Choosing a business structure is one of the first steps to forming a business and, arguably, the most important one. The business structure you choose will affect various factors in your business, such as taxation, management, and the organization. If you’re looking to learn more about the types of business structures and their advantages and disadvantages, then our article will prove extremely useful.
We’ll go over the five main types of business structures and discuss the potential benefits and drawbacks of each one. At the end of our article, we have included a detailed section where we share some tips on how to decide on the right business structure that will hopefully make this process significantly easier for you.
What Is a Business Structure?
Before we delve into each type of business structure and go over its advantages and disadvantages, let’s define what business structures actually are.
A business structure refers to the legal representation of a company’s organization. In other words, it determines the company’s owner, how the profits are distributed, the members’ responsibilities, and the company’s taxation policies.
The first step to registering a business is determining its structure. Before determining what kind of organization you’d like your company to have, it’s important to consider the pros and cons of each business structure.
While you can change the structure of your business at a later point, it comes with a whole host of costs and restrictions. So, it’s best to choose wisely at the beginning of your journey.
Types of Business Structures
There are five main types of business structures: sole proprietorship, partnership, corporation, S corporation, and a Limited Liability Company (LLC).
We’ll start off with the most simple business structure — a sole proprietorship.
A sole proprietorship is an unincorporated business that’s owned and managed by a single individual. It often goes under the name of “sole trader” or just proprietorship. Proprietors have full control of all the intricacies of the business and its profits.
It’s important to note that a sole proprietorship isn’t a legal entity; it merely refers to the person who is in charge of the business.
When it comes to naming a sole proprietorship, it can either take the name of its owner (operate under the legal name of the trader) or go by a completely different name, depending on the preferences of the owner. If the owner opts for the latter, they’ll need to register the trade name with the local authority. Once the name of the sole proprietorship has been determined, the owner can begin operating their business.
The owner of a sole proprietorship can choose to change the business structure at any point into a more complex one, such as a partnership, especially if the business has substantial growth within the first few years of operation.
Advantages of a Sole Proprietorship
Now that we provided a brief overview of sole proprietorships as a business structure, it’s time to examine some of their pros and cons.
Sole proprietorships are the most affordable way to start a business. Unlike some more complex structures like corporations, sole proprietorships require relatively low start-up costs. Not to mention, you won’t be required to pay any formation fees. This is one of the reasons why it’s a go-to option for entrepreneurs who are just starting out.
Even if things don’t go according to plan, the economic loss will be minimal compared to other types of business structures.
Easy to Set Up
Apart from being incredibly affordable, sole proprietorships are also easy to set up. You won’t be required to spend hours upon hours doing paperwork upon starting a business or complete any filings. However, if you want to start a business in a particular field, such as medical care, you might be required to obtain a special permit or licence.
For this reason, the sole proprietorship business structure is recommended for those who are just starting out or have multiple businesses and don’t have the time to invest in operating a new one.
Easy to Manage
Proprietors are in charge of every aspect of the sole proprietorship. Not only does this free you from any delegation, but it gives you a lot of freedom in terms of deciding how you want your business to operate, which is incredibly appealing to many.
Sole proprietorship taxation is relatively easy since the owner is completely in charge. You won’t have to pay corporate taxes or be viable for double taxation. The most common taxes you’ll be required to pay include income taxes and self-employment taxes. If you’re selling goods, you will also have to pay a sales tax. As long as you keep track of all your expenses and earnings, taxation will be an easy process.
Easy to Operate
With sole proprietorships, you won’t have to file annual reports or spend hours completing paperwork, audits, or filings. Instead, you could invest that time into operating your new business, allowing you to become more time-efficient.
Disadvantages of a Sole Proprietorship
As with any business structure, there are disadvantages. Here are the two related to sole proprietorships that you should be aware of.
No Limited Liability Protection
Unlike other business structures like LLCs, sole proprietorships have unlimited liability. In other words, you’ll be liable for any debts, lawsuits, damages, and expenses that occur as a result of your business or products. In other words, your personal assets will be up for grabs in case anything goes wrong.
No Business Loans
Since sole proprietorships aren’t legal entities, you won’t be able to take out a business loan for your start-up. In case you decide to take out a loan, it will be considered a personal loan since you are indistinguishable from your business.
