The 6 Types of Business Structures to Choose From

Every entrepreneur must take several key steps when starting their own business. Some of the first few steps include writing a business plan, deciding on the business name, choosing a location and more. An equally important step, however, is choosing a business structure.

Choosing your business structure is of fundamental importance. Your business structure defines what kind of business entity you are in the eyes of the IRS — and that means it has a direct impact on how your business is taxed. Not only that, the structure of your business defines which individuals are owners, which people have control of management, which are purely investors, how income and losses are accounted for, and much more. In short, don’t take it lightly.

When it comes to choosing a business structure for your company, there are a few options you have to choose from.

The six business structure types you can choose from are:

Learn more about the six business structures to chose which one is the best fit for starting your business.

Sole Proprietorship

A sole proprietorship is a business structure in which “one person owns an unincorporated business by himself or herself,” according to the IRS. However, if you’re a sole business owner, you’re not limited to choosing a sole proprietorship as your business structure. For example, you can elect to be treated as an LLC by the IRS. Establishing a sole proprietorship might have different filing requirements in some states than others. In California, for example, you don’t need to file any organizational documents with the state for this business structure.

Partnership

“A partnership is the relationship existing between two or more persons who join to carry on a trade or business,” according to the IRS. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

Partnerships deal with income taxes in a manner very different from a corporation, for example. A partnership must file an annual information return to report the income, deductions, gains, losses, and the like, from its operations, but the company does not pay income tax itself. Instead, the partnership “passes through” profits or losses to its partners. As a result, each partner includes his or her share of the partnership’s income or loss on his or her personal tax return.

To create a general partnership in California, for example, you don’t need to file any organizational documents with the state. Although not legally required, all partnerships should have a written partnership agreement. The partnership agreement can be very helpful if there is ever a dispute among the partners.

Another form of partnership is a limited partnership. In some states, a limited partnership requires that at least one partner be the general partner, who has full management control of daily functions and is responsible for debts and obligations. A limited partner, typically investors who give up management control for monetary protection, is also required and is only liable for the amount invested.

Related: How to Get a Business License

C Corporations

In forming this type of business, prospective shareholders exchange money, property or both, for the corporation’s capital stock. A key feature of a corporation is that, for federal income tax purposes, a C Corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.

Another critical feature of C Corporations is how they are taxed. The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends, creating a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.

S Corporations

The principal difference between S Corporations and C Corporations is how they are taxed. With an S Corporation, it passes corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S Corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S Corporations to avoid double taxation on the corporate income. S Corporations are responsible for tax on certain built-in gains and passive income at the entity level.

Other unique traits of S corporations include features such as limitations on who can be shareholders. Allowable shareholders include individuals, certain trusts and estates. Non-allowable shareholders include partnerships, corporations or non-resident alien shareholders. There can also be no more than 100 shareholders, only one class of stock and some corporations are ineligible to be S Corporations, such as certain financial institutions, insurance companies and domestic international sales corporations.

Also: What Is a Fiscal Year?

LLCs

Known as a limited liability company or LLC, this business structure is the most common among small businesses. An LLC is a business structure regulated by the state, so laws and practices vary from state to state. Owners of an LLC are referred to as members, and there is no maximum as to how many an LLC can have. Also, most states allow for “single-member” LLCs, which have only one owner; and most do not restrict ownership so LLC members can be individuals, corporations, other LLCs and even foreign entities.

For tax purposes, an LLC can be treated a number of ways by the IRS. For example, the IRS can classify your LLC as either a corporation, partnership or as part of the LLC’s owner’s tax return, depending on elections made by the LLC and the number of members.

Find Out: 5 Questions to Ask Yourself Before Starting a Business

Non-Profits

Starting a non-profit business is similar to starting a for-profit business, with business structures like LLCs and corporations being common. However, where LLCs are the most popular among startups, corporations are the more traditional business structure for non-profits. Non-profit corporations organize themselves like for-profit ones in terms of electing a board of directors and having bylaws. But a crucial difference is that, after filing their Articles of Incorporation, non-profits then apply to the IRS for 501(c)(3) status, which recognizes them as tax-exempt organizations.

Starting a non-profit LLC is certainly possible, but there are reasons why it is less common. State law regulates LLCs, and in many states, a key part of establishing an LLC is providing a lawful purpose or business purpose for the organization. It is providing a business purpose that can raise issues for creating a non-profit LLCs in some states, which is why incorporating is still the traditional route.

If you decide on creating a non-profit LLC, you’ll have to meet federal requirements to be considered a 501(c)(3) organization. In the case of an LLC, to be considered a 501(c)(3) organization, it must be owned by a sole member that is a 501(c)(3) or owned by two or more members that are all 501(c)(3) organizations.

Related: The Best States to Start a Business

The Bottom Line

In the end, each business entity type has its own advantages and disadvantages, so there’s no right or wrong structure. Your decision comes down to what you’re trying to accomplish as a business, and where you see it going in the future.

Choosing the right business structure is something you need to get right from the start — changing it down the line can be more trouble than it’s worth. Take the time to research different business structures to choose the one that’s the best fit for both you and your business from legal, financial, tax and business perspectives.

When considering tax implications, it’s best to consult a tax professional to determine the optimal business structure for your needs and priorities.

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Photo credit: Monkey Business Images/Shutterstock.com

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