How To Choose the Best Business Entity for Your Startup

CIO Applications | Friday, March 11, 2022

One of the first steps in successfully running a business is selecting how the business will be legally structured. United States law and tax code offer multiple structures, and each offers different legal, tax and fundraising features. You’ll be one step closer to success after you evaluate which of these options is most suited for your business’s current stage.

How To Choose the Right Structure for You

Choosing a business is ultimately a situationally specific decision. While general guidance is helpful, you ultimately must evaluate the structures in light of your business’s situation. Legal protections, taxation benefits and fundraising allowances should all play into your calculation, as should any local, state or federal laws that are applicable.

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Take solace knowing that your decision isn’t immutable. You can change your business’s structure as it grows and morphs, adapting the legal structure to new needs. Many businesses maintain the same structure throughout their course, but many others have changed.

For example, a doctor’s office that has only one location might remain a limited liability corporation indefinitely. A retailer who grows from a single location into a regionally known company could transition from a sole proprietorship to a corporation as necessary.

Help is also available if you need assistance in making your decision. CPAs can explain taxation and fundraising differences between these various business structures. Attorneys can illuminate the different legal protections and fundraising possibilities, as well as detail any particularly applicable laws.

The main business structures are:

  • Sole Proprietorship
  • Limited Liability Partnership
  • Limited Liability Corporation
  • Corporation (S Corp, C Corp)

Sole Proprietorship

Sole proprietorship is the most basic legal structure, and this is what your business will operate as by default if you don’t file under another structure. Just because the structure is basic doesn’t mean it’s not worth considering, though. Under a sole proprietorship, the lines between business and personal are blurred.

Legal

The owner receives no legal protections against business debts or risks, and can be personally sued if the business is found liable for harm. While this makes sole proprietorship unsuitable for professionals who have high risk exposure, those with low risk exposure might accept the personal liability. Before accepting liability, however, consider the potential cost of a liability injury claim. Lawsuits can be expensive regardless of their outcome.

Taxation/Fundraising

Business finances are also largely treated as akin to personal finances. The structure allows for legitimate business expenses to be deducted when filing taxes, and a separate tax form must be filed. Any income from the business is taxed at personal income tax rates, and all other business financial matters are intermingled with the owner’s personal finances. Any loans that are sought will depend on the owner’s personal credit and be guaranteed by them, and the only other way to raise capital is by personally investing or bringing partners on board.

Although business and personal finances are blurred with this business structure, business owners should keep their business and personal finances separate. In the event of an audit, proving what income and expenses are for the business is much easier if the funds are in different accounts.

Filing

Should you choose this business structure, check whether your local municipality or county requires any registration. Some areas want even simple businesses to register or file. The requirements are usually no more than a simple form (e.g. 1-2 pages) and perhaps a nominal payment (e.g. $10 - $30).

Pros of Sole Proprietorship

  • Simplest business structure to set up and maintain
  • Low initial filing fees and easy year-end tax forms
  • Business expenses can be deducted from revenues
  • Dissolve business any time with no formal paperwork

Cons of Sole Proprietorship

  • No personal legal protection against business debts or lawsuits
  • No taxation benefits for income from the business
  • Capital raisin is dependent largely upon personal finances and credit

The sole proprietorship is one of the most commonly used legal structures for small businesses.

Limited Liability Partnership

Limited liability partnership (LLP) is a common legal structure for businesses that have multiple owners or investors. The structure can function much like a limited liability corporation.

LLPs distinguish between operating and non-operating partners, and they provide legal and tax benefits that sole proprietorships don’t. These benefits are in contrast to general partnerships, in which partners share equally in all aspects of the business and other benefits may be different.

Legal

The LLP structure provides a “corporate veil” that grants owners personal legal protection against business debts and lawsuits. Owners won’t be personally liable for these costs, unless they act in an illegal, irresponsible or unethical manner.

Taxation

Revenues from an LLP may be taxed like a sole proprietorship (see above) or limited liability corporation (see below), depending on the partnership’s documentation. Both the business and owners must file additional tax forms each year, but these are relatively simple.

Fundraising

LLPs' capital raise options are the same as those of LLCs (see below).

Filing

Creating an LLP requires filing documents with the state and paying a registration fee ($40 - $500 in most states). Some states have annual filing and fee requirements.

