Every year, more than 600,000 small businesses get off the ground. But what is a small business? Are they structured like their larger siblings, or are the rules simpler when your business is small?
Here are some of the most common types of small business structures, along with their pros and cons.
Sole Proprietorship
This is the simplest structure for a small business. There’s no real distinction between you, the business owner, and your business. On the bright side, all profits are directly yours. On the dark side, you are personally liable for all debts and liabilities. If the business can’t pay its debts, or if it’s sued, that money can come out of your personal funds.
You don’t have to file any paperwork to be a sole proprietor: if you’re freelancing or selling something, you already are one. But you may need to obtain the right license for the job you’re doing.
Taxes for a sole proprietorship are reported on your personal taxes, on Schedule C and 1040 forms. You will need to withhold your own taxes and might need to pay self-employment tax.
Pros:
- Simple and free to start
Cons:
- You’re liable for your company’s debts
- You can’t sell stock
- Banks may hesitate to lend to you
Partnership
If you’re not the only person running your small business, you may structure it as a partnership. Like a sole proprietorship, a partnership is just a “pass-through” entity: profits and liabilities pass straight through the partnership to the members. Each partner pays taxes on their portion of the profits in their personal tax filing. Each partner is also liable for any of the partnership’s debts.
You don’t have to file any specific paperwork to form a partnership, although you should definitely get the expectations of the partnership in writing.
A subtype of the partnership is a limited partnership, in which one partner, the general partner, takes on the decision-making and liability, while limited partners contribute money and receive a share of the profits without taking on liability. This type of partnership does need to be registered with your state.
Pros:
- Simple and free to form
Cons:
- Little to no protection from liability
- Difficulty raising money
- Conflicts may arise between partners
Limited Liability Company
If the liability of a sole proprietorship or partnership worries you, you can form a limited liability company (LLC). An LLC establishes a separate business entity that takes on the liability for debts and lawsuits, protecting your personal finances. An LLC can consist of one person or several people.
You file your LLC with your state. There are usually filing costs, and you may also want to have a lawyer look over your documents. You may also have to pay annual fees.
Taxes normally work the same in this small business structure as in a sole proprietorship or partnership: the profits pass through the company to you and your partners, and you pay taxes on them in your personal return.
Pros:
- Simple to form
- Protects you from liability
Cons
- Costs money to form
- You can’t raise money by selling stock
Corporation
The previous structures may work for a small business, but what about when your business grows? Bigger businesses might consider forming a corporation. The most common types are C-corporations and S-corporations.
A C-corporation is a separate entity owned by shareholders. It’s more complex to set up than an LLC, but unlike an LLC, it can raise funds by selling stock. It’s taxed separately, as a business, meaning that its profits are taxed twice: once when the company makes a profit, and once when that profit is distributed to shareholders. A C-corporation can write off charitable donations on its taxes.
Some businesses can avoid double taxation by becoming an S-corporation instead. While an S-corporation can sell stock, profits are only taxed when the shareholders receive them. Not all businesses are eligible for this status: they must be domestic businesses, with fewer than 100 shareholders, and meet other eligibility requirements.
Pros:
- Can raise money with stock
- You’re protected from liability
Cons:
- Complex and expensive to form
- Many corporations are subject to double taxation
How Should You Structure Your Small Business?
Which of these structures will work best for your small business? There’s no single right answer. It depends on the size of your business, the amount of risk you can handle, and how much paperwork you want to do. A financial advisor can look over your business idea and suggest ways to start. Contact us to be connected to a financial advisor for your small business.
