Choosing a Business Structure
There are a number of business structures out there that can easily overwhelm first-time founders and even investors navigating the world of business. The business structure one chooses impacts how much they pay in taxes, their ability to raise money, the paperwork they need to file, and their personal liability. Businesses should choose the structure that gives them the right balance of legal protections and benefits.
The Business Structures
Sole proprietorship: Sole proprietorships give individuals complete control of businesses. Sole proprietorships do not produce a separate business entity. This means the business assets and liabilities are not separate from the individual’s personal assets and liabilities and can thus be held personally liable for the debts and obligations of the business. As sole proprietorships cannot sell stock, it can be hard to raise money.
Sole proprietorships are a good choice for low-risk businesses and for proving business ideas before transitioning to a more formal corporate structure.
Partnership: Partnerships are the simplest structure for two or more people to own a business together. The two most common types of partnerships are limited partnerships (LP) and limited liability partnerships (LLP).
Limited partnerships have only one general partner with unlimited liability, and all other partners have limited liability. The partners with limited liability also have limited control of the company. Profits are passed through to personal tax returns, and the general partner must also pay self-employment taxes.
LLPs are similar limited partnerships, but give limited liability to every owner. An LLP protects each partner from debts against the partnership, they won’t be responsible for the action of other partners. Partnerships are good choices for businesses with multiple owners, professional groups (like attorneys), and others who want to test their business idea before transitioning.
Limited Liability Companies (LLC): LLCs take advantage of the benefits of both corporation and partnership corporate structures.
In most cases LLCs, protect individuals from personal liability if an LLC faces bankruptcy or lawsuits.
Profits and losses are passed through an individual’s personal income without facing corporate taxes. Members of an LLC are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security.
LLCs can have a limited life in many states. When a member joins or leaves an LLC, some states may require the LLC to be dissolved and re-formed with new membership unless there’s been an agreement in place to transfer ownership. LLCs are good choices for owners with significant personal assets they want to be protected, and owners who want to pay a lower tax rate than they would with a corporation.
Corporation: There are a variety of different corporation types so we’ll go through each and their intricacies.
C Corp: Corporations, or C Corps, are legal entities that are separate from its owners. Corporations can make a profit, be taxed, and be held legally liable.
C Corps are the most common corporation type for startups and other businesses as it offers the strongest protection to its owners from personal liability, but the cost associated with forming a corporation is higher than other structures. Corporations also require more in-depth record-keeping, operational processes, and reporting.
Corporations have an easier time raising capital because they can raise funds through the sale of stock. For example, public and private companies like Google, Facebook, and Airbnb have raised capital privately and publicly by selling equity.
S Corp: S Corps are special types of corporations that are designed to avoid the double taxation drawback of regular C corps. S corps allow profits, and some losses, to be passed through directly to owners’ personal income without being subject to corporate tax rates.
Not all states tax S corps equally and tax the shareholders accordingly. Some states tax S corps on profits above a specified limit and others don’t recognize S corps at all and treat them as C corps. In order to receive S corp status, S corps must file with the IRS instead of registering with the state.
There are, however, special limits to S corps. S corps cannot have more than 100 shareholders, all shareholders must be U.S. citizens, and S corps must follow the strict filing and operational processes required of C corps. Like C corps, S corps have a separate life from its shareholders.
B Corp: Benefit corporations, or B corps, are for-profit corporations that differ from C corps in purpose, accountability, and transparency, but are taxed the same.
B corps like Allbirds are driven by both mission and profits. B corp shareholders hold the company accountable to produce a public benefit in addition to financial profit.
Close Corporation: Close corporations are similar to B corps, but have a less traditional corporate structure. For example, shares of close corporations are normally barred from being publicly traded. As such, close corporations tend to be run by a small group of shareholders without a board of directors.
Nonprofit Corporation: Nonprofits corporations, or 501(c)(3) corporations (referencing the IRS code that is commonly used to grant tax-exempt status), are organized to do charity, educational, religious, literary, or scientific work. Because the work of nonprofits benefits the public, nonprofits can receive tax-exemption status, meaning the nonprofits don’t pay state or federal income taxes on any profits it makes. As such, nonprofit corporations must file with the IRS to receive tax exemption.
Nonprofits follow organizational rules similar to C corps. Nonprofits must also report what they do with the profits they earn. For example, nonprofits cannot distribute the profits they earn to members or to political campaigns.
Cooperative: Cooperatives are businesses or organizations owned by and operated for the benefit of those using its services. Profits and earnings generated by the cooperative are distributed amongst its members. An elected board of directors and officers typically run the cooperative while regular members have voting power to control the direction of the cooperative. Members can become part of the cooperative by purchasing shares, though the amount of shares held may not reflect the weight of their vote.
Hopefully you have a better understanding of the different business structures. For the most part, you only need to focus on the most common ones you’ll see in the startup ecosystem and our realm of equity crowdfunding are C corps, and to a lesser extent, B corps.
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About: Francis Vu
An investment professional with a background in private equity and venture capital having spent time conducting investments at VU Venture Partners and Pacific Oak LLC with a finance and management degree from Tulane University.