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Which business structure is right for your small business?

Which business structure is right for your small business?

By Wil Chan
Aug 15, 2022
7 min read

When you start your own small business, you have to choose a business structure. A business structure is a legal classification that affects things like how you pay taxes and who is liable for the business's debts — so it's important to choose carefully.

These are the most common business structures for small businesses:

In this guide, we’ll discuss how these business structures work so you can figure out which is best for your small business.

Sole proprietorship

A sole proprietorship is a popular business structure for one-person operations, independent contractors or freelancers who have simple operations. A sole proprietorship cannot have multiple owners. 

The biggest plus of registering a small business as a sole proprietorship is simplicity. Registering your sole proprietorship is simple: Get an employer identification number (EIN) from the IRS, and you’re in business. 

As a sole proprietor, your taxes are “pass-through,” which means you file your sole proprietor taxes as part of your personal return without worrying about a separate report.

The main downside of sole proprietorships is that there’s no legal separation between you and your business entity. That means you'd be personally liable if your business gets sued or goes into debt — which means creditors could target your personal assets and bank accounts.

Partnership

In a business partnership, multiple business owners join forces to grow their business while remaining legally self-employed.

There are different kinds of partnerships. The simplest is a general partnership, in which members share full control over the company as well as its profits, losses and liabilities. You can start a general partnership with something as simple as a verbal agreement, but it’s a good idea to draw up a formal partnership agreement. 

Like sole proprietorships, partnerships are considered "pass-through" entities by the IRS. That means the partnership itself is not taxed at the federal level. Instead, business income and losses are "passed through" to the personal tax returns of their owners.

Even though a partnership does not directly pay federal taxes, it must report its gains and losses to the IRS each year on Form 1065. Each partnership member files a Schedule K-1 form to report the amount passed through to their share of tax.

Keep in mind that partnerships are not legally separate from their members, which means members may be personally liable if the business gets sued or goes into debt.

Limited partnership

In a limited partnership, at least one member is a "limited partner." This is typically an investor who does not run the company and whose share in its profits, losses and liabilities is limited to their investment. 

To form a limited partnership, you have to register in your state, pay a fee and file a partnership agreement that describes each partner's share in the company. 

Limited liability corporation (LLC)

A limited liability company, or LLC, is a business structure with some important benefits over a sole proprietorship or a partnership. 

The biggest advantage is that an LLC helps create a legal separation between business owners and the business itself. That means lenders may not be able to go after your personal assets and bank accounts if your business is sued or can't pay its debts.

The downside of an LLC? There’s paperwork and fees involved with starting and maintaining an LLC. 

Regarding taxes, the IRS treats an LLC with a single member as a sole proprietorship and an LLC with multiple members as a partnership. That means earnings would "pass through" to the LLC's members, who report it as income on their personal tax returns.

As an LLC owner, you can also file IRS form 8832 and request that the IRS treats your LLC like a corporation. Depending on your business and its location, this could help save on your tax bill. 

S-Corporation

If you structure your business as an S-corporation, you can sell shares of stock to raise money for your business. Like an LLC, an S-corporation helps create legal separation between a business and its owners, which protects owners’ personal assets from business debts or lawsuits. 

The IRS treats an S-corporation as a “pass-through” entity: the corporation itself is not taxed at the federal level. Instead, its owners pay taxes on the earnings on their personal tax returns. 

There are some federal restrictions around S-corps: You can't register a new business as an S-corp; it has to be a business already formed. The company must be U.S.-based with no foreign investors. An S-corp is limited to 100 individual shareholders and can only offer one class of stock.

There is a fair amount of paperwork involved with starting and maintaining an S-corp, and it’s a good idea to get the help of a lawyer.

Be aware that a few states and cities don’t recognize S-corps and tax S-corporations like other corporations. Check your local laws to make sure. 

C-Corporation

C-corporations are another legal structure allowing you to sell stock shares to raise money for your business. A C-corporation also creates legal separation between a business and its owners, which protects owners’ personal assets from business debts or lawsuits.

Unlike an S-corporation, a C-corporation is taxed separately from its owners. C-corps must file quarterly and annual business tax returns and pay corporate tax on earnings. 

One drawback of C-corporations is what’s called "double taxation." After the business is taxed on its profits, individual shareholders are also taxed on the profits they receive as dividends. That means owners and shareholders are essentially taxed twice on the business's earnings. 

But C-corporations have a big advantage in terms of how they can raise money. With a C-corporation, there are no limits on the number of shareholders or where they’re based, and a C-corporation can issue multiple classes of stock. That makes this business structure suitable for companies that plan to grow big.

Starting and maintaining a C-corporation can involve complex paperwork, and it’s a good idea to get the help of a lawyer.

NEXT helps you launch and protect your business

Once you’ve launched your business, getting comprehensive business insurance is a must. We’re here to make that simple.

Our streamlined online application allows you to get the coverage you need, including general liability, commercial property and workers' compensation policies. As soon as your purchase is complete, you can access your certificate of insurance immediately online.

If you have questions, our licensed, U.S.-based insurance professionals can help.

Get started today with your free online quote.

Which business structure is right for your small business?

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About the author
Wil Chan is a content writer at NEXT and has been a professional writer for more than ten years. His work has been featured in publications including Forbes and Greatist. He has run a freelance business since 2016 and feels passionate about helping self-employed people in all industries succeed.
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