Figuring out that next stage for our businesses, or maybe even the first step, can be quite an overwhelming moment, especially for people who are owning and operating their own businesses for the first time. In this article, we will take a look at some of the most common business structures you’ll come across in the United States and why some business owners prefer that model over some of the others we’ll see today. That means that, hopefully, by the end of this article, we’ll all be a lot more comfortable with the direction we need to take our businesses in and where they can potentially grow from there.
Different Business Structures
So the first business structure we’re going to talk about is one of the most common types of businesses in the United States and that is sole proprietorship. Most of what this business structure is in the name already, but let’s take a closer look at what that really means.
1. Sole Proprietorship
A sole proprietorship is a business that belongs to one person. Most businesses like hairdressers, small kiosks or even people who work independently, like freelance journalists or artists, will own and run a sole proprietorship. This business is usually not a part of any bigger corporation, rather, just one person doing their thing and making their living. Such businesses usually belong to self-employed people involved in low-risk, low-profit businesses targeted towards a specific audience.
This means that this business structure is also usually the first step someone takes when turning their hobby into a business. It also means that sometimes these businesses don’t even have a separate trade name to operate under, or even a trade name to start with.
Many businesses out there today get their start as a sole proprietorship before they change or move onto some of the other business structures we’ll talk about later today. But why do so many businesses start with a sole proprietorship? And why do so many people choose to stick with this model when there are quite a few options to choose from?
Benefits of Sole Proprietorship Business Structure
Sole proprietorship is actually one of the easiest business structures for setting up a business. You don’t need to fill out any federal or state forms to get it up and running and, as long as there are no other companies operating under the same name in your area, you can basically name them whatever you want and hit the ground running.
That’s one of the huge advantages of using this type of business structure, but to explain why so many people stick with it, we’re going to have to talk about taxes.
Taxes: When it comes to paying taxes on a sole proprietorship business, this business structure has a huge advantage. Sole Proprietorship Businesses don’t have to pay corporate tax and any profit they make goes straight to the owner.
At the end of the year, all the owner has to do is show that profit on their own personal tax returns and then both the owner and the business are all caught up. This is a huge advantage to other structures we’ll talk about today, especially ones like a corporate structure, where both the company and the owner can end up paying taxes separately.
In this case of a sole proprietorship the profits move directly from the company to the owner and this is called “pass-through”. This is really important to remember because the Tax Cuts and Jobs Act of 2017, came with a tax break for pass-through businesses. This means that some sole proprietorship businesses can be eligible for up to a 20% tax reduction all the way until 2026, when it’s entirely possible that congress will extend this act further.
With this model, you now have potentially lower income taxes to pay and they’d be part of your personal income tax returns as well. This means that you don’t have to get an employer identification number, or an EIN, from the IRS. You still could get one if you wanted to, but you could also just use your own social security number to pay the taxes for your business.
This doesn’t really work if you need to employ people to work for you though, then you’d need to get an EIN, and you’d need to check with your state’s laws to see if you need to register for a sales tax license, but if you’re good to go after that, you’re essentially good to go and get started running your own business.
Seeing as you’re the sole owner of your business, you can run it in a way that makes sense for you. You’ll need to keep an eye on your expenses, especially figuring out which ones are personal and which ones are for the business, so you could open a checking account specifically for the business. You don’t have to. It’s definitely not something that you’d have to do for legal reasons, but again, the choice is yours.
Cost Effective:Sole proprietorship business structure offers flexibility for various situations including where and when you work. Maybe you’re a contractor and you’ll be travelling around, maybe you work from home and all you need is your laptop and a steady internet connection. In most cases, you’ll have relatively lower expenses to get your sole proprietorship business off the ground.
It’s also usually pretty straightforward to separate the owner’s personal items and those that belong to the business in the event that something happens and maybe the owner dies. There won’t be a lengthy legal process or a messy handing over of the entire business because a sole proprietorship usually dies with the owner, leaving a fresh start for anyone who wants to take over afterwards.
Limitations of a Sole Proprietorship
So with all of that being said, are there any disadvantages to owning a sole proprietorship? It could surely look like the one and only type of business structure that anyone could need, but there are a few kinks and quite a few risks to using this model.
We’ve actually touched on a few of them already because they’re somewhat a part of the advantages as well, kind of in the sense that anything worth doing is usually a bit risky as, but the big main risk here is still in the name.
1. In a sole proprietorship, you’re on your own
Sounds pretty self-explanatory, but it needs to be said. If something happens, if something goes wrong, you get sued, you go bankrupt, you can’t repay a loan – you’re on your own. You’re not eligible for any government protection and the banks definitely view you and your business as one entity.
In case something happens and you get sued. You now have the massive bill you have to pay and there’s no way that your business can cover it. Authorities may take charge and take possession for everything you own to make sure that you cover your bill, which means your house and your car or anything else that you own.
It could even go the other way around and a personal bill that you can’t pay winds up making you lose some of the assets in your business. It’s tough. It’s definitely a lack of security and that’s why some businesses choose to shift to a different structure to give them a barrier between their personal property and the company’s. That way if something happens on either side, you’re not going to end up losing everything.
