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Understanding how different business structures work and how they impact the growth of a business tends to be challenging since every business is different. This fact can make it hard to choose a legal business structure for your new venture.
If you’re starting a business, it’s imperative to understand the various options in front of you and choose the right one from the get-go.
In this article, we’ll observe the main factors that influence how you choose your business structure, while also looking at the pros and cons of each option. This way, you can make an informed decision for your new business.
What Is a Legal Structure for Your Business?
A registered business entity, or a business legal structure, is known as a government classification, which controls certain aspects of a business. It’s essentially the type of business you run in the eyes of the government. These types include LLCs (Limited Liability Companies), Partnerships, S-Corporations, and Sole Proprietorships, to name a few.
Your legal business structure influences your tax burden on a federal and state level. It also regulates how much liability a business faces in case of a lawsuit.
Moreover, your business structure determines if you need a board of directors and how often you should file paperwork. Depending on what structure you choose to register your business as, it either ensures that there’s no barrier between your business and personal taxes, or that there’s a strong one.
Factors to Consider When You Choose a Business Structure
It can be hard for new entrepreneurs to choose a business structure. When trying to choose one, think about your financial needs, the ability of your business to grow, and the potential risks that might come with it.
A business structure is not set in stone. You can always change it later. However, switching the legal business structure once you have registered your business is a complex process. Therefore, it’s recommended to thoroughly analyze your options before picking one.
Here are the factors you need to keep in mind when you choose a legal business structure.
1. Flexibility of Your Business Plan
Return to your business plan and review all of your goals to see which business structure will be more suitable for you. The ideal business structure will align with all of your objectives. The business entity you pick should allow plenty of room for growth.
In this case, an LLC offers the most flexibility when it comes to high growth potential. Plus, there’s lower risk and limited liability.
2. Operational Complexity
Each type of legal business structure comes with its own costs and setup procedures, which also include complexities. Therefore, it’s recommended that new entrepreneurs pick a business entity that can easily be set up, comes with minimum legal formalities, and doesn’t cost a fortune.
In this case, a sole proprietorship tends to be more straightforward as compared to other structures. However, it might be a bit hard to finance your business with external funding.
3. The Level of Liability
When you choose a business structure, think about the extent you want your liabilities and assets to be protected. Certain structures offer limited liability protection that keeps the business owners’ assets safe in case the business goes through a loss or bankruptcy.
Alternatively, unlimited liability businesses offer full responsibility to the owner when it comes to legal issues or debts. New entrepreneurs need to take this critical factor into account as it’s going to affect their involvement in potential liability.
In this case, a corporation comes with the least personal liability due to being its own entity, while an LLC comes with the same protection but offers tax benefits similar to a sole proprietorship. In a partnership, the liabilities are shared between the different partners based on their agreement.
Your chosen business structure will also determine your tax obligations. This is because each entity is treated differently when it comes to taxation. Generally, sole proprietors get taxed on a personal level since the business and the owner is seen as one legal entity.
In the case of other entities like a corporation or an LLC, business owners are required to pay personal tax, corporate tax, or other specialty taxes that are charged by the government.
According to experts, you should avoid double taxation during the early stages of your business. An LLC structure can help with that by ensuring that you only get taxed as an individual and not as a company. Also, it helps to use a payroll service to help clarify taxation issues and payroll complexities.
5. Responsibility and Control
Make sure you choose a business structure where you can handle a certain level of responsibility and control. For instance, when you’re the sole owner of a company, you have much more control as compared to being in a partnership or as a shareholder.
On the other hand, the more control you have, the more responsibilities you will have to take care of. In other business structures, such as a partnership, both the control and the responsibilities are divided between two or multiple people.
If you are willing to take on full responsibilities in addition to full control, then an LLC or a sole proprietorship business structure is the ideal choice. In the case of a corporation, there is a board of directors responsible for making important business-related decisions.
Initially, a single person can handle a corporation, but as the business grows, the need for more people to take on certain responsibilities will grow as well.
6. Capital Investment
As a new business owner, you might need external funding of some sort to meet the costs of starting a business. In this case, corporations are more than likely to receive outside funding as compared to other business structures, like a sole proprietorship.
A corporation can also sell its shares of stock in order to obtain extra funding for growth, but a sole proprietor can only get funds through personal credit, personal bank accounts, or by getting a partner. An LLC business goes through similar struggles, but the business owner does not necessarily have to use their personal assets or credit.
7. Business Permits and Licenses
You will require certain permits and licenses to operate once you register your business. Based on how you choose a business structure, you might need licenses on federal and state levels, in addition to the local level.
Each state has its own legal requirements for starting a business, and this includes business licenses. Most of the time, businesses aren’t aware of the licenses that are applicable to them. Take into account your business industry and the state you chose to launch your business in.
Types of Business Structure
Here’s a list of all the types of business structures with their pros and cons. This will help you choose a business structure that’s ideal for you.
1. Sole Proprietorship
This is the most straightforward and simplest business structure. In a sole proprietorship, the owner has full rights to their business, including all responsibilities.
- Offers complete control
- Does not have a lot of administrative work
- Offers low cost
- Offers tax deduction
- Comes with increased liability risks
- Hard to get outside funding
This is an unincorporated business that’s owned by two or more owners. A partnership consists of people or other businesses. All profits get divided among the different owners while getting reported on each of their tax returns.
- Comes with easy tax treatment
- Offers capital in the early stage
- Offers ease of operation
- There’s more expertise and knowledge
- More attorney costs
- Arguments among partners
- Liabilities of different partners
3. Limited Liability Company (LLC)
This is a hybrid business structure. Similar to a corporation, the owners’ or members’ personal liability is limited, but the profits can be taxed on a corporate level or a member level.
Here’s how to start an LLC.
- Comes with limited personal liability
- Has a favorable tax regime
- Offers improved credibility
- Increased paperwork and maintenance
- Offers limited options for investment
- There are costs for renewal
This is a legal business structure that’s fully independent and it’s separated from the owners. There are several types of corporations in the US, where C-corps and S-corps are the most popular ones. Other corporation types include B-corps, nonprofit corporations, and close corporations.
- Offers limited liability
- There’s business continuity
- Comes with secured business finance
- It can be costly to set up
- Risk of double taxation
- Comes with numerous obligations
Essentially, this is an employee-owned business, where each member has equal rights. It doesn’t matter how many shares each member owns, earnings and profits are equally divided among everyone.
- Employees are more invested
- There’s reduced liability
- More funding opportunities
- Comes with a lower overhead
- More tax advantages
- Not a profitable option for founders
- There are certain funding challenges
- Comes with legal restrictions
What Business Structure Is Best for Me?
So, what do you do when the time comes to choose a business structure? You take into account everything related to your business before making the final decision. For instance, if your business is based on a hobby such as video production, photography, blogging, and so on, then a sole proprietorship is the ideal business structure for you.
However, if your business has the potential for growth and comes with a massive customer base, then a corporation or LLC will suit you better. These two business structures offer the most protection and a reduced risk of personal loss.
How to Choose a Business Structure – Conclusion
There’s no one-size-fits-all when it comes to business structures. Every business entity has its own unique elements and knowing how to properly utilize these elements is how you will have a successful business.
The ideal structure depends on the current condition of your business, and also where you want your business to be in the future. Therefore, choose a business structure according to your needs.
Read our article on avoiding common mistakes when you’re starting a new business.