How to Choose the Right Business Structure
Choosing a business structure is an important decision—your business structure impacts everything from your ability to take out loans and grants to how much responsibility you’ll have to take on when paying for liabilities incurred by your ecommerce business.
In this article, we’ll explore the details you should know before choosing a business structure, the pros and cons of each entity type, and the many factors to consider before making your decision.
How to choose a business structure
When choosing a business structure, the best decision is an educated one. The decision is best made with the counsel of an attorney, accountant, and any other law, business, or tax professionals who can analyze your unique situation and offer specific advice that will set you up for success.
A note on limited liability
As we explain the characteristics of each business entity type, a term we’ll reference often is limited liability.
Limited liability refers to the amount of personal liability you’re likely to carry for business liabilities. This liability is limited, which means that your personal assets, like cash, stocks, homes, cars, and boats, are protected from seizure in instances where your business can’t pay its own liabilities.
For example, let’s say your liability limit in your business is $10,000 and the company owes $150,000 on a lawsuit. If the company is not able to cover the cost, then you should only be potentially liable for $10,000 on that suit, due to the protection of the liability limit.
Types of business entities
Below, we’ll dive deeper into each type of business entity and offer insights into the type of company that should work for your needs.
1. Sole proprietorship
Sole proprietorships are a single-person business entity type. This is the default business entity if you begin commerce without registering with the state as a business. There is no limited liability for sole proprietorships. Business taxes are paid on your personal income tax in a process called pass-through taxation.
- Hobbyist-turned-business that sells to a narrow market
- Hyper-local business that relies on immediate surroundings for supply and/or demand
- Occasional or seasonal business that only operates in some parts of the calendar year
- New entrepreneurs testing out if their business is viable on a controlled market
- Simplicity: Once you start selling something, you’re considered a sole proprietor. No registration or paperwork is required. Similarly, if you stop selling your product or service, your business is considered effectively closed.
- Low cost: Sole proprietorships cost nothing in terms of filings, registration, or other paperwork to open and run. The only costs are the cost of goods sold (COGS), labor, and other direct business expenses.
- Low risk: Because starting up as a sole proprietorship is so straightforward and low-cost, it’s less of a risk to experiment with your product or service. You can be innovative with your offering or try to enter new markets.
- Pass-through taxation: You’ll pay small business taxes on your personal income tax filing when you operate as a sole proprietor. Depending on your company’s current size, this can be cheaper than paying tax as a separate business entity. Corporate tax rates are generally much higher than personal income tax rates.
- Greater personal liability: Sole proprietorships offer no limited liability protection, which leaves your personal assets vulnerable if your business encounters liabilities like a lawsuit or an overdue loan repayment.
- Lower growth ceiling: Less formal business structures aren’t designed to support scale. If you’re hoping to grow well beyond what a sole proprietorship can offer, be prepared for the paperwork, money, and time it will take to change business structures down the line.
- No tax benefits: There aren’t any tax detriments to operating as a sole proprietor, but there also aren’t any benefits—if you’re hoping to cash in on business tax perks, a sole proprietorship might not be what you're looking for.
- Keep records: If your sole proprietorship develops into a thriving business and you want to transition into a different business structure to support its growth, the records you have from your sole proprietorship era will help legitimize your new business venture to customers and financial service providers.
- An artisan making custom wooden housewares and selling them on Etsy
- A local in-home pet grooming service
- A farm offering seasonal activities like pick-it-yourself strawberries
- A new consultant developing their client base for the first time
Partnerships are made up of two or more people, are not registered with the state, and do not provide their owners with limited liability. Taxes are paid on your personal income tax via pass-through taxation. There are two types of partnerships: general and limited.
A general partnership splits business operations and profits between all partners, including profits, losses, and debts. In a limited partnership, general partners handle operations. Limited partners are more hands-off but still contribute to and benefit from the company’s profits.