2. Concerns for Customers and Investors In uncertain Situations
Earlier in this article, we’ve just talked about how easy it is to dissolve a sole proprietorship, especially when the owner dies, but what exactly happens when the owner dies and someone’s already placed an order with the company that they’re not going to get now? Will they get their money back? Who’s going to handle that? Is anybody even going to? What happens when the owner gets sick or maybe has to go on something like maternity leave? Does the business just stop until they get back?
It’s questions like that and the risks involved with starting any business that make investors and banks wary about investing in sole proprietorships. Yes, they have relatively fewer expenses to get them started, but they also have fewer opportunities to raise funds or to solve any cash flow problems. This could mean that your business ends up failing when all it needed was some extra time to get itself established and you end up losing out to a competitor working in the same market and providing a similar service.
Other business structures also have more than one leader, like when a company has a board of directors or other management positions in place. In some ways, owning your own company and doing exactly what you want with it is a huge plus, but it can also lead you to failure. If you’ve only got one voice, one set of eyes and one opinion trying to fix the problems you face on the road, you could end up tripping yourself up. That’s why it can be helpful to have a board, or people you trust to help guide you or offer solutions, and you just don’t get that when you’re on your own. This brings us to the second type of business structure.
2. Partnership
There is a way to have the advantages of a sole proprietorship and combat, not all, but some of the disadvantages of that particular business structure.
There’s something called a partnership, and again, it’s pretty self-explanatory. Maybe now that your business is growing, you decide to bring in new people and make them co-owners. Maybe you actually set out on this journey together and now you’ve got more than one voice and an extra pair of hands around in case something goes wrong. It’ll also mean that if you do end up with a lawsuit or a bill, or something that throws the whole operation, it won’t just be your business and your personal property that’ll be at risk.
This also makes you look a bit more appealing to other investors and the bank, but it’s important to remember that it would still be a pass-through profit structure. However you decide to split the profits between you, all of you will still be responsible for paying your own personal taxes and it’ll still be all of you that are held liable in the case of something happening.
So what type of business structures actually put that divide between the owner and the business? One of those would be a limited liability company and this one is appealing for a lot of business owners and for a couple of good reasons too.
3. Limited Liability Company (LLC)
With a limited liability company, the owner’s personal property is protected in the event of something going wrong with the business AND it’s still a pass-through company when it comes to profits. So already from the start, you’ve got the best of both worlds.
It is important to note that LLC legislation changes from state to state, so make sure to check with your local legislation before you take our word for it in this case, but in general, you’re able to separate the owner and the business from each other without losing the advantage of directly receiving your profits.
For this structure, the owners are called members and an LLC can have multiple members. These can even sometimes be other businesses and not just individuals and this is a lot more common than you may think. Alphabet, Google’s parent company, PepsiCo Inc. and Johnson & Johnson are all LLCs. Pretty much the only things that aren’t allowed to become members of LLCS are banks and insurance companies.
How Do LLC Business Structures Work?
An LLC will first have to establish itself as a business by picking a name and filing articles of organisation with the state. This is a must as an LLC can’t get started without a clear chain of command and a clear structure in place in the case of the death of one of the members, especially if they’re the main one running the LLC. After a bit more paperwork and paying the fee for registering an LLC, they can pretty much get started on building their business.
Benefits of LLC Business Structures
This structure addresses a lot of the main issues with a sole proprietorship. The member’s personal properties are protected, without losing the advantage of pass-through profits. There’s a clear structure in place in case of an unexpected death or the main operating member has to step away from the business and they’re more attractive to the more conventional means of raising funds. An LLC can even choose how they want to pay their taxes and could act more like a sole proprietorship or a corporation.
Most states don’t require LLCs to have annual member meetings, which is something that happens with corporations. They don’t have to have a board of directors, which again happens with corporations, and they aren’t limited in terms of how many shareholders they can have. Again, we’ll touch on a model where this is the case a little later on, but on the surface, it could look like an LLC is the perfect solution to anyone wanting to take their business to the next step and protect themselves.
Limitations of LLC Business Structures
It’s not always the case, but there have been times when an LLC has had no other choice but to dissolve after the death or the bankruptcy of a member. Because of all the paperwork it takes to get one off the ground as well, they have much higher expenses to get started than a sole proprietorship does and that’s not the only thing that’s more expensive either.
Because this is essentially a business with multiple shareholders receiving their share of a pass-through profit, the IRS keeps a close eye on them. The moment there’s any whiff of fraud or the LLC failing to meet the legal and reporting requirements, everyone is going to know about it. You could end up in trouble with the IRS or with your creditors who could then go after your members and derail your whole operation.
And there is definitely room for some genuine error and not just fraud. Chances are members are also paid employees of the company and that means that they both have a wage and a share of the profits. Their wages count as a business expense and therefore have an impact on the overall profits of the company and there’s plenty of room there to try to tweak the system to pay fewer taxes.