Additionally, you won’t be able to sell shares or interest, which puts you at a greater risk of having to close your business in case it isn’t as successful as you imagined.
Partnerships are among the most common business structures in the US. A business partnership is a business structure that allows you and your business partner(s) to share ownership of a business.
One of the reasons why many entrepreneurs opt for business partnerships instead of an LLC or a corporation is because it allows you to reap most of the benefits of forming a corporation or an LLC without some of the formalities attached to it.
Advantages of Business Partnerships
Business Partnerships Are More Cost-Effective
Since business partnerships have at least two owners, you’ll be splitting all the business expenses with your partners. These expenses entail anything from rent to buying equipment or paying legal fees.
When starting a business, the list of expenses can seem a bit daunting, which is why the idea of forming a business partnership appeals to many entrepreneurs who are just starting out.
Additionally, if a corporation is on the brink of bankruptcy, selling stocks is always a viable option.
Not only will you be sharing the expenses with your partners, but you’ll also share the workload. Depending on the type of business you’ll be operating, it could take up more hours than you’ve initially estimated.
Having a business partner to share your workload with makes it easier to get things done, saves you a lot of time, and will significantly contribute to the growth of your business at the beginning stages.
Exchange of Ideas
Business partnerships often lead to a productive and creative exchange of ideas. If you’re operating a sole proprietorship and you’re stuck on a problem, chances are you won’t have anyone to turn to but yourself, provided that you don’t want to pay additional fees for consultations.
In a business partnership, your partners will help with creative problem solving and fill in any gaps you might have in your knowledge, and vice versa. This will lead to more productivity and time efficiency with your tasks, which is always a plus.
Let’s face it — nobody likes doing paperwork. You’ll be glad to know that partnerships require you to complete less paperwork than corporations, allowing you extra time to work on your business.
When forming a business partnership, you’ll be asked to sign a partnership agreement that details the responsibilities of the partners and the division of the profits. Apart from trade name applications and some filings that are obligatory when forming a partnership, you won’t have to worry about doing extensive paperwork.
If you’re required to fill out additional paperwork as your business grows, you can always consult your partners for help.
Disadvantages of a Business Partnership
While many people are drawn to the idea of sharing the responsibilities within a business with someone, it’s important to consider some of the drawbacks of partnerships.
You Always Have to Consult Your Partners
Regardless of whether it’s a big decision or not, you always have to consult your partners and inform them about any changes that might occur within the business. You have to be prepared for disagreements and accept the fact that things might not always go your way.
This is a risk every partnership has to take, but conflicts can be avoided by encouraging open communication and remaining calm.
Sharing the expenses of your business with fellow partners is a huge advantage that’s inherent to business partnerships, but you’ll also have to share any profits you make.
Unlike sole proprietorships, where the owner is entitled to all the profits, in business partnerships, profits have to be split. The decision of how you split the profits remains up to the business partners. Some choose to divide them equally, whereas others choose to divide them based on how many responsibilities the partner in question has. Regardless of your decision, you are expected to remain faithful to the initial agreement.
Unlike a sole proprietorship, a corporation is a recognized legal entity that is separate from its owners. It’s created by individuals who share the same business goals, and its purpose is to operate for profit.
Corporations have limited liability, which means that the shareholders won’t be held personally responsible in case of a debt or a lawsuit. Their personal assets remain protected at all times.
In order for a corporation to be officially formed, its owners have to go through a process called incorporation, which includes providing information about the name, location, and stocks of the business.
Corporations can be single-shareholder corporations and multiple-shareholder corporations. They can also be divided according to the purpose of the profit — there are for-profit organizations and non-profit corporations where all the profits go to charity.
Advantages of a Corporation
One of the biggest advantages of forming a corporation is being protected from personal liability. The owners of a corporation won’t be held liable for any situation involving the corporation, and their assets will remain protected at all times.
They’re only financially liable as far as their investments are concerned. This advantage is especially useful if the business in question involves some kind of risk.
Corporation owners can decide to sell shares in case they need funding for their business. In addition, they can issue bonds, making them extremely cost-effective.
