner in an LLC is considered a member.
There’s no upper or lower limit to how many members an LLC can have. LLCs offer a lot of flexibility since you can form a single-member LLC by yourself, or you can form an LLC with as many members as you’d like.
LLCs generally protect members’ personal assets, including homes and bank accounts, but there are some exceptions when a judge may rule differently. While LLCs are fairly easy to start in terms of paperwork and fees, there are some annual ongoing requirements you need to keep up with, including filing an annual report.
By default, single-member LLCs are taxed as a disregarded entity–meaning that you’ll report your income on your individual tax return– while multi-member LLCs are taxed as a partnership. That said, you can also choose to be taxed as a C or S corporation. If your LLC is taxed as a partnership, each member has to pay self-employment taxes. This isn’t a significant downside, but it’s something to consider before you start an LLC.
4. Corporations: C-Corps, S-Corps, and more
The main draw of corporations is that they offer limited liability protections and allow you to choose between different business structures based on how they want to operate and pay taxes. Let’s compare the two different types of structures for corporations.
C-Corp
C-Corp is the most common tax status for large corporations. The main draw of a C-Corp is that the business is considered an entirely separate entity from you. With a C-Corp, decisions are overseen by a board of directors or officers who guide the business. For these reasons, C-Corps are much more complicated business structures to set up and work within.
A C-Corp may seem unnecessary when you’re just starting out, but there are several advantages. For example, there are no restrictions on who can own shares with C-Corp status and members don’t have to be US citizens or residents.
As a C-Corp, you pay federal corporate income tax, and shareholders pay taxes on personal income from dividends or stock sales. This is known as double taxation.
S-Corp
As an S-Corp, you don’t have to worry about double taxation. Instead, individuals are taxed based on profits and losses on their personal taxes. S-Corps also offer the same protection from personal liability.
The downside to S-Corps is that there are stricter requirements. An S-Corp can’t have more than 100 shareholders, all members must be US citizens or residents, and they can only issue one class of stock. S-Corp shareholders must also meet certain requirements to invest.
5. Cooperatives and joint ventures: Collaborative business models
Cooperatives and joint ventures are less common business structures, but these structures are common for certain types of businesses. For example, farmers often operate within cooperatives.
Cooperatives are designed to give everyone a sense of equality. No individual member of a co-op can have more control over the co-op than other members, and there are limits to how much members can profit.
Since cooperatives are considered not-for-profit, they’re taxed differently than other business structures. Members are only liable for the money they invest.
Co-ops face several challenges, including profit and member collaboration. Everyone has to work together to achieve goals because no member has authority over another.
Joint ventures are a way for businesses to pool their resources and work together to achieve a goal. For example, businesses may work together to secure a government contract using their combined resources.
Married couples who jointly own a business can elect qualified joint venture (QJV) status. Otherwise, by default, businesses that are jointly owned by spouses are considered partnerships.
Tax implications of each business structure
Before you choose a business structure and apply to get an EIN number, let’s quickly summarize and compare the tax implications of each business structure we discussed above:
- Sole Proprietorship: You’re taxed at the individual level instead of paying business taxes. You’re also responsible for paying self-employment taxes. This includes a 12.4% tax for Social Security and a 2.9% tax for Medicare.
- Partnership: Profits or losses are passed through to partners who pay taxes on them. Each partner is responsible for reporting their share of profits or losses when they file their individual tax return.
- LLC: Can file as a corporation or partnership. In LLCs that are treated as partnerships, individual members pay self-employment taxes. If the LLC is a corporation, you need to file Form 1120, US Corporation Income Tax Return.
- Corporations: C-Corps pay corporate income taxes, but S-Corps don’t. Instead, individual shareholders pay taxes on profits from sales of shares and dividends. Individual investors are also taxed in a C-Corp, which is known as double taxation.
- Cooperatives: These entities can enjoy certain tax benefits and exemptions because they’re considered a not-for-profit business.
- Joint ventures: Tax implications for joint ventures depend on the specific type of joint venture. As a corporation, you’ll be responsible for paying corporate taxes. In unincorporated joint ventures, the entities who join the venture are responsible for individual taxes.
Factors to consider when choosing a business structure
When evaluating the different types of business structures, here are a few things to consider:
Startup costs
Consider startup costs and complexity before choosing a business structure. Certain types of businesses are easy and affordable to start, while others can cost more, not only for filing and legal fees, but for accounting and other ongoing expenses. For example, a corporation is going to require more than a sole proprietorship in terms of filing fees.
Personal liability
You also have to factor in personal liability. Some business structures protect your personal assets–like an LLC–if you have business debts, but your personal assets could be at risk if you choose to operate your business as a different type of entity.
Tax obligations
For many people, taxes are an important factor in all financial decisions, including running a business. As we outlined above, different types of companies also have varying tax responsibilities. Think about which structure will benefit you the most when tax season arrives. You might also consider consulting a tax expert for more guidance.
Keep in mind that your business structure isn’t necessarily set in stone. Whether you want to change your business structure or apply for an IRS name change, you can make changes to your company’s set-up down the line.
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