- Hobbyist-turned-business that sells to a narrow market
- Hyper-local business that relies on immediate surroundings for supply and/or demand
- Former coworkers banding together on a new venture
- Family members and/or spouses running a family business together
- Lower financial burden: Most partnerships have multiple partners financially invested in the company (rather than just one of the partners). With this shared investment, you can choose to invest less capital into the company, which in turn can lower your financial risk. Keep in mind that lower financial investments are not always possible.
- Greater collaboration: Having another smart person on your team, especially an individual who is as invested in your company’s success as you are, widens the scope of your vision on important product, workplace, and business decisions, like whether to hire someone or start working on a new product.
- Low risk: Like sole proprietorships, partnerships have a relatively low barrier to entry. Your partnership begins as soon as commerce occurs or if you get anything in writing before commerce. This also means that a partnership is just as simple to dissolve and relatively low-risk to start.
- Shared responsibility: The operations of a business take time and mental energy to experiment with and refine. You may have to make important decisions every day, from defining your company’s cultural values to deciding on a payroll service provider. Having someone else to share the responsibility with allows partners to rest and focus on what’s important.
- Greater personal liability: As with sole proprietorships, partnerships offer no limited liability to business owners. This protection is exclusively offered to LLCs and corporations. Your personal assets can be seized if your business is unable to repay a liability.
- Co-opted liability: In partnerships, you’re liable for any actions taken by your business partner. Be sure to partner with someone you trust to make decisions in everyone’s best interests, both on and off the clock.
- Lower personal income: If your new company is a small business operating informally enough to be a partnership, chances are that your revenue streams are not flowing steadily yet. The result is that you’re splitting razor-thin profit margins between two people. Decide whether a lower personal income is something you can afford.
- Get a lawyer: Partnerships are often conceived from pre-existing relationships, including friends, family, or coworkers. Legal supervision over business agreements sometimes gets skipped. Getting a lawyer to ensure all partners are protected in emergency circumstances isn’t a sign that you distrust your partners; it’s a way to show that you’re prioritizing everyone’s best interests.
- A couple who owns a small, seasonal storefront
- A mother and daughter turn their custom phone case design hobby into an ecommerce store
- An engineer and a sales executive team up to create a better bug tracking system
3. Limited liability company
Limited liability companies (LLCs) are registered with the state government. The business entity is registered by filing forms called articles of organization. There are annual reports and costs associated with maintaining LLCs and your personal assets are protected from business losses by limited liability. The company is taxed on your personal income tax via pass-through taxation.
- Growing companies that are looking to hire their first employees
- Funded businesses ready to open a bank account or accept a business loan
- Sole proprietorship or partnership profiles who want limited liability protection
- Protected personal assets: When you form an LLC, you create a business entity distinct from yourself. This provides your personal assets with limited liability, protecting your bank accounts, boats, cars, homes, or properties from seizure. With limited liability, if your company owes money it can’t pay back, you won’t have to pay out-of-pocket to cover the difference.
- Operational flexibility: LLCs are more structured than sole proprietorships or partnerships, but they still allow you to design your business operations however you would like. Unlike corporations, there aren’t stringent requirements for aspects like a board or certain compliance evidence. You simply write your operating agreement and go for it.
- Flexible taxation: By default, LLCs are taxed as pass-through entities. However, an LLC can also opt to be taxed as an S-corporation, which would allow the business to pay taxes separately from the LLC member(s). This gives you the flexibility to choose the tax filing that is most appropriate for your unique circumstances.
- Member-owned: Members of an LLC are the owners of the LLC, and are typically involved with the company’s day-to-day dealings. This means that everyone who owns the company contributes to its growth. Members will usually have a sense of personal responsibility to support the business’ success, which can lead to a culture of teamwork as well as more successful business outcomes.
- Not as investor-friendly: If you’re interested in raising funding for your business from angels, venture capitalists, or investment firms, LLCs aren’t the right choice. Legally, many investors can’t invest in anything but corporations. Other investors simply don’t like to invest in LLCs because of the structure’s operational flexibility, which makes these companies—and returns on investment—less predictable.
