Take our business formation quiz to find out what the best form of business ownership is for you.
When you start a business, you must decide whether it will be a sole proprietorship, partnership, corporation, or limited liability company (LLC). (If you need a brief explanation of the main business types, see Nolo's article on business ownership structures.)
Which of these forms is right for your business depends on the type of business you run, how many owners it has, and its financial situation. No one choice suits every business: Business owners have to pick the structure that best meets their needs. This article introduces several of the most important factors to consider, including:
- your ownership and management structure
- your investment and financing needs
- the potential risks and liabilities of your business
- the formalities and expenses involved in establishing and maintaining the various business structures, and
- your income tax situation.
Ownership Structure
One of the first issues you should consider is how many owners your business will have, and how involved each of the owners will be in the day-to-day management of the company. If you own the business by yourself, you can operate a sole proprietorship, a single-member LLC, or a corporation. If you have more than one business partner, you can explore a partnership, an LLC, or a corporation. As the number of owners increases, it becomes more difficult to get a consensus for decision-making, which makes an LLC or a corporation the better choice over a partnership. However, if you have more than 100 owners, you can not elect S Corporation tax status.
An LLC offers the most flexibility in terms of ownership and management structure. All owners of an LLC can be involved in day-to-day operations, or you can designate one or more owners to run the business while the other owners serve as passive investors. You can read more about your options for LLC management here.
Investment and Financing Needs
The financing needs for your business might impact which business entity type you can form. If you plan on obtaining a bank loan to start your business, you might find that banks are more likely to loan to an LLC or a corporation over a sole proprietorship or a partnership. If you are hoping to work with investors, a corporation is likely your best bet. Unlike other business forms, the corporate structure allows a business to sell ownership shares in the company through its stock offerings. This makes it easier to attract investment capital and to hire and retain key employees by issuing employee stock options.
But for businesses that don't need to issue stock options and will never "go public," forming a corporation probably isn't worth the added expense. If it's limited liability that you want, an LLC provides the same protection as a corporation, but the simplicity and flexibility of LLCs offer a clear advantage over corporations. For more help on choosing between a corporation and an LLC, read the article Corporations vs. LLCs.
Formalities and Expenses
Sole proprietorships and partnerships are easy to set up -- you don't have to file any special forms or pay any fees to start your business. Plus, you don't have to follow any special operating rules.
LLCs and corporations, on the other hand, are almost always more expensive to create and more difficult to maintain. To form an LLC or corporation, you must file a document with the state and pay a fee, which ranges from about $40 to $800, depending on the state where you form your business. In addition, owners of corporations and LLCs must elect officers (usually, a president, vice president, and secretary) to run the company. They also have to keep records of important business decisions and follow other formalities.
If you're starting your business on a shoestring, it might make the sense to form the simplest type of business -- a sole proprietorship or a partnership. Unless yours will be a particularly risky business, the limited personal liability provided by an LLC or a corporation may not be worth the cost and paperwork required to create and run one.
Risks and Liabilities
In large part, the best ownership structure for your business depends on the type of services or products it will provide. If your business will engage in risky activities -- for example, trading stocks or repairing roofs -- you'll almost surely want to form a business entity that provides personal liability protection ("limited liability"), which shields your personal assets from business debts and claims. A corporation or a limited liability company (LLC) is probably the best choice for you.
To learn more about the advantages and disadvantages of each type of business structure, see Ways to Organize Your Business, a chart that compares the pros and cons of each.
Income Taxes
Owners of sole proprietorships, partnerships, and LLCs all pay taxes on business profits in the same way. These three business types are "pass-through" tax entities, which means that all of the profits and losses pass through the business to the owners, who report their share of the profits (or deduct their share of the losses) on their personal income tax returns. Therefore, sole proprietors, partners, and LLC owners can count on about the same amount of tax complexity, paperwork, and costs.
Owners of these unincorporated businesses must pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. Even if all of the profits are kept in the business checking account to meet upcoming business expenses, the owners must report their share of these profits as income on their tax returns. However, under the Tax Cuts and Jobs Act (HR 1, "TCJA"), owners of pass-through businesses may be eligible to deduct up to 20% of their net business income, reducing their effective income tax rate to 80%.
In contrast, the owners of a corporation do not report their shares of corporate profits on their personal tax returns. The owners pay taxes only on profits they actually receive in the form of salaries, bonuses, and dividends.
The corporation itself pays taxes on any profits that are left in the company from year to year (called "retained earnings"). The TCJA established a new single flat tax rate of 21% for corporations. This replaces the corporate tax rates ranging from 15% to 35% that corporations paid under prior law.
This separate level of taxation adds a layer of complexity to filing and paying taxes, but it can be a benefit to some businesses. Owners of a corporation don't have to pay personal income taxes on profits they don't receive. Corporations have to pay taxes on dividends paid out to shareholders, but this rarely affects small corporations that seldom pay dividends. And, because corporations enjoy a new lower flat tax rate of 21%, a corporation and its owners may have a lower combined tax bill than the owners of an unincorporated business that earns the same amount of profit.
Changing Your Mind
Your initial choice of a business structure isn't set in stone. You can start out as a sole proprietorship or partnership and later, if your business grows or the risk of personal liability increases, you can convert your business to an LLC or a corporation.
Next Steps
Nolo's book LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso, provides lots of real-world scenarios that demonstrate how these options work for different types of companies.
After learning the basics of each business structure and considering the factors discussed above, you may still find that you need help deciding which structure is best for your business. A good small business or tax lawyer can help you choose the right one, given your tax picture and the possible risks of your particular situation.
