How to Choose a Business Structure

As you take the leap into self-employment, there are plenty of thrilling decisions to make — from setting your prices to marketing your brand. But let's face it, choosing the right business structure probably isn't one of them.

This choice isn't just about paperwork; your business structure influences how you're taxed and the extent of your personal liability if something goes south. But with five different types of business structures to choose from, how do you know which is right for you? 

What is a Business Structure?

A business structure is the legal framework that defines how your business operates. It affects how you're treated for taxes and whether you’re personally responsible if things go wrong. Business structures are also called business entities. 

5 Common Types of Business Structures

Most small business owners choose one of these five business structures: sole proprietorship, partnership, LLC, S Corporation, or C Corporation. Let’s take a look at each. 

1. Sole Proprietorship

A sole proprietorship is the simplest business structure you can have. It’s often the default choice for freelancers or contract workers who are just starting out. 

If you do nothing to form a legal business structure, the IRS considers you a sole proprietorship by default. You do not need to file any paperwork. While this is the easiest type of business to form, it means there is no legal distinction between you and your business. So if you take on business debt or get sued, you’ll be personally responsible for handling it. 

How to become one: To register as a sole proprietor, you simply need to start doing business. You shouldn’t need any licenses or permits unless they’re required in your line of work. 

Taxes: As a sole proprietor, you will report your business income and expenses on your personal tax return using Schedule C. You will also need to pay self-employment taxes, which cover Social Security and Medicare. 

Pros:

• Easy and inexpensive to set up

• No need to file a separate tax return

• Complete control over the business

• All profits go to the owner

Cons:

• Unlimited personal liability

• Limited ability to raise capital

• No separation between personal and business assets

2. Partnership

A partnership is a simple business structure where two or more people will own a business. There are two types of partnerships: limited partnerships (LP) and limited liability partnerships (LLP). In an LP, there is at least one general partner who is personally liable for the business's debts and one or more limited partners who are not. In an LLP, all partners have the same limited liability.

Pros:

• Personal liability protection for all partners (in an LLP)

• Easy to set up and operate

• Pass-through taxation

Cons:

• Unlimited personal liability for general partners (in an LP)

• Limited ability to raise capital

• Can be difficult to manage if there are many partners

How to become one: To register as a partnership, you will need to file a partnership agreement with your state's Secretary of State office.

Taxes: As a partnership, the business income and expenses are reported on a partnership tax return. Each partner will receive a K-1 form that shows their share of the business's income and expenses. They will then report this on their personal tax return.

3. Limited Liability Company (LLC)

An LLC, or limited liability company, shields your personal assets from business liabilities, unlike a sole proprietorship where there's no legal separation between you and the business. So if your LLC goes bankrupt or you face a lawsuit, they can’t come after your house, car, or personal bank accounts. 

An LLC is a flexible and relatively easy-to-set-up option for small businesses. If you’re a freelancer, contract worker, or self-employed person with personal assets to protect, setting up an LLC can be a great move. 

How to become one: Forming an LLC involves selecting a unique business name and filing articles of organization with your state's Secretary of State office online. You may also wish to get an Employer Identification Number (EIN) for your business, so you don’t have to hand out your Social Security number to clients. 

Taxes: The beauty of an LLC is its flexibility in taxation. By default, the IRS treats all LLCs as a sole proprietor. You report your business income and expenses on your personal tax return using Schedule C. You only have one tax form to file.

However, there is also a lesser-known tax status you can choose as an LLC — you can elect to be taxed as an S Corporation. (More on S-Corps in a sec.) Generally, the income threshold where it makes sense to shift from an LLC that’s taxed as a sole proprietor to an S-Corp varies based on your state and financial situation. Working with a CPA to look at your options could pay off in the long-run. 

