Considerations when choosing a business structure

September 26, 2023 | 13 minute read

Choosing the right business structure is critical for all types of businesses. It is very important to understand the available options because the selected business structure will affect the business owner’s tax and legal liability, the paperwork they have to tackle every year and their ability to raise outside funds.

 

What is a business structure or business entity?

A business structure, sometimes known as a business entity, refers to the form in which a business is established or maintained. The type of business entity used may impact how the owners of the business are taxed and the potential liabilities they may face under the laws of the state in which the business operates.

 

A business owner may need to set up a separate business entity to open a business bank account, get a business credit card or apply for a small business loan.

 

Why is it important to pick the right business structure?

There are many reasons it is essential to select the right business entity.

 

  • Taxes. The type of business entity selected will determine whether the business owner is subject to one or two levels of tax and the tax rate to which the business income will be subject.
  • Protection of personal assets. Certain business structures may protect the owner’s personal assets up to their investment if there is a lawsuit or other liability.
  • Ability to secure funding. If the business owner wishes to raise funds, they may need to set up a business entity that can issue stock or other equity.
  • Separate credit score. Setting up a separate business entity can help the business owner establish credit for the business that is separate from the business owner’s personal credit.
  • Paperwork. Certain business entities will require filings with governmental authorities, such as annual reports.
  • Registration. If the business owner wants to register the business in their state for tax or legal reasons, they may need to set up a business entity.

 

Types of business structures

There are many types of business entities available to small businesses and startups. Here is an overview that may be helpful.

 

Sole proprietorship

When a person starts a business and does not select a business structure, in many jurisdictions the business will be a sole proprietorship by default. As the name implies, sole proprietorships are owned by one person. They report income, gain, loss, deductions, etc. of the business and pay taxes with respect to the business as part of their individual income tax return. At tax time, they generally must file Schedule SE with Form 1040 if their income from self-employment is $400 or more. Sole proprietorships are popular among freelancers, such as writers and designers, tutors and childcare professionals.

Pros
  • This is generally the easiest form of business to start. Setting one up is inexpensive, and usually, license fees and business taxes are the only associated costs. Generally, there is minimal or no paperwork to file, and minimal or no special regulations and rules apply.
  • Taxpayers who are self-employed may be able to take advantage of certain tax deductions, such as health insurance premium deductions; the Small Business Health Care Tax Credit, which provides a credit for up to 50% of certain healthcare premiums paid for any employees; and the self-employment tax deduction, which permits deduction of half of Social Security and Medicare taxes.
  • It is also relatively easy to terminate a sole proprietorship. Depending on the jurisdiction, the owner may need to notify the secretary of state, local tax authorities and any licensing entities who have issued the business license.
Cons
  • The owner is personally responsible for the company's debts and liabilities, which puts their personal assets, such as their home, at risk. When the owner dies, the business becomes part of their estate.

Partnership

If a person starts a business with one or several other people and all the partners have personal liability for the debts of the partnership, that is considered a general partnership. A general partnership, designed for situations where one or more partners are actively involved in the business, is generally the easiest type of partnership to start and maintain.

 

If someone invests in the business but doesn't want personal liability beyond that investment, a limited partnership can be formed instead of a general partnership. The investor could be a limited partner. This type of partnership is more complicated to form and maintain than a general partnership because of the administrative complexities and required filings. Both general and limited partnerships feature pass-through taxation, which means that the partnership itself generally is not subject to tax, but each partner must include their share of partnership income, gain, loss, deductions, etc., on their own tax returns via Schedule K-1 to Form 1040. The cost of maintaining a partnership may generally be higher than that of maintaining a sole proprietorship because of the fees associated with creating a partnership agreement and other filings with the state that may be required.

Pros
  • Generally, partnerships are easy to set up because little or no paperwork filing is required (depending on the type of partnership and the jurisdiction), and the partnership may be able to continue if one of the partners retires or dies.
  • Beyond this, a partnership may potentially have improved access to loans because the partnership would be drawing on the personal credit and collateral of more than one partner. And there is a potential tax benefit from partnerships because partners report their share of income or losses on their individual tax returns, creating one level of taxation.
Cons
  • The general partners are personally liable for the company's debts and liabilities. (However, the limited partner's responsibility is typically limited to their investment in the business.)

