Marketing insights to grow your business

Activate Conference, June 24-26, 2018

Activate Conference, June 24-26, 2018

Get your ticket

How to Choose a Business Structure for Your Small Business

small business structure

What’s the difference between “Small Business Inc.” and “Small Business LLC?”

If you operate a small business, you’ve at some point wondered how to register your business, if you need to, and what business structure you could choose.

As you ask how to structure a small business, it can be a bit tricky to choose which business structure makes the most sense. Are you a corporation? An “S Corp?” What’s the difference between a partnership and an LLC?

The decision of how to structure a small business only needs to be made once, but you do have to make it—and what you choose matters. Tax and legal situations change based on your business structure, so it’s important to make sure you understand the implications before you fill out the paperwork.

Although there are several different types of business structure (and types within those types), there are basic five business structures that are the most common.

Sole proprietorship

A sole proprietorship is the simplest form of business structure.

In a sole proprietorship, one person owns a business—and is responsible for everything that entails. A sole proprietor’s personal and business finances are not considered separate, meaning that all of the business’ profits and losses will appear on the proprietor’s taxes.

A sole proprietorship is not required to register with a state, which makes it very easy to begin operating. This ease of start-up is the major benefit of a sole proprietorship, but the lack of separation between personal and business activities can cause some challenges.

A sole proprietor is personally responsible for any losses and business bankruptcy, as well as any legal cases against a business. If a sole proprietor’s business goes bankrupt or becomes involved in legal activities, the proprietor can be held liable.

In taxes for a sole proprietor, revenue from the business is treated as income tax. The sole proprietor is required to pay self employment tax (Social Security and Medicare) on business revenue.

Partnership

Partnerships are similar to sole proprietorships in that the business partners are personally liable for the business’ profits and losses.

In a partnership, multiple partners enter into a business agreement together. Like a sole proprietorship, the profits and losses of the business are taxed as individual income.

The laws around forming partnerships differ from state to state—you’ll need to check on the requirements of your state to see if you would like to register your partnership.

A partnership offers some flexibility in business structure, which causes many small businesses to operate as partnerships.

In a partnership, there can be multiple different types of partners:

  • Partners can be junior or senior, with the respective benefits and responsibilities
  • A partner can manage day-to-day operations of a business, or they can simply be invested in the business
  • Partners can be paid a salary or compensated through equity in the company

There are also a few different ways to structure a partnership. A limited partnership, for example, allows some partners to hold partner status without being liable for the business.

Corporation

A corporation is different from a sole proprietorship or partnership because of a key characteristic—corporations are legally separate from their owners.

In a corporation, some number of shareholders own pieces of the business. Number of shareholders can vary wildly, from just a few primary owners to the thousands of shareholders in publicly traded companies.

Most corporations are considered closely held, meaning that they have a relatively small number of shareholders.

A corporation differs significantly from other business structures in day-to-day operation. In a corporation a board of directors guides the overall direction of the business. Below that, executives manage the day-to-day operation of the business.

The process of setting up a corporation (called “incorporating”) is relatively complicated, requiring a large amount of paperwork that will differ from state to state. However, that process comes with the benefit of separating your finances from your business’ finances.

When filing taxes, a business owner and a business will file separately. This protects personal finances from business losses or bankruptcy. It can also provide some protection for individuals in legal cases.

This means that corporate profits are taxed twice: once as profit through corporate taxes and once as dividends in individual taxes.

S corporation

An S Corporation is a specific type of corporation with some significant tax differences from a normal corporation (also called a C Corporation).

An S Corporation has two defining characteristics that separate it from a C Corporation:

  • An S Corporation has fewer than 100 shareholders
  • An S Corporation does not pay corporate tax rates

In an S Corporation, profits and losses are taxed at individual tax rates. That means they appear in an individual shareholder’s taxes, which can have implications for allocating profits and losses.

Despite this, an S Corporation provides some liability protection to shareholders—a shareholder’s assets cannot be seized to fulfill debts incurred by a business.

Incorporating as an S Corp also means that profits aren’t subject to double taxation in the same way as they are in a C Corporation.

Limited liability company (LLC)

A Limited Liability Company (LLC) is a relatively recent type of business entity. It combines some characteristics of corporations and partnerships to offer business owners a degree of flexibility afforded by neither.

An LLC needs to be registered in the state where it does business, but in most cases it is relatively simple to create an LLC. This, combined with its flexible protection, makes it a popular option for small businesses.

In an LLC, the owners of the business are able to make major business decisions without answering to a board of directors, as is true of a partnership. At the same time, an LLC affords a degree of protection for its owners, as in a corporation.

In an LLC, the owners’ individual assets are somewhat separated from the businesses—which protects owners from losses.

When filing taxes, there is no separate “LLC tax form.” Instead, the number of members of an LLC determines whether the business is taxed as a sole proprietorship or a corporation.

The flexibility of an LLC—and protection of personal assets—makes LLCs a popular choice for small business owners. When you research how to structure a small business, an LLC will often come up as a recommended option.

At the same time, an LLC must be dissolved if its owners die or declare bankruptcy—if a company is destined to go public or survive the death of its owners, an LLC may not be the best option.

A trial is worth a thousand words.
Get started today, no credit card required.