Business Structure – Guide

Starting a business means that you will have to make a lot of important decisions over the course of your business. And one such decision is to choose the right business structure for your company. Not only will this decision affect how you pay the taxes, but it will also affect the amount of paperwork that your business needs to do, your ability to raise money, and the personal liabilities you face.

This article would help you learn all that you need to know about a business structure and how to choose the best one for your company.

Understanding Business Ownership structure

A business structure is a category of an organization that is legally recognized in a given jurisdiction. Some of the common examples of a business structure include partnerships, corporations, holding companies, limited liability companies, subsidiaries, and nonprofits.

What is the “ownership structure” for a business entity?

Ownership structure concerns the internal organization of a business entity and the rights and duties of the individuals holding an equitable or legal interest in that business. Being an owner of the business entity, it is important to understand how the ownership structure of a business is organized and what that means for the owner’s rights.

For instance, a shareholder who is also the owner of a corporation has specific rights. These rights are different from those members of a limited liability company. In addition to this, the holder of preferred stock in the corporation might have different rights than the holder of common stock.

There are many types of business organizational structures. The next section would explain all the business structure types in detail.

Types of Business Ownership Structure

The kind of business entity that you choose will depend on three main factors: record-keeping, taxation, and liability. Below are the kinds of business structures that are available to choose from.

#1 Sole Proprietorship

One of the simplest structures is the sole proprietorship. It normally involves just one individual that owns and operates the enterprise. So, if you want to work alone, this is the best structure for you. Additionally, the tax aspects of this business structure are appealing as the income and expenses made from the business are all included in the owner’s personal income tax return, Form 1040.

All the profits and losses are recorded on a form called Schedule C, which is filed with the form 1040. And the amount at the bottom of Schedule C form is transferred to your personal tax return. This is especially attractive because business losses you suffer may balance the income you have earned from your other sources. You will also have to file the Schedule SE with this form, which is used to calculate self-employment taxes that you owe the government.

Along with paying the annual self-employment taxes, you will also have to make estimated tax payments if you expect to owe at least $1,000 in federal taxes for the year after deducting your credits and withholdings. And your withholding will be less than the smaller of:

• 100% of your previous year’s tax liability; or
• 90% of the tax to be shown on your current year tax return.

The federal government allows you to pay the estimated taxes in four equal amounts throughout the year, which is on the 15th of April, June, September, and January. Basically, in a sole proprietorship, your business earnings are taxed only once unlike the other business structures. Another benefit of this business organization structure is that you will have complete control over your business. This means that you make all the decisions without anyone interfering.

#2 Partnership

The next business structure is a partnership. If your business will be owned and operated by several individuals, this is the structure you need. There are two kinds of partnerships: limited partnerships and general partnerships.

• In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and any other obligations.
• In a limited partnership, there are both limited and general partners. The general partners own and operate the business and assume the liabilities for the partnership. The limited partners serve as the investors only. Limited partners do not have any control over the company and are not subject to the same liabilities as are the general partners.

So, unless you want to have a lot of passive investors, limited partnerships are usually not the choice for many new businesses. Another reason that this business structure isn’t that great is that it has a lot of filings and administrative complexities as well.

Moving ahead, partnerships have a good advantage when it comes to the tax treatment. A partnership does not pay tax on its income but passes through any profits or losses to the individual partners. During tax time, the partnership will have to file a tax return (Form 1065) that reports its income and loss to the IRS. Along with this, each partner reports his or her share of income and loss on Schedule K-1 of Form 1065.

But again, in this business structure, personal liability is a major concern for each partner just like a sole proprietorship. This means that each partner is personally liable for the debts and obligations of the partnerships. In fact, if one partner gets in trouble with some legal issues, all the partners will be liable for the legal fees and fines if that one person isn’t able to pay. It should be kept in mind that partnerships are more expensive to establish than sole proprietorship that requires accounting and legal services.

#3 Corporation (Also called a C corporation)

This corporate structure is more complex and expensive than most of the other business structures. It is a legal and independent entity that is separate from its owners and due to this, it has to comply with many regulations and tax requirements. But with this comes the biggest benefit for the business owner who decides to incorporate, which is the liability protection it receives.

