Ready to plunge into the world of business ownership? You might have the perfect new business or startup idea and are eager to get started, but you feel confused with all the legal considerations and business taxes.
Before you take the leap and start your business, it's important to understand the different legal structures you could have for your business. This understanding would empower you to choose the one that best suits your needs.
Although many business types are available in the U.S., there are five that many people use. Let’s explore each type and what it offers.
Why your type of business matters
Although choosing your business name could be a matter of personal preference, choosing your structure and form of business isn't. There are legal and financial considerations you need to take into account when making this decision.
The type of business you choose would determine:
- The legal structure of your business
- How easy (or difficult) it is to get funding
- Your business tax liability
- Which tax forms you file
- Your personal liability
- The types of business licenses and permits you might need
- The amount of paperwork you would deal with
The 5 most common types of businesses
There is no one size that fits all when it comes to starting a business. There are many factors to think about when considering how to start a business.
There are five common types of business structures to choose from, each with its own benefits and drawbacks. Choosing the right type of business takes careful consideration and research.
1. Sole proprietorship
A sole proprietorship means you are the only owner of the business. This is the simplest business structure because it is automatically created when you begin your business activities.
However, you might need additional licenses and permits in some states, cities, or industries, depending on the type of business you conduct. The U.S. Small Business Administration (SBA) offers a great starting point to determine your necessary licenses or permits.
|Pros of sole proprietorships||Cons of sole proprietorships|
A sole proprietorship gives you complete control over all aspects of the business, from the product or service you provide to how you run your day-to-day operations. But you also assume all the risk. Being a sole proprietor is a bit like being a one-person show.
If your business will be owned or operated by multiple people, a partnership might be the right type of business structure.
|Pros of partnerships||Cons of partnerships|
In a business partnership, each business owner or partner shares responsibility for the business. Therefore, each partner is personally liable for the debts and obligations of the business. Each partner is also liable for decisions made by other partners.
Partnerships might take different forms, but the two most common types are:
- General partnerships: In this structure, all the partners share equally in the profits, losses, and management of the business. This structure is relatively easy to form because there are few initial paperwork and compliance requirements. However, because all the partners have an equal say in how the business is run and are legally bound by contracts, general partnerships might be somewhat inflexible.
- Limited partnerships: This structure has general and limited partners. General partners manage the business and have personal liability for the debts and obligations of the business. Limited partners are not involved in the day-to-day operations of the business. They're only liable for the amount of money they've invested in the business.
The key advantage of general partnerships over limited partnerships is that general partners have more control over a business, but this comes at the expense of personal liability. So, weighing the pros and cons of each type of partnership is important before deciding which one is right for your business.
A corporation is an independent legal entity separate from its equity holders. Equity holders own equity in the corporation, entitling them to a portion of the corporation's profits and assets., However, the equity holders are protected from being personally liable for the corporation’s debts and obligations.
The equity holders elect a board of directors to oversee the corporation's operations. The board of directors is responsible for managing the corporation's day-to-day operations.
|Pros of corporations||Cons of corporations|
The two common types of corporations are C corporations and S corporations:
- C Corporations: These corporations are taxed separately from their equity holders, which means both the corporation and the equity holders pay taxes on income, which results in double taxation.
- S corporations: These corporations don’t have to pay income tax. Instead, their corporate tax requirements are pass-through to equity holders who pay income tax on their dividends. That’s why S corporations aren’t subject to double taxation.
The S corporation structure might be a better fit for U.S. small business owners who don’t plan to go public, as S corporations have a legal limit of no more than 100 shareholders. C corps don’t limit the number of shareholders they could have but are subject to double taxation.
4. Limited liability company
A limited liability company (LLC) is a business entity that offers its owners protection from personal liability. Although LLCs are different from corporations, they enjoy similar liability protection to the protection offered by corporations.
|Pros of limited liability companies||Cons of limited liability companies|
The LLC owner's personal assets are not at risk if the business is sued. The law views an LLC as a separate legal entity from its owners. Therefore, creditors could only go after the business's assets, not the owners' personal assets.
By keeping the profits and expenses of an LLC separate from your personal finances, you’d essentially be protecting yourself. For example, you could use one of the best credit cards for LLCs to keep the expenses of your LLC separate from your own expenses.
Opening an LLC usually requires some paperwork, but some service providers could help simplify the work needed. For example, ZenBusiness is a company that helps entrepreneurs start an LLC or a corporation by tackling many of the tasks needed to start them.
Find out more information in our ZenBusiness review.
5. Nonprofit Organizations
A nonprofit organization is a business entity organized for charity, education, religion, or other benevolent purposes. They cannot be political organizations, and they cannot lobby for or against political candidates.
