In many ways, the earliest stages of a new business are the most important. The decisions you make today can set your new venture on the path to success.

One of the first choices you’ll need to make is which business structure to use for your new organization.

  • Sole proprietorship
  • Partnership
  • Limited Liability Company (LLC)
  • S Corporation
  • Corporation

Each option has its own set of pros and cons. Let’s walk through them.

What is a business structure?

A business structure defines how your business is legally organized and operated, as well as its ownership, liability, governance (how it’s run), and taxation. 

Will the business be owned by one person, or will it be a partnership? Will the owner(s) pay taxes on the company’s profits, or will the company have to pay its own taxes?

The answers to these questions and more are determined by the business structure you pick.

Why does your business structure matter?

Most of the reasons why business structures matter come down to legal factors and tax implications.

  1. Some business structures are only available to individual owners, not partners
  2. Some structures make it easier to sell shares, offering more ways to get outside funding
  3. Some offer you more personal protection for the company’s debts or potential mistakes
  4. Some are taxed as businesses, while others pass the income to their owners, who are taxed personally  

Seeking advice from an expert can help you choose the right structure based on your personal situation and business objectives. This post walks you through the essentials, so when you do talk to a professional, you’ll be more prepared — and you’ll know what questions to ask.

Can you change business structures later?

Yes, but some changes are easier than others. It’s relatively easy to go from a less complicated structure to a more complicated structure. It’s harder to go backward. 

Many people start a business as a sole proprietorship or LLC and later incorporate, but changing from a corporation to a simpler structure is much more complicated, especially if you’ve sold shares of stock.

The common types of business structures

There are several business structures available in the US. Here’s a simple guide to help you understand the differences between them.

Sole proprietorships

Ownership: One owner

Sell shares: No

Personal protection: No

Taxation: You’re taxed personally; the company does not pay its own taxes

A sole proprietorship is an unincorporated business that you own and run by yourself.

That word “unincorporated” is important. Since the business is unincorporated, it’s not a separate legal entity from you. If someone sues the business, they’re suing you. And you’ll be personally responsible for the business’s debts too.

This is one of the simplest business “structures” because in many ways, it isn’t a business structure at all. It’s just you, doing business under a business name.

Pros:

Easy. A simple option with minimal formalities. 

If you’re going to run the business by yourself and you aren’t concerned about debt or liability, this could be a good way to get started.

Cons:

Provides no personal protection. You’ll be personally liable for business debts as well as any actions your business takes. Not recommended for high-liability industries.

You can’t sell shares to raise money, and banks are often reluctant to lend money to sole prorprietorships.

Partnerships

Ownership: Two or more owners

Sell shares: No

Personal protection: Yes, although it varies between LPs and LLPs

Taxation: Partners are taxed personally; the company does not pay its own taxes

Partnerships let two or more people own a business together. There are two common kinds: limited partnerships (LP) and limited liability partnerships (LLP).

In limited partnerships, one “general partner” has unlimited liability while all the other partners enjoy limited liability, but they also have limited control of the company. These limits are usually laid out in a partnership agreement. 

In limited liability partnerships, all partners are treated equally, with limited liability.

In both cases, profits are passed through to personal tax returns, meaning the partnership itself does not pay taxes. Instead, the taxes are paid by the partners as part of their personal taxes. In limited partnerships, the general partner also has to pay self-employment tax.

Pros:

Partnerships allow you to own a business together. They’re popular among groups of professionals like lawyers, accountants, or consultants who want to pool their resources, sharing the risks and responsibilities of owning a business. 

Cons:

May be limited to certain types of professionals, depending on your state. May be required to file annual reports. Often have more formal obligations for filings and paperwork than LLCs.

Limited liability company (LLC) 

Ownership: One or more members

Sell shares: No

Personal protection: Yes, your personal assets are generally protected from business debts and legal liabilities

Taxation: LLC members are taxed personally; the company does not pay its own taxes

A limited liability company (LLC) can be owned by one person (a sole-member LLC) or by two or more people together (a partnership LLC). It provides protection for your personal assets against business lawsuits and creditors.