However, there are also downsides of this corporate business structure. One of the major ones is higher costs. Corporations that are formed under the law have to follow a set of regulations of its state of incorporation. And since a corporation has to follow complicated regulations and rules, it requires more tax and accounting services.

Another drawback is that the owners have to pay double tax on the business earnings. Not only are corporations subject to the corporate income tax at both the federal and state levels, the earnings distributed to the shareholders are also taxed at the individual level. There is a strategy for this where you can pay some of the money to yourself and the other shareholders in the company as a salary. You would not have to pay the corporate tax on this amount used as reasonable compensation. It can be deducted as a business expense. But keep in mind that the IRS has limits to what is believed to be reasonable compensation.

#4 S Corporation

An S corporation is a subpart of a C corporation and was created to reduce it’s drawbacks. It is a highly attractive business structure for many small business owners as compared to a regular corporation. The reason is that it has some appealing tax benefits while it still offers the business owners with the liability protection of a corporation.

With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there’s just one level of federal tax to pay. Additionally, the owners of an S corporation who do not have inventory can use the cash method of accounting, which is much simpler than the accrual method. As per this method, the income is taxable when received and expenses are deductible when paid.

An S Corporation can also have a maximum of 100 shareholders. This makes it possible to get more investors and attract more funding. But S corporations do have its downsides as well. One of them is that it has to follow the same rules as the corporation which means it would cost more for tax and legal services. Along with this, they also need to file the Articles of Incorporation, keep corporate minutes, hold directors and shareholders meetings, and allow shareholders to vote on major corporate decisions.

#5 LLC

The next kind of business structure is limited liability companies, or LLCs for short. It has been around since 1977, but their popularity has increased in recent times. The LLC is a hybrid entity that brings together some of the best features of corporations and partnerships. LLCs were created to offer business owners the liability protection that corporations enjoy without the double taxation issue. This means that in the LLC business structure, the earnings and losses pass-through to the owners and are then taxed in their personal tax returns.

Sounds a lot like the S corporation, right? It is, except that an LLC offers the owners even more benefits than an S corporation. To begin with, there are no limitations on the number of shareholders that can be there in the company. Along with this, any owner or member (officers of the LLC are called members) of an LLC is permitted a full participatory role in the operation of the business.

For setting up an LLC, you will have to file the Articles of Organization with the secretary of state, of the state in which you want to open and do business. For some , you also need to file an operating agreement. Technically, the company dissolves when a member dies, quits or retires. In some states, the LLC Act provides that the death or withdrawal of the last remaining member causes dissolution. But even in these states, an LLC can provide that a new member will be appointed to continue the company.

You will have to see the rules in the state before you decide to open your business in that particular state. If you plan to operate in multiple states, you will also have to see how a state will treat a foreign (out of state) LLC. You will also need an experienced accountant who knows all the rules and regulations of an LLC.

#6 Limited Partnerships

There has been a development in recent years where you can also choose to open a limited liability partnership (LLP). In this, the general partners have limited liability. This means that the partners are liable for their own malpractice and not that of their partners. The LLP business structure works well for those involved in a professional practice like doctors. But the downside to this is that they are expensive and complex in setting up and running. Due to this, it is not recommended for the average small business owner.

To highlight how it works, an LLP is created by one person called the general partner who will solicit investment from others who would be the limited partners. The general partner is the one who controls the day-to-day operations of the company and is personally liable for the business debts. This is only unless the general partner is a corporation or an LLC. On the other hand, limited partners have minimal control over the daily business decisions or operations and in return, they are not personally liable for the business claims or debts.

#7 Non Profit

Another business organizational structure are nonprofit corporations, which are organized to do charity, literary, religious, education, or scientific work. And as their work benefits the public, nonprofits can receive the tax-exempt status, which means that they do not pay any federal or state income taxes on any profits made. Nonprofits are often called 501(c)(3) corporations — a reference to the section of the Internal Revenue Code that is most commonly used to grant tax-exempt status. But to be tax-exempt, the nonprofit will have to file with the IRS to get the tax exemption.