- Don’t rush the paperwork: With all the freedom involved in LLC structures, it can be easy to miss important clauses when drafting your operating agreement. Make sure each founding member runs the contract by lawyers and peers before it’s signed.
- An Amazon merchant hiring their first support representative
- A Shopify seller opening a business bank account
- A local franchisee setting up their new storefront
Corporations are state-registered businesses formed by filing articles of incorporation. There are annual reports, meetings, and costs associated with the maintenance of a corporation, as well as operational requirements such as having a board of directors. Your personal assets are protected from business losses by limited liability. The company is taxed as a distinct entity, so it pays income tax completely separate from its owner.
- LLCs which are outgrowing their current business structure
- Venture capital-funded companies like startups
- Protected personal assets: As with LLCs, a corporation can protect your personal assets from seizure if there is a business liability that the company can’t pay for. This protection isn’t a failsafe but can act as an added layer of protection.
- Greatest corporate power: When your company is registered as an entity, it’s able to take actions independent of you, including opening a business bank account, accepting business loans, suing and being sued, and paying taxes. Your company is also governed by corporate laws which are custom-built to protect businesses. Plus, your personal identity is protected from any lawsuits, e.g. Their Company versus Your Company instead of Their Company versus You Individually.
- Tax benefits: There are corporate tax laws that help corporations benefit from their contributions to the economy in the form of credits. For example, hiring employees for your corporation is considered job creation. The government rewards job creation with tax credits because increased employment is seen as serving the state’s and country’s economic statuses (and reputations).
- Investor-friendly: Investors tend to prefer corporations. Because corporations are highly regulated business structures, they're less volatile than structures like LLCs. This predictability makes it more likely for investors to receive a return on investment. Additionally, some investors are required to invest only in corporations and not other business structures.
- Strict, pricy operations: Corporations need to have a board of directors, annual shareholder meetings, quarterly estimated tax payments, and more. These requirements make for investor-friendly environments but can feel limiting and expensive for entrepreneurs.
- Higher risk: Registering a corporation is a near-permanent decision that requires upfront capital, long-term capital, contracts, and adherence to a long list of operational requirements. These businesses can be harder and more costly to dissolve than other types, which makes starting up a higher financial risk.
- Keep a few backup names: There are millions of businesses in the United States, and it’s best to plan for the worst. Enter the incorporation process armed with a few alternative name options for your company. Better yet, try and make sure your name is very distinct from the start.
- Drop shippers with global and/or high volume clients
- Etsy stores selling controversial products such as marijuana paraphernalia
- Startups funded by angels, venture capitalists, and/or investment firms
Key factors to consider when choosing a business structure
Your business structure impacts its taxation, operations, management, costs, maintenance, and investment viability. Here are some details to keep in mind when deciding which structure to choose.
- Cost: Starting a business always costs money, but some structures cost more than others and have different payoffs. For example, corporations are more costly to start and maintain than sole proprietorships, but have greater growth potential.
- Growth: Sole proprietorships and partnerships are easy to start but have limited growth potential. On the other hand, corporations are hard to start but have huge growth potential. Choose a structure that aligns with your business growth and scale goals.
- Market: Corporations and LLCs are more capable of serving customers across geographies, verticals, and demographics than sole proprietorships and partnerships.
- Your commitment: If you’re running a side hustle with the goal of increasing your pocket money, the tedious paperwork and maintenance of a corporation might be more than you need or realistically want.
On the other hand, if you’re trying to turn your business into a full-time venture, a more complex business structure and the strenuous maintenance schedule that comes with it will be worth it. Consider how much time, effort, money, and mental energy you’re willing to offer your business, and build a strategy from there.
Each business structure supports different goals. As always, be sure to also check in with a lawyer, accountant, and other business professionals for the most personalized advice.