Unlimited Number of Investors
Another extremely appealing perk of forming a corporation is that it can have an unlimited number of investors. Not only that, but corporations are quite attractive to potential investors, which can be a problem with other types of business structures like LLCs.
Corporations Can Exist for a Long Amount of Time
The ownership of a corporation is very easy to transfer. This is an important factor when it comes to the longevity of the corporation. If the ownership of a corporation can be passed from one generation to the other, it means that they inherently have a longer lifespan than some other business structure types.
Since corporations operate based on stock ownership, they offer a lot more flexibility in terms of managing profits because they allow for easier ownership transfer.
Depending on the type of corporation in question, owners might qualify for tax benefits. Some of these tax benefits include retirement plan deductions and insurance. The tax advantages will vary from state to state, so make sure you consult your tax advisor if you have any questions.
Access to Loans
Bankers are more likely to offer loans to incorporated businesses as opposed to sole proprietorships. This is one of the reasons why many business owners choose to form a corporation over other business structures.
Disadvantages of a Corporation
Since corporations are a lot more complex compared to the previous two entities, they inevitably carry more complicated disadvantages.
Corporations Take More Time to Form
Contrary to sole proprietorships, corporations take longer to form due to the long application process. This means that you’ll have to shift through more paperwork and provide more documents, a process that can be very time-consuming.
Corporations Can Be Expensive
Corporations are both expensive to form and maintain. There are a lot more fees and expenses involved than in the other business structures we covered.
For instance, states charge a higher annual fee for corporations as opposed to sole proprietorships. In addition, attorneys charge corporations a higher fee during the formation process and for providing legal advice. Corporations also have larger taxes.
If you’re unsure about how much forming a corporation will cost or if the investment will pay off, you can always hire a consultant.
Corporations come with a larger number of legal formalities. You’ll have to pay attention to your state’s protocols and laws or hire someone who could handle the legal side on your behalf.
S corporations are among the most common types of corporations. They’re considered pass-through entities that come with many tax benefits. In other words, S corporations are taxed as partnerships, all the while having the tax benefits of incorporation and being exempt from paying corporate taxes.
For this and many other reasons, S corporations are a common business structure for smaller businesses that want to enjoy all the benefits of a corporation without the tax commitment.
In order for your business to become an S corporation, it must register as a C corporation or an LLC first and meet the required IRC (Internal Revenue Code) guidelines.
Benefits of an S Corporation
As we implied and given the popularity of this business structure, there are many advantages that come with forming an S corporation.
Just like with many other business structures, the shareholders of an S corporation enjoy the benefits of having limited liability. Their personal assets remain protected at all times, and they aren’t up for grabs if something goes wrong along the way, like the business being indebted, for instance.
The shareholders of an S corporation qualify for pass-through taxation, meaning they don’t have to pay corporate taxes. The profits are passed through to the shareholders, who have to include them in their personal tax returns.
This benefit is especially useful for shareholders invested in new businesses that are just starting out and testing the waters in terms of potential profit.
Easy to Attract Investors
Another perk you’ll get to enjoy if you decide to opt for an S corporation is the ability to attract potential investors. Investors can make or break a business, and having investors who are willing to add capital to your S corporation is incredibly useful, especially at the beginning stages of your business.
Unlike sole proprietorships or partnerships, S corporations are generally seen as more credible, both with potential customers and investors.
More Stock Benefits
Corporations come with more stock benefits, including the ability for employees to buy new stock.
Easy Ownership Transfer
If at any point in your career, you’d like to transfer the ownership of your S corporation to someone else, you can do so without paying extortionate fees or additional tax. S corporations have easy ownership transfer, which is one of the many reasons why entrepreneurs decide to go for this business structure.
Disadvantages of S corporations
Believe it or not, there are also certain drawbacks to forming an S corp.
S Corporations Are More Expensive to Form and Maintain
Since S corporations are a more complex business structure, it won’t come as a surprise to know that they come with higher formation fees. You’d have to invest in a registered agent at the start and pay some starting fees for your business to form.
