How to Structure a Small Business
Small business operations make up the majority of businesses in the United States. In July 2022 alone, there were 425,698 new business applications across the United States. With so many entrepreneurs launching new ventures daily and the rate of failure at over 50% in the first five years after formation, business owners should carefully choose the best structure for their small business. Prepare to grow your business by understanding how to structure a small business first.
How to Structure a Small Business
The structure that a small business owner chooses when launching a new business will affect taxes, their ability to raise money, the paperwork, administrative requirements, and personal liability. Considering these elements will guide an entrepreneur's choice of the best structure for their goals and individual concerns.
Before registering a new business with the state, business owners must choose a structure. A tax ID is needed, and the owner will be responsible for obtaining appropriate licenses and permits according to their industry and state requirements. Consulting with business coaches, tax professionals, and lawyers is advisable. While it is sometimes possible to change the business structure later, the process can have costly consequences, and there may be restrictions. Avoid the risk and consult with trusted professionals when choosing a business structure.
What is Business Structure?
Business structure is the organizational category of a business that impacts its legal and tax obligations. The structure of a business affects daily operations, the ability to obtain funding, the tax treatment, and the owner's liability. Decision-making regarding business operations depends on the number of owners and the business structure type. A business's operational details are typically outlined in what is known as Articles of Organization or Articles of Incorporation, depending on the structure type.
When deciding how to structure a small business, owners should understand how that choice will impact future operations and ensure the chosen structure aligns with their business goals.
Business Structure Types
Before choosing a business structure, business owners should understand the basics of different business structure types. The main business structure types are sole proprietorships, partnerships, LLCs (Limited Liability Companies), corporations, and cooperatives. These categories can be broken down into further sub-categories as well. Some structure types are more popular than others.
Sole Proprietorships: A sole proprietorship is the simplest structure for solo business owners. Sole proprietorships are the default structure if the owner does not register as any other kind of business with the state. In this structure, the assets and liabilities of the business are the same as those of the owner. In other words, there is no separate business entity. However, sole proprietorships are still able to get a trade name, otherwise known as a DBA ("doing business as"), by registering the name with the state. Sole proprietorships are simple structures that are often attractive for small business owners. Tax is collected on the owner's personal return; there is no separate corporate tax. The main disadvantage of this structure is the total liability of the owner. Should the business face issues, the owner is held liable, and personal assets such as their savings, home, etc., could be at risk.
Partnerships: A partnership is the simplest structure for two or more people starting a business together. Tax treatment in partnerships is the same as with sole proprietorships, i.e., passed through directly to the partner's tax returns. The operating agreement should make clear each partner's share of profits and losses in the business. Partnerships can either be set up as Limited Partnerships (LPs) or Limited Liability Partnerships (LLPs). In LPs, one owner maintains unlimited liability while the others have limited liability - and usually limited control, depending on agreements. In LLPs, every owner in the partnership has limited liability.
LLCs: LLCs are the most popular business structure in the United States. An LLC can have one or multiple owners, usually referred to as members. While still fairly simple to set up, they allow the protection of the members in the form of limited liability. An LLC creates a business entity that is separate from its members. Another benefit of LLCs is that there is some flexibility in tax treatment. By default, single-member LLCs receive the same tax treatment as sole proprietors, while multiple-member LLCs are taxed the same as partnerships. However, by filing form 8832 with the IRS, LLCs can elect to be treated and taxed as corporations. Many types of LLCs are discussed in more detail below.
Corporations: Corporations, or C Corps, provide the most protection for their owners. The cost to form a corporation is usually higher and requires more record-keeping and reporting. Income taxes must be paid on profits at the corporate level and again on dividends paid to shareholders. The main advantage of a corporation is the power to raise capital through stock sales. Starting a business as a corporation is often a good idea for business owners who plan to take their company public or later sell. Other types of corporations include S Corps, B Corps, Close Corps, and Nonprofit Corps.
S Corps allow for some profits and losses to be passed through directly to the owner's personal income taxes, thus avoiding double-taxation. Owners of corporations must file with the IRS to get S Corp status. There are more limitations and eligibility requirements to achieve this status.
B Corps are driven by profit and mission. They are taxed the same as C Corps but differ in purpose, accountability, and transparency. Shareholders hold the company accountable for providing some public benefit.
Close Corps resemble B Corps but usually have a less traditional corporate structure. They can be run without a board of directors by small groups of shareholders. Rules and regulations may vary by state, but these corporation types are usually barred from public trading.