Pros of Limited Liability Partnership

  • Corporate veil provides business owners with legal protection
  • Business finances are kept separate from personal finances
  • Tax setup can give business owners some profits as non-earned income
  • Non-complex business structure to set up and maintain

Cons of Limited Liability Partnership

  • Most lenders require personal guarantees for loans
  • Dissolving the business requires documentation and agreement
  • High registration and annual fees in some states

The limited liability partnership is one of the most common legal structures for small businesses that have multiple owners.

Limited Liability Company

Limited liability company (LLC) is a common legal structure for small businesses, although not quite as widely used as sole proprietorships. Business owners that choose this structure usually do so for the LLC’s legal and/or tax benefits.

Legal

The LLC structure provides a corporate veil that provides personal legal protection against business liabilities in most cases. This is identical to the LLP’s veil and benefits.

Taxation

Business owners can choose either of two taxation options with an LLC. Profits can be reported and taxed as personal income in the same way that sole proprietorships are (see above). Alternatively, business owners can pay themselves a “reasonable salary” and disburse any additional profits as investment income. The salary is taxed at standard personal income tax rates and subject to FICA, but the investment income can be taxed at lower capital gains rates.

Fundraising

LLCs technically can secure business loans that carry no personal risk because the structure provides a corporate veil against business debts. Many lenders will only underwrite loans that have a personal guarantee by one or more owners, though. When signing a personal guarantee, owners consent to personally back the loan if there’s a default.

Filing

Creating an LLC requires filing documents with the state and paying a registration fee ($40 - $500 in most states), you can do this yourself with the help of a lawyer or or you can use an online service to register your LLC. Some states have annual filing and fee requirements. Requirements are similar to those of LLPs, although the exact forms and fees can differ slightly.

Pros of Limited Liability Company

  • Corporate veil provides business owners with legal protection
  • Business finances are kept separate from personal finances
  • Tax setup can give business owners some profits as non-earned income
  • Non-complex business structure to set up and maintain

Cons of Limited Liability Company

  • Most lenders require personal guarantees for loans
  • Dissolving the business requires documentation
  • High registration and annual fees in some states

The limited liability corporation is the second-most common business structure for small businesses that have only one owner.

S/C Corporation

S/C corporations afford medium and larger companies opportunities that other legal structures don’t provide. These advantages usually are only helpful to larger businesses or those looking to grow.

S corps primarily provide tax benefits, while C corps transition ownership to shareholders. B corps (less common) are for-profit businesses that seek to positively impact the world.

Legal

Both S corps and C corps provide business owners with a corporate veil, shielding them from business risks like LLCs and LLPs do. Owners who have leadership roles may be responsible for certain errant decisions, but directors and officers (D&O) insurance can help protect against this risk.

Taxation

S corps are taxed the same way as LLCs that pay a salary (see above), as the second LLC option is actually based on the S corp tax structure.

C corporations are taxed as distinct entities, and their taxation is more complicated because the shareholders own the corporation. These businesses generally pay payroll tax and corporate tax, while owners and investors pay capital gains taxes.

Fundraising

Both S corps and C corps can issue stock. S corps may privately issue common stock, which means everyone gets the same type of shares at the same price. C corps can issue different classes of stock at different prices, and they may do so privately or publicly.

Corporations also can qualify for business loans, perhaps with or without a personal guarantee.

Filing

The filing and ongoing documentation for S and C corps is more complex than that of other business structures. The associated fees are also higher (sometimes much higher).

Pros of S/C Corporations

  • Corporate veil provides business owners with legal protection
  • Tax setup can give business owners some profits as non-earned income
  • Businesses can raise capital by issuing stock

Cons of S/C Corporations

  • Extensive filing, ongoing and dissolving documentation
  • Highest filing and annual fees
  • Most complex business structure to maintain
  • Professionals usually must be hired to manage the business structure

The S/C corporation is used by large and growing businesses. Some businesses start with this structure, but others transition to it as they expand.

Set Up Your Business With the Right structure

Only you can ultimately decide which of these structures is right for your business’s legal risks, taxation considerations and capital raising goals. Select the one you deem most suitable, and you’ll be legally set up for success.

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