Pros:

• Legally protects your personal money

• Only one tax return to file in most cases

• Can include multiple members

• Fairly easy to maintain

Cons:

• More paperwork than sole proprietorships or partnerships

• Must register with the state and pay a fee

• Has the same tax structure as a sole prop, by default

4. S Corporation

If you're a highly profitable business owner, an S Corporation might be an enticing option to minimize your tax burden. With an S Corporation, you can pay yourself a reasonable salary and usually classify the rest of your earnings as distributions, potentially reducing your self-employment tax liability. However, this structure is more complex to set up and maintain, often requiring professional assistance to ensure compliance with legal and tax requirements.

How to become one: To register as an S Corporation, you will need to file articles of incorporation with your state's Secretary of State office. You will also need to file Form 2553 with the IRS to elect S Corporation status.

Taxes: As an S Corporation, the business income and expenses are reported on a corporate tax return, but the profits and losses are passed through to the shareholders' personal tax returns. This can provide tax savings, as the shareholders only pay taxes on the profits they receive as income. Some LLCs can also elect to be taxed as an S-Corp, which provides similar tax benefits.

Pros:

• Personal liability protection

• Pass-through taxation

• Can provide tax savings

Cons:

• More expensive to set up and operate than a sole proprietorship or LLC

• Limited ability to raise capital

• More complex management structure

5. C Corporation

For entrepreneurs who want to attract external investors, a C Corporation could be a game-changer. This entity provides unlimited growth potential, and you can issue different classes of stock to raise capital and incentivize investors. 

However, C Corporations face double taxation, where profits are taxed at the corporate level and again when distributed to shareholders, which might not be ideal for some small business owners.

How to become one: To register as a C Corporation, you will need to file articles of incorporation with your state's Secretary of State office.

Taxes: As a C Corporation, the business income and expenses are reported on a corporate tax return. The profits are taxed at the corporate level, and any dividends paid to shareholders are taxed again on their personal tax returns.

Pros:

• Limited liability for owners

• More access to capital

• No limit on the number of shareholders

Cons:

• Double taxation

• Extensive paperwork and bureaucratic procedures

• High regulatory compliance and administrative costs

Summary of Business Structures

For those just starting and seeking simplicity, a sole proprietorship might be the initial choice. However, for entrepreneurs looking to protect their personal assets and enjoy some flexibility, an LLC may be a better fit. 

High-earning small business owners may explore the tax advantages of an LLC that’s taxed as an S Corporation, while those with ambitious growth plans can consider the benefits of a C Corporation.

Source: U.S. Small Business Association 

Which Business Structure Should You Choose?

If you’re still stuck on choosing a business structure, considering these factors can help you make an informed decision:

• First, think about your personal liability. The degree of personal liability you're willing to take on should be a major factor in your choice. Sole proprietorships and general partnerships leave you more exposed, as you can be held personally responsible for business debts, while limited liability companies (LLCs) and corporations provide more protection for your personal assets.

• Another key factor is the tax implications of each business structure. For instance, corporations are subject to double taxation, while LLCs, sole proprietorships, and partnerships benefit from pass-through taxation, meaning the profits are taxed only once — at the individual level. Consult a professional to help you understand these differences and choose the most advantageous option for you.

• Consider the ease of formation and maintenance. Some business structures, like sole proprietorships, are relatively easy to establish and maintain. Whereas, corporations have more regulations to follow, meaning more paperwork and potential costs. How much time and money are you willing to put into maintaining your chosen structure?

• Finally, weigh your growth potential and funding needs. If you plan to raise a significant amount of capital or plan to go public in the future, a corporation might be your best choice.

Sole Prop or LLC? Make Tax Time a Breeze with Found

Once you choose a business structure, figuring out how to prepare for taxes becomes the next hurdle for a lot of entrepreneurs. Luckily, Found helps you put your taxes on autopilot. 

Once you open a Found account, we find and track tax write-offs, estimate your tax bill, auto-generate your Schedule C form, and more. In some cases, you can even pay your tax bill directly through the app! It couldn’t be easier. Try Found for free today to see for yourself.

The information on this website is not intended to provide, and should not be relied on, for tax advice. Found does not offer legal advice.