Nonprofit Corps provide charity, education, religious, literary, or scientific work. Also referred to as 501(c)3 corps, these types of corporations can receive a tax-exempt status due to the public benefit they provide. Nonprofit corps must follow the organizational rules of C Corps and additionally follow rules about the distribution of profits.
Cooperatives: A less common business structure is cooperatives. In this structure, the organization is owned by and operated for the benefit of those using its services. User-owners receive the distribution of profits based on their shares. New members can easily join a cooperative by purchasing shares. Cooperatives are usually run by a board of directors, while all regular members have voting power toward the direction of activities. The number of shares does not influence voting power.
Because there are so many business structure types and the consequences for choosing the wrong one are so high, business owners should consult with a business coach before embarking on their new venture to have the highest chances of success.
Different Types of LLCs
Many different types of LLCs exist for various purposes. Some common types include single-member LLCs, multi-member LLCs, Series LLCs, L3Cs, Foreign LLCs, PLLCs, Restricted LLCs, and Anonymous LLCs. Regulations and restrictions vary according to state, and some types of LLCs are not allowed in certain states.
Single-Member LLCs: In single-member LLCs, the owner is solely responsible for the company and any taxes or debts owed. Although there is the implication of limited liability, there is some risk of being held accountable should issues arise. The member-owner can help reduce this risk by stating in the operating agreement that the owner and the LLC are separate entities.
Multi-Member LLCs: With multi-member LLCs, they can choose to either be member-managed or manager-managed. Owners run operations in member-managed LLCs, and each owner is authorized to act on behalf of the business. Manager-managed LLCs appoint a member or outside manager to manage the company on behalf of the other members. Appointing a manager is typical when passive members such as investors are involved.
Series LLC: A series LLC acts as an umbrella or parent LLC that controls smaller subsidiary LLCs. The "cells" within the series LLC are each separate entities within the parent and are independent and protected from each other. Setting up a series LLC is quicker and easier than setting up multiple LLCs, as there is only one filing fee for the parent LLC. However, each cell is taxed separately. Not all states permit series LLCs.
L3C: L3Cs are low-profit LLCs. There is value put on purpose as well as profit. The benefit of purpose makes L3Cs attractive to philanthropic contributions and private investments. Marketing strategies are similar to those of non-profit corporations, and positive press is a benefit of this structure. The challenge with L3Cs is that because profit is involved, donations are not tax-deductible, which is a big driving force for many donors.
Foreign LLC: A foreign LLC is formed in one state but does business in another. Doing business in another state can increase profits and allow the company to take advantage of advantageous laws and taxes. Each state has different rules, but the owners will be required to file taxes and Articles of Organization in each state in which they operate.
PLLC: A PLLC, or professional LLC, is for professionals who require board-regulated licenses to operate. PLLCs are common in medical professions as members receive protection from the malpractice of other members. Rules and regulations vary by state, and not all states allow PLLCs.
Restricted LLC: A restricted LLC is restricted from the liquidation of assets for at least ten years after formation. Members cannot receive business distributions during the waiting period. As a result, they also cannot be taxed during this time. Currently, Nevada is the only state that allows restricted LLCs.
Anonymous LLC: The purpose of an anonymous LLC is to keep the member's private information hidden from the public. Anonymity is not guaranteed in the case of a court subpoena. Only a few states currently allow anonymous LLCs.
Choosing a Business Structure
When choosing a business structure, business owners should consider their long-term goals. With an understanding of the various business structure types, business owners can assess the level of business protection they desire and their ideal federal tax treatment. The type of business they are starting, level of control desired, and end goals can direct an owner to the best business structure for them. However, with so many elements to consider, both legally and organizationally, it is essential for entrepreneurs to consult with a business coach before choosing a business structure and registering with the state.
Business coaches and advisors, lawyers, and tax professionals understand the process of starting a new business and can help entrepreneurs set themselves up for the best chances of success. Particularly for new business owners with the desire to grow their business, they should turn to professional help in clarifying their goals and the steps needed to reach them.
What Business Structure is Best for You?
If your business idea is a seed, then the business structure you choose is the soil in which you plant it. Coachwell's experienced business coaches have the expertise to help you choose the best business structure for your business idea. Set yourself up for success with Coachwell's holistic approach to business growth. Contact Coachwell today and get started on the right track for your business!