Like sole proprietorships and partnerships, LLCs don’t pay taxes as corporate entities. Their profits pass through to the individual members, who pay taxes as part of their personal income taxes. That’s why sole proprietorships, partnerships, and LLCs are sometimes called “pass-through entities.” 

Pros:

LLCs offer significant benefits for those who want to enjoy pass-through tax advantages and protection from personal liabilities without the full regulatory burden of corporations. They’re a popular choice among entrepreneurs, freelancers, small business owners, and real estate investors. 

Cons:

One of the biggest trade-offs of choosing an LLC is that you generally can’t sell shares. If you want to raise funds through equity financing or pursuing an IPO, the LLC structure usually won’t let you do that.

LLC rules, like other business entity rules, also vary by state. Depending on where you live, LLCs may only be allowed for more than one member, may have a limited lifespan, or may be required to dissolve and reform if there’s a change in ownership. 

S Corporation

Ownership: 1-100 shareholders

Sell shares: Yes

Personal protection: Yes, your personal assets are generally protected from business debts and legal liabilities

Taxation: Shareholders are taxed personally; the company does not pay its own taxes

An S Corporation (S Corp) allows for shareholders while still passing income, losses, deductions, and credits through to those shareholders for federal tax purposes. This helps the shareholders avoid double taxation in the same way an LLC does. 

This structure is a good option for small to medium-sized businesses looking to limit their liability and benefit from pass-through taxation while still allowing for the possibility of shareholders. To qualify, a business must have a limited number of shareholders, all of whom must be U.S. citizens or residents.

Pros:

S corporations offer liability protection as well as the tax advantages of a pass-through entity, while also allowing for shares that can be transferred. The S corp structure may also enhance credibility with customers and investors due to its formalized structure.

Cons: 

On the downside, S corps face limitations on the number and type of shareholders, which can restrict fundraising efforts and the potential for growth. There are also stricter operational processes and compliance requirements, such as holding regular meetings and maintaining detailed records. 

Corporation

Ownership: Ownership in a corporation is divided into shares held by shareholders

Sell shares: Yes

Personal protection: Provides the strongest shield in protecting personal assets from business liabilities

Taxation: Taxed as separate entities, paying corporate income tax

A corporation is a legal entity that exists independently of its owners. It provides the strongest liability protection for its shareholders, meaning their personal assets are typically protected from the corporation’s debts and liabilities. However, corporations are taxed separately from their owners, leading to the potential for double taxation on income—the corporation pays income tax, and shareholders may also pay personal income tax on their net gains.

This business structure is suitable for larger businesses or those seeking to raise funds through the sale of stock, as it allows for an unlimited number of shareholders and greater access to investment capital.

Pros:

This structure offers the strongerst liability protection to shareholders, which can encourage investment and limit personal financial risk. Corporations can also raise capital more easily through the sale of stock, they may benefit from a wider range of tax deductions and incentives, and they have perpetual existence, meaning they can continue operating independently of changes in ownership or management.

Cons: 

Small businesses or individual entrepreneurs might face challenges due to complicated regulations, high administrative costs, and the risk of double taxation on earnings when choosing this business structure.

How to pick a business structure for your business

Following these steps can help you navigate the issues and choose the best fit for your business.

Step 1 – Review your needs

Decide how many owners your business will have, whether you want to sell shares, how much you care about personal protection against business debts & liabilities, and how much formality you’re prepared to manage (including the possibility of corporate taxes.)

Step 2 – Weigh each structure against those needs

With those factors in mind, consider the legal and tax implications of each structure. As a business owner, you’ll need to weigh the liability protection of each entity, the administrative requirements that will have to be met, and the potential tax advantages.

Step 3 – Seek professional advice

Consult with a lawyer and/or tax advisor, especially regarding the specific rules for each structure in your state. Make sure you understand the local nuances of each business structure before you make a final decision. 

Step 4 – Revisit your options as your business grows

Regularly review and reevaluate your business structure as your company grows and evolves. You’ll want to make sure your business structure still meets your objectives and that you stay compliant with regulatory agencies and tax authorities.