Additionally, the maintenance fees can be quite higher as well, depending on which state you decide to form your business in. Even though S corporations come with many benefits, like being more appealing to investors, it’s important to factor in these higher fees at the beginning so that you know how much it’ll cost. Alternatively, you can always opt for a sole proprietorship or a partnership.
S Corporations Can Be Time-Consuming
Not only are S corporations more expensive to form, but the process is generally more time-consuming than that of other business structures. You have to prepare various documents and file them before you can officially start your business, which could take a while.
S corporations come with more formalities as opposed to sole proprietorships and partnerships. You’d have to hold regular meetings with fellow shareholders, do more extensive paperwork, and provide records for your business, among other formal obligations.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business structure that provides liability protection for its members. The members of the LLCs own the company, and their personal assets can’t be used in case of lawsuits, claims, and debts. The members of an LLC can be individuals or businesses.
LLCs are common among new and smaller businesses since they provide all the benefits of a corporation without some of the drawbacks and formalities. Depending on the type of business, some states require LLCs to provide official credentials.
It’s important to note that the LLC regulations and laws regarding the formation of LLCs differ from state to state.
Advantages of an LLC
Unlimited Number of Owners
One of the main advantages of forming an LLC is that you don’t have any restrictions in terms of how many owners/members the LLC can have. Additionally, the owners can be both US citizens and individuals who live outside the US, giving you a lot of leeway.
LLCs have pass-through taxation — all the profits go to the members without undergoing any corporate taxation. The members are taxed individually based on their income tax returns.
Not only does this make filing taxes easier, but it also results in more profit overall. This type of taxation is extremely favourable for the members, and it’s one of the main reasons why LLCs are so appealing as a business structure.
As their name suggests, LLCs offer limited liability for their members. Forming an LLC is an extremely safe and low-risk option for entrepreneurs who want to protect their personal assets from creditors.
Easy to Form and Maintain
Unlike S corporations, LLCs are both easy to form and maintain. The paperwork required to start an LLC is relatively easy and straightforward, while the maintenance is very time-efficient. If you want to make this process even easier for you, you can always hire an accountant or a legal consultant.
LLCs come with fewer formalities like board meetings and paperwork, saving you a lot of time and energy that you can invest in your business.
Easy to Manage
LLCs provide their members with a lot of flexibility in terms of management. The owners of the LLC have a say in terms of how the LLC will operate and get to actively participate in the decision-making.
Disadvantages of an LLC
LLCs Can Be Expensive to Form
Compared to sole proprietorships and partnerships, LLCs are both more expensive to form and maintain. There are regular fees you need to pay in addition to the initial starting fees, which vary from state to state.
Ownership is Hard to Transfer
Another drawback of forming an LLC is that the ownership can be hard to transfer. Since LLCs don’t operate with stocks, in the case of an ownership transfer, all members must reach an agreement. The same also applies to making any structural changes to the company, such as adding new members.
How to Choose the Right Legal Structure for your Business
Here are some key points that will help you choose the right legal structure for your business.
One of the first things to consider is the taxation practices that pertain to your structure of choice. Some structures are required to adhere to corporate taxation, while others separate the company’s income from the owner’s. Decide which would work best for your goals and opt for the business structure that matches them.
With each business structure, you’ll be required to do some kind of paperwork. Some structures come with less paperwork, while others require you to fill out forms and articles on a regular basis. If you’re not so keen on this idea, then you might want to look into forming a business partnership as opposed to a corporation.
If you’d like your assets to remain protected at all times from potential claims, lawsuits, and debts, then choosing a business structure that provides limited liability for its members is highly advised.
Another point you’ll want to consider is how much control you’d like to have in the company. If you want to be the one in charge, opt for a sole proprietorship or an LLC. Other business structures require you to consult the other owners before making any decisions, so the control of the company is shared.
It’s important to examine the funding opportunities that come with each structure before making a final decision. For instance, it can be harder for LLCs to find potential investors, whereas corporations are extremely appealing to investors due to the stock options.
We hope you found our article on the types of business structures and their advantages and disadvantages useful in helping you decide which business structure will be most beneficial for you.
Each business structure comes with a unique set of advantages and disadvantages, so it’s important to review your goals and your business plan beforehand to ensure that you’re making the right decision for yourself and for your business.