Every in and out is going to be highly scrutinized and that means that you have to have a really good accountant working for you to make sure that you don’t end up in hot water. That’s another expense that you don’t have in a sole proprietorship and that doesn’t include any ongoing fees that some states impose on LLCs, like annual reports and franchise tax fees.
So all in all, you have more opportunities for investments and growth with an LLC, but you definitely also have more expenses when it comes to keeping them running as well.
But what about a structure where a member’s wage and their share of the profit are held completely separate to each other? That would make your structure a corporation and if you’re involved with one of these, you’re a shareholder not a member.
4. C Corporation
A corporation has a lot more power than the other structures we’ve talked about today. They can own land and property, they can sue and be sued by other parties and the shareholders are more protected than ever. In the case that the corporation is sued or fails, the shareholder only stands to lose the amount of money they’ve invested in shares and nothing more.
A C Corporation is the most common type of corporation out there and the main difference between it and other corporations is that it has to deal with what we call double-tax. A shareholder is taxed for their wages and then they are taxed again when they receive their portion of the profit, but there’s a reason that a C corporation wants to keep things separate.
The idea is that most, if not all of the profits, can be pumped back into the business at a lower corporate tax rate to help it grow quickly and that’s why they want that very clear divide between wages and profits.
Benefits of a Corporation Business Structure
With this structure, shareholders are still protected like they are with an LLC. The corporation will definitely continue to exist in the event that the owners change or die and they can have as many shareholders and owners as they like. They’re able to quickly raise funds by selling shares and stock and usually find it very easy to raise more money through banks and loans. They also tend to have bigger, more established names, and that usually means that they attract the most talented and skilled people to work for them, making the voices you’ll have on your team the brightest and the smartest out there.
But, there are a lot of criteria a company needs to meet in order to keep itself a C corporation.
Limitations of Corporation Business Structure
Complicated Business Model: For starters, a C corp is one of the most complicated business structures to set up and you actually need a lawyer to do it for you. That’s already a bigger expense than one of the smaller options and things are only going to keep getting more expensive from there.
They face the same scrutiny as an LLC and they’ll also be subject to several fees from the states that they’re located in throughout the year, and then there’s the meetings. A C corp has to hold at least one shareholders meeting every year. These meetings have to be documented and have their minutes taken to create transparency on how the business operates and the shareholders decide who gets to run the business. Shareholders will vote on members of the company’s directors, meaning that management of the company can come to a screeching halt if no one can decide who’s going to lead them.
Taxes: And then there’s the taxes. We already talked about how a C corp experiences double-taxes, but there’s also more. Shareholders aren’t able to deduct business losses from their tax returns and, while sole proprietorships have been getting a tax reduction, corporations have been getting the exact opposite. As of 2022, the American Jobs Plan increased the tax rate for c corporations from 21% to 28%.
But for a corporation looking to get out of double-taxing, there’s always a S Corporation.
5. S Corporation
An S corp actually takes us back to pass-through profits and means that the individual members can go back to paying their own income taxes and deducting their business losses. In every other way, an S corp functions like a C corp, but aside from taxing, they have one major difference.
An S corp is limited to having 100 shareholders. That can sound like a lot at first, but if you think about it, a successful and rapidly growing business could quickly outgrow the resources 100 shareholders can provide. That makes an S corp more suitable for smaller, family-run businesses and could be the way to go when a sole proprietorship business owner wants to protect their personal property.
A lot of this business model comes down to shareholders and what they can do with and for the company. A shareholder has to be either a US citizen or resident and the company can only offer them one kind of stock. After that, what a shareholder stands to gain or lose by investing in the company depends on how big of a share they own and they can’t deduct losses bigger than the size of their investment.
Benefits of S Corporation Business Structure
An S corp will also have more flexibility in terms of shareholder wages, profit sharing and tax exemptions and they get to benefit from having that credibility with banks and other financiers. They face the same expenses as other corporations and you should expect to deal with the same fees and expenses as well.
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Limitations of S Corporation Business Structure
Profits at an S corp are always counted as if they are paid directly to the shareholders. They could be reinvested or maybe something went wrong and they weren’t paid out correctly or they’re going to be paid out later than expected, either way, the shareholder will be taxed as if they received their share of the profit on the date that they were supposed to receive them. This means that they could end up paying taxes on an income they never received and could potentially not ever receive.
The IRS will also be keeping a close eye on shareholder’s salaries and payrolls, so that’s another big investment in hiring an accountant. When it does happen that an S corp ends up in trouble, it’s possible that the IRS could shut them down, but they’re usually able to change the way their company operates to fit the criteria before that happens.
Conclusion
In conclusion, choosing the right business structure for your company is a critical decision that requires careful consideration of various factors, such as the size and nature of your business, tax implications, liability protection, management structure, and funding sources. Each structure has its own advantages and disadvantages, and what works for one business may not work for another. It is essential to seek professional advice and conduct thorough research before making a final decision. With the right business structure in place, you can minimize risks, maximize profits, and achieve your long-term goals.