Nonprofit organizations are exempt from federal taxes.
Nonprofits are structured similarly to C corporations but must follow different rules regarding profit distribution and permitted financial contributions. For example, the money they make cannot be distributed to their members or political campaigns.
Nonprofits could be public charities or private foundations such as educational institutions, religious organizations, charities, and scientific research organizations. Each type of nonprofit has its specific purpose, motivated by a desire to serve the public good rather than generate profit for its owners or shareholders.
The IRS has also designated public charities as tax-exempt nonprofits. Public charities receive support from the public through donations, government grants, and other forms of revenue charitable revenue.
Private foundations are nonprofits that a single donor or family typically funds. They are not as reliant on public support and often have more flexible guidelines for how they could use their funds.
3 things to consider when choosing your business type
When starting a business, it's essential to choose the proper legal structure for your company. The type of business entity you choose will impact factors such as how much you pay in taxes, personal liability, and the level of paperwork required.
1. Understand liability and taxes
Liability is the legal term for the potential financial consequences of your actions. If you get sued and are held legally responsible for certain actions, you might be on the hook for a large sum of money — sometimes more than the value of your business.
So, it's crucial to understand how liability works and what type of business entity could offer you the most protection. LLCs, for example, provide more protection for your assets than sole proprietorships. This protection would allow you to limit potential liability and financial losses to the boundaries of your business.
The tax implications of your business organization are also essential. The IRS taxes businesses differently depending on their legal structure. For example:
- Business income made through sole proprietorships and partnerships is taxed once as personal income.
- Profits made by corporations are taxed as separate legal entities. They might also be subject to double-taxation, once at the corporation level and another time as personal income when the owners and equity holders get their profit shares.
Your tax liability could significantly impact your tax bill, so it's worth working with an accountant or a business advisor before you choose your business entity. LegalZoom is a service provider that could help you figure out how to create an LLC, a corporation, or a nonprofit in as few as 10 days, depending on your chosen package.
Learn more about what LegalZoom could offer in our ZenBusiness versus LegalZoom comparison.
2. Consider partners and investors
If you’re the only business owner, you might find a sole proprietorship an easy choice. However, when more people become involved in your business, it is important to consider the best type of business that allows you to include partners or investors.
When adding partners or investors to your business, you could consider:
- The level of control and liability each partner would have. This factor would help you find the right type of partnership agreement for your business.
- The legal protection investors may desire to avoid being liable for more than what they invest. Corporations offer liability and legal protection that might make your business more attractive to investors.
3. Weigh your potential employment needs
The type of business you use shapes how you’d hire people and what benefits you could offer them. For example:
- Sole proprietorships: This structure allows you to hire employees. However, this often complicates a simple business setup since you’d need an employer identification number (EIN). That’s why many sole proprietors operate under self-employment terms and hire independent contractors instead of employees.
- Partnerships: This structure allows you to hire employees as an integrated part of their legal structure. Your employees could also become partners and share in the earned profits. This allows you to offer incentives in the form of equity in the business.
Keep in mind that hiring employees comes with liability. A business structure that limits your liability could protect your personal assets if an employee is injured on the job or sues the business.
FAQs about business types
What counts as a business?
A business is an entity or an organization that engages in commercial, industrial, or professional activities. For example, offering roofing services, using your translation skills to make money, or holding guided tours in your town might all be businesses.
You could make sure that you’re using the correct tax treatment and legal lane by consulting a legal advisor or reviewing the business guidelines provided by the IRS.
What are the costs associated with starting a business?
There are several costs to starting a business, including the cost of establishing a business plan and getting licenses and permits. There are also borrowing costs and expenses for equipment and technology.
Once your business starts operating, you might have costs such as advertising, promotion, and employee expenses. Of course, these are just a few of the many potential costs associated with starting a business. Be sure to do your cost research and budget accordingly.
Is it possible to borrow money to start a business?
There are several ways to borrow money and finance a business, including credit unions, online business lenders, and business-focused banks. These lenders offer a variety of loans, lines of credit, bank accounts, and other financing options to help businesses get started.
Additionally, Although starting a business often requires capital upfront, there are actually several small businesses you can start with $1,000.
Learning how to make money through a business doesn’t come without its own risks and challenges, but with the proper planning, you could set your business up for success. Make sure that you understand the different types of businesses and their respective benefits and drawbacks.
Consider your potential liability, taxes, partners or shareholders, and employment needs when deciding. And remember, the type of business you choose impacts how you operate, so be sure to determine what works best for you and your business.