Choosing a Business Structure
There are a number of business structures out there that can easily overwhelm first-time founders and even investors navigating the world of business. Business structures impact taxes, the ability to raise money, what paperwork needs to be filed, and personal liability. Understanding the various structures available can provide insight into the balance of legal protections and benefits each one brings.
Business Structures 101
Sole Proprietorship
Sole proprietorships give one individual complete control of a business without producing a separate business entity. This means the business assets and liabilities are not separate from the individual’s personal assets and liabilities. Thus, the individual can be held personally liable for the debts and obligations of the business. As sole proprietorships cannot sell stock, it can be hard to raise money for this type of business.
Sole proprietorships are a good choice for low-risk businesses and for proving business ideas before transitioning to a more formal corporate structure.
Partnership
Partnerships are the simplest structure for two or more people to own a business together. The two most common types of partnerships are limited partnerships (LPs) and limited liability partnerships (LLPs).
LPs have one general partner with unlimited liability for financial responsibilities like taxes and debts. All other partners have limited liability, so their personal assets aren’t at risk even if the company fails. Partners with limited liability also have limited control of the company. Profits are passed through to personal tax returns, and the general partner must also pay self-employment taxes.
LLPs are similar to LPs, but they give limited liability to every owner. An LLP protects each partner from personal responsibility for anything beyond what they put into the company. They won’t be responsible for the actions of other partners.
Partnerships are good choices for businesses with multiple owners, professional groups (like attorneys), and people who want to test their business idea before transitioning to a different structure.
Limited Liability Companies (LLC)
LLCs take advantage of the benefits of both corporation and partnership corporate structures.
In most cases, LLCs protect individuals from personal liability if the LLC faces bankruptcy or lawsuits. Profits and losses are passed through an individual’s personal income without facing corporate taxes. As a result, members of an LLC are considered self-employed and must pay self-employment tax contributions toward Medicare and Social Security.
LLCs can have a limited life in many states. When a member joins or leaves an LLC, some states may require the LLC to be dissolved and reformed unless there’s an agreement in place to transfer ownership.
LLCs are good choices for owners with significant personal assets that they want to protect and owners who want to pay a lower tax rate than they would with a corporation.
Corporation
Corporations are entities that are considered completely distinct from the people who run them. Legally, corporations share many of the same functions as an individual person, including making a profit, being taxed, and being held legally liable.
The cost associated with forming a corporation is higher than other structures. Corporations also require more in-depth record-keeping, operational processes, and reporting.
Corporations have an easier time raising capital because they can usually raise funds through the sale of stocks. For example, companies like Google and Meta have raised capital privately and publicly by selling equity.
There are a variety of different corporation types, so we’ll go through each.
C corp: C corporations, or C corps are the most common corporation type for startups and other businesses, as they offer owners the strongest protection against personal liability.
C corporations must have a board of directors, who are selected through voting, and hold at least one annual meeting for shareholders and directors.
C corps are subject to corporate income taxes, and shareholders must also pay personal income taxes on dividends — a situation referred to as “double taxation.”
S corp: S corps are designed to avoid the double taxation drawback of regular C corps. S corps allow profits — and some losses — to be passed through directly to owners’ personal income without being subject to corporate tax rates.
Not all states tax S corps in the same way. Some states tax S corps on profits above a specified limit, and others don’t recognize S corps at all and treat them as C corps. In order to receive S corp status, S corps must file with the IRS instead of registering with the state.
There are, however, special limits to S corps. S corps cannot have more than 100 shareholders, all shareholders must be US citizens, and S corps must follow the strict filing and operational processes required of C corps. Like C corps, S corps are separate from shareholders.
B Corp: Benefit corporations, or B corps, are for-profit corporations that are taxed as a C corp or S corp. B corporations differ in that they are certified to have proven positive social or environmental impacts. B corps are driven by both a mission and profits, so shareholders hold the company accountable to produce a public benefit in addition to financial profit. B corps need to be publically transparent about performance.
Close Corporation: Close corporations have a less traditional corporate structure. Shares of close corporations are normally barred from being publicly traded. As such, close corporations tend to be run by a small group of shareholders, often the business owners, without a board of directors. With fewer shareholders, close corporations are under less shareholder pressure and thus can be more flexible. Without being publicly traded, though, the company can face challenges when it comes to raising capital.
Nonprofit Corporation: Nonprofit corporations are organized to do charity, educational, religious, literary, or scientific work. Because the work of nonprofits benefits the public, nonprofits can receive tax-exempt status from the IRS, meaning they don’t pay state or federal income taxes on any profits they make. Nonprofits must also report what they do with the profits they earn. For example, nonprofits cannot distribute the profits they earn to members or to political campaigns. Nonprofits and C corps follow similar organizational rules.
Cooperative
Cooperatives are businesses or organizations owned by and operated for those using its services. Earnings generated by a cooperative are distributed amongst its members. An elected board of directors and officers typically runs the cooperative, while regular members have voting power to control the cooperative’s direction. Members can join a cooperative by purchasing shares, though the amount of shares held may not reflect the weight of their vote.
Startup Investing and Business Structures
Hopefully, you have a better understanding of the different business structures now. The most common ones you’ll see in the startup ecosystem are C corps and, to a lesser extent, B corps.
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This article was updated on January 4, 2023.
