If you are in the process of starting a new business, there will inevitably be several important decisions you are going to have to make. Obviously, things such as the specific industry you hope to enter into, your target market, and even the name of your business will all have a major impact on how your business performs over time. But one dimension that many new entrepreneurs frequently overlook is the specific type of structure their business will use.
The type of business structure you end up selecting will affect your business in multiple ways. Taxes, liabilities, ownership, and right to various revenue streams will all be dependent on the structure you choose. This article will briefly examine five of the most common structures for new business and how to choose the type of business structure that is best for you.
Sole proprietorships are the easiest type of business to create and, naturally, they are also overwhelmingly the most common type of business in existence. In fact, according to the Tax Foundation, there are currently an estimated 23 million sole proprietorships currently operating in the United States.
What makes sole proprietorships different than other businesses is that there is fundamentally no distinction between the owner and the business itself. Though with a sole proprietorship, you will be able to enjoy the benefit of all profits, you will also be held liable for paying all expenses and assuming all liabilities. The profits made by sole proprietors are usually taxed as ordinary income by the Federal Government and whatever state they are operating out of. Additionally, though a sole proprietorship typically does not need to be formally declared, you will still need to apply for whatever permits are relevant to your industry.
Like sole proprietorships, partnerships are relatively easy to start and often make sense for businesses that begin their operations on a smaller scale. But, as the name might imply, a partnership is a business that is owned by two or more individuals.
In a partnership, every partner is expected to contribute something—whether that is labor, capital, or anything else—and, in exchange, they will be entitled to a share of any profit that the business ends up making. Similarly, each partner will be responsible for a share of the losses. The level of responsibility (and entitlement to profits) that each member in the partnership will have is typically determined by a pre-established partnership agreement. Though this agreement is something that could be modified over time, it is generally a good idea to clearly establish the nature of the organization in order to avoid future sources of conflict.
Limited Liability Company (LLC)
Though starting a sole proprietorship or a partnership can often be an exciting—and profitable—adventure, you may be looking for ways to effectively decrease your exposure to risk. A limited liability company (LLC) is an entity created separately from the owners, who are typically referred to as partners, in order to minimize the liabilities they will endure in the instance that the business goes under or into debt.
LLCs can be owned by an individual, multiple people, or even other LLCs. In order to minimize your exposure to risk, creating an LLC may be a good idea even if your business plans to remain relatively small. Unlike corporations, LLCs are not subject to an additional round of taxation. Additionally, these sorts of businesses are widely preferred because of their tremendous amount of flexibility.
Cooperatives are not as common as the other business structures mentioned in this list, but they do offer a number of benefits that many people find appealing. Essentially, a cooperative is a business that is owned by the users of the business themselves. For example, in order to save on the cost of food, one of the most common forms of cooperatives might be a “food court” styled business to which members pay a monthly fee.
Other common business types that could benefit from using a cooperative structure include retail services, agriculture communities, and various service exchanged. Individuals enjoy cooperatives because they are often run in a democratic style (with members electing the board of directors) and have a large incentive to listen to customer concerns.
Corporations are often the best structure for businesses that seek to be owned by multiple different entities and are operating on a relatively large scale. In general, a corporation can be summarized as an organization that is legally independent from its owners (also known as shareholders).
Shareholders of a corporation have the right to claim whatever equity the corporation may possess. Additionally, they may be entitled to periodic dividends. If a corporation becomes large enough, it may want to consider issuing an IPO (initial public offer) and becoming publicly traded on a stock exchange. Corporations are subject to more taxes, regulations, and reporting standards than any other business in this list. However, contrary to popular belief, not all corporations are massive organizations. Many relatively small businesses still decide to incorporate simply for the sake of minimizing long-term liabilities.
Choosing the Business Structure that is best for your Business
The type of business structure that is best for your business will depend on a variety of different factors.
- Long-term goals, targeted size, general financial objectives
- Targeted number of employees and owners
- Willingness of founder(s) to accept risk
- Ideal distribution of profits
- Relative state and federal taxes
- Relative state and federal regulations
- Need to raise outside equity
Other relevant factors to consider are the amount of experience you have running a business and if the mission of your business could be better achieved with the help of other people. Additionally, it is important to note that—even if you commit to a specific business structure for the coming year—your business could potentially change its structuring over time. Starting as a sole proprietor and then evolving into a partnership, followed by an LLC, followed by a corporation is not an uncommon sequence for ambitious entrepreneurs. Regardless of how you choose to begin, it is important to understand the benefits and risks that are associated with each type of business.