Nonprofit corporations have to follow the organizational rules that are similar to the ones for a regular C corporation. They also need to follow special rules on what they do about the profits that they earn. For instance, they are not allowed to distribute the profits to political campaigns or to the members of the company.

#8 Cooperatives

The last kind of business structure available is called a cooperative. This is a business or organization owned by and operated for the benefit of those using its services. It is an organization owned and operated democratically by its members. The profits and earnings of the cooperative are distributed amongst the members, also known as the user-owners.

Typically, an elected board of directors and officers run the cooperative while regular members have voting power to control the direction of the cooperative. Members can become part of the cooperative by purchasing shares, though the amount of shares they hold does not affect the weight of their vote. For instance, a consumer co-op could be formed to run a food store, a bookstore, or any other retail business. Or a workers’ co-op could be created to manufacture and sell arts and crafts.

Most states do have specific laws dealing with the set-up of cooperatives, and in some states, you can file paperwork with the secretary of state’s office to have your cooperative formally recognized by the state. Check with your secretary of state’s office for more information on this business structure.

Factors for Choosing Best Types of Business Structure

Now that you know all the business structure types, it is time to understand all the criteria that make the business structure different from the other ones. That is when you will be able to select the right business organizational structure for your company. It is important to make this decision first as it can be difficult to switch your legal structure after you have registered your business. So, carefully analyze all the factors before making your choice. Here are the factors that you need to consider:

• Flexibility: Check which business structure allows your business to reach its goals and achieve the kind of growth you envision. The structure should be able to support the possibility of change and growth. In short, it should support flexibility.
• Liability: Running a business shouldn’t mean putting your house or any other personal assets at risk. That is why choosing the structure that offers limited liability is a great choice. A corporation offers limited liability, which means that if someone sues the company, the owner’s and shareholder’s personal assets would not be at risk. The LLC offers the same protection but with additional tax benefits of a sole proprietorship.
• Complexity: When it comes to startup and operational complexity, nothing is as simple as a sole proprietorship. All you need to do is register your name, start your business, report the profits and pay taxes on your personal tax return. But it has a lot of drawbacks that don’t make it a viable choice for many. An LLC and corporation business structure have a lot of complexities but also come with a lot of benefits.
• Taxes: The owner of an LLC pays taxes just as a sole proprietor does where all the profits are considered as personal income and taxed accordingly at the end of each tax year. The same is true for partnerships as well. But a corporation has to pay taxes on two levels; the corporate level for the profits earned by the company and the personal level after the dividends are distributed. In short, you will pay double tax on the same amount unless you choose another business structure.
• Capital Investment: In case you need to get outside funding for expanding or running your company, it is better to choose the corporation business structure as it is easier for this kind of company to secure loans or fundings. On the other hand, the sole proprietorship doesn’t have such a benefit. An LLC can face similar struggles, although, as its own entity, it is not always necessary for the owner to use their personal credit or assets.
• Control: If you want the primary or sole control over the business and its activities, a sole proprietorship or an LLC might be the best choice for you. The same control can be negotiated in a partnership agreement as well. But a corporation is constructed to have a board of directors who make the major decisions in the company. Initially, a single person can control the corporation, but as it grows, the board will need to start controlling it.

You should keep in mind that every state has different requirements for different business structures. Based on where you set up, you might have to make some additional requirements. As you choose your structure, understand the state and industry you’re in. It’s not a ‘one size fits all,’ and businesses may not be aware of what’s applicable to them.

Once you have successfully considered all these factors, you can then make the choice of which business structure suits your business idea and goal the best.

Comparing Business Structure

With all clear above, let us now compare the general traits of these business structure types. But remember that the filing requirements, taxes, liability, and ownership rules can vary state-by-state. The comparison is done in the table below:

In short, choose the business structure that would work out to be the best for your company and its goals. As soon as you have decided and start your company, remember to keep track of all the shares in it, including the ones going out. For this, Eqvista is a great application. Check it out here!