6 Business Types: Which Formation Structure is Best for You?

We are only successful if we are helping your small business succeed, and for us, that starts with high-quality content. Each business type offers distinct advantages and challenges. Understanding these business structures is crucial for your business’s formation. This article provides insights into each business type’s legalities, taxation, and operational considerations, helping you make an informed decision.

A graphic for an article discussing the different types of business structures. The graphic contains an anamorphic, multicolored blueprint to illustrate something taking many shapes.

1. Sole Proprietorships

A sole proprietorship is the simplest form of business structure for an individual. It does not form a separate legal entity. This structure identifies one person as the sole owner and is personally liable for the business’s debts. To establish a sole proprietorship, no formal legal documentation is required at the national level. However, it may be necessary to obtain local licenses and permits.

Sole Proprietorship Example:

  • Dave’s Landscaping is run by Dave, who offers landscaping services in his local area. As the sole owner, he’s responsible for all aspects of the business, including debts.
  • For Dave, getting up and running is his greatest priority. In this case, Dave chose a sole proprietorship because it’s easiest to start and requires minimal paperwork.

IRS Tax Information:

2. General Partnerships

A general partnership is a business structure based on collaboration. In it, two or more individuals own and manage a business together. Partners contribute various resources to the enterprise. These resources can include capital, property, labor, or skills. They also agree to share the profits and losses. Additionally, they accept the financial and legal responsibilities of the business.

Forming a general partnership is straightforward. It mainly involves an agreement among the partners. This agreement can be oral, written, or implied. It does not require filing formal articles of partnership with state authorities. However, creating a detailed partnership agreement is advisable. Such an agreement should clarify the terms and conditions, roles, and responsibilities of the partnership.

General Partnership Example:

  • Baker & Smith Consulting is a business consultancy run by two friends, Baker and Smith. They agree to share profits, losses, and management responsibilities.
  • They form their general partnership with a simple agreement and register their business name without the need for complex state filings.

IRS Tax Information:

3. Limited Liability Companies (LLCs)

A Limited Liability Company (LLC) combines features of partnerships, sole proprietorships, and corporations. It is recognized by state law for its tax efficiency and operational flexibility. Additionally, it offers limited liability to its owners. Filing “articles of organization” with the state authority is required to create an LLC. This step also involves paying any applicable fees. The process for forming an LLC differs across states due to varying local regulations. Although not mandatory, creating an operating agreement is strongly advised. This agreement outlines the LLC’s operational, financial, and management structures. It provides clear guidance for the members of the LLC.

LLC Example:

  • Tech Innovate LLC is a startup that develops innovative software solutions. The founders choose an LLC structure to protect their personal assets from business liabilities.
  • They file articles of organization with their state and create an operating agreement to get their LLC started.

4. C Corporations

A C Corporation stands as an independent legal entity separate from its shareholders. It can generate profit, incur taxes, and bear legal liabilities. Establishing a C Corporation requires specific steps. These steps include filing articles of incorporation with the relevant state authority. Additionally, it involves creating and adopting bylaws for governance. The process also demands issuing stock to shareholders and securing any necessary licenses and permits.

The tax structure of a C Corporation is distinctive. It subjects the corporation to separate taxation from its owners. This results in “double taxation,” where the corporation’s income is taxed at the entity level and then again as shareholder dividends. Despite the drawback of double taxation, C Corporations provide a significant benefit. They offer limited liability protection, shielding shareholders from personal responsibility for the corporation’s debts or liabilities.

C Corporation Example:

  • GlobalGoods Inc. manufactures and sells consumer products worldwide. The founders incorporate the business to raise capital through stock sales and benefit from corporate tax deductions.
  • They file articles of incorporation, elect a board of directors, and issue stock. All of which are among the steps taken to start a C Corporation.

IRS Tax Information:

5. S Corporations

An S Corporation is a unique type of entity. It gains its special tax status through an election with the IRS. This status is designed to avoid the double taxation that C Corporations face. In an S Corporation, profits and losses pass directly to shareholders. These are then taxed at the individual rates of the shareholders. To establish an S Corporation, one must first incorporate as either a C Corporation or an LLC.

After incorporation, the entity must file Form 2553 with the IRS. This form is a request to elect S Corporation status. The IRS must approve this election. Approval depends on whether the entity meets certain criteria. The criteria include being a domestic corporation and having only allowable shareholders. Allowable shareholders do not include partnerships, corporations, or non-resident alien shareholders. The entity must also limit its shareholders to 100. It must maintain only one class of stock. Finally, it cannot be an ineligible corporation. Ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations.

S Corporation Example:

  • Quality Craftsmen S Corp is a small home renovation business that wants to avoid double taxation faced by C Corporations.
  • After incorporating, they elect S Corporation status by filing Form 2553 with the IRS, allowing profits to pass through directly to the owners’ personal income without facing corporate tax.

IRS Tax Information:

6. Nonprofits

Nonprofit organizations are formed to achieve goals beyond their members’ financial gain. They focus on broader societal, educational, charitable, or cultural objectives. The formation process of a nonprofit begins with incorporation in the state of operation. This step establishes its legal foundation. After incorporation, the organization applies for 501(c)(3) tax-exempt status with the IRS. This recognition exempts it from federal income tax.

Additionally, the organization must implement specific governance practices. This includes establishing a board of directors to oversee its activities. It also requires meticulous record-keeping to ensure transparency and accountability. These steps are crucial for the nonprofit. They help it gain legal recognition, fulfill its mission, and comply with regulatory requirements.

Nonprofit Example:

  • Helping Hands Charity is an organization dedicated to providing meals and support to the homeless. To pursue its mission without the goal of profit, it incorporates as a nonprofit, files for 501(c)(3) status to receive tax-exempt status, and operates under a board of directors.

IRS Tax Information:

Now, It’s Your Turn

Remember, a proper business structure protects your personal assets, offers tax advantages, and sets the stage for your business’s growth. Consider the immediate benefits and long-term implications when choosing a business type.

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