Learn more: What’s needed to apply for a bank account as a limited partnership or general partnership

Limited liability company (LLC)

A limited liability company (LLC) is a type of business entity whereby the members of the company generally are not held personally liable for the company's debts or liabilities (beyond the members’ investment in the LLC). LLCs are generally hybrid entities that combine the asset protection characteristics of a corporation with the tax characteristics of a partnership or sole proprietorship. The costs of setting up an LLC may vary, depending on whether outside help is used. The state filing fee may range from $50 to several hundred dollars or more. Online LLC formation services will charge additional fees, though these fees typically cover additional activities required to set up the business. Hiring an attorney will often cost more than $1,000.

Pros
  • An LLC offers some benefits of the corporate structure, such as protecting the business owner’s personal assets, but is generally easier to set up. This form of business offers more flexibility in how profits are distributed, compared to S and C corporations.
  • Depending on state law, there are generally no restrictions on how many members the business can have. Some state laws may not require LLCs to have annual meetings or a board of directors, which makes them relatively easy to maintain.
Cons
  • An LLC may not offer liability protection if the business owner does not keep their business and personal finances separate. Members of LLCs generally must pay self-employment taxes along with income and other taxes.

Learn more: What’s needed to apply for a bank account as an LLC

Cooperative

A cooperative is a member-owned structure that is designed to meet the social, economic and cultural needs of those who belong to it. Common types of co-ops include housing co-ops, credit unions, retail co-ops and consumer co-ops. They are typically made up of at least five members.

Pros
  • A co-op is a separate legal entity from its members, and members, employees and directors are generally not personally liable for its debts. Co-ops are generally egalitarian: All members get equal voting rights, no matter how many shares they own.
Cons
  • Because co-ops depend on cooperation, they can struggle to make decisions if members don’t see eye to eye.

Corporations

C corporation

A C corporation is a separate legal entity from its owners, and it generally protects the owners from personal liability. Instead of pass-through taxation, the business may be subject to double taxation since the C corporation is subject to tax and its shareholders may be subject to tax on distributions from the C corporation. An LLC may in certain circumstances elect to be treated as a C corporation for tax purposes.

Pros
  • In some ways, a C corporation enjoys the greatest flexibility of any business structure. A shareholder can often more easily transfer shares of the C corporation to their beneficiaries, which may help in estate planning, and there's generally no limit on the number of owners, unlike S corporations or partnerships that elect to be taxed as an S corporation, which have a limit of 100 shareholders.
  • If a business owner has big plans for their business, a C corporation may, initially or at some later time, be a viable option since it can sell shares to more than 100 investors. In fact, if a business owner plans to go public someday, they may have to incorporate as a C corporation either when established or at a later time.
Cons
  • The flexibility of a C corporation often comes with the costs of processes and fees. C corporations file state paperwork and pay fees upon incorporation and every year thereafter.
  • A C corporation also must have a board of directors, hold annual meetings of shareholders and file annual reports with the state and other governmental regulators.

Learn more: What’s needed to apply for a bank account as a corporation

 

S corporation

Forming an S corporation or electing for an LLC to be taxed as an S corporation may help a business owner save on self-employment taxes. An S corporation generally cannot have more than 100 shareholders, must have only one class of stock and can only have U.S. residents and certain trusts as shareholders.

Pros
  • Any distributions the S corporation makes to an individual shareholder are generally not subject to payroll taxes, such as Social Security, Medicare and unemployment. This can bring a savings of as much as 14.13% a year (assuming that 40% of income is paid as salary since a reasonable salary must be paid to a shareholder or employee).
  • The earnings of an S corporation generally may be taxed only once, at the shareholder level; by comparison, in a C corporation, the earnings generally are taxed twice — when the corporation is taxed and when earnings are distributed to shareholders.
  • An S corporation also may shield shareholders from the debts of a corporation.
Cons
  • The number and types of owners are more limited for S corporations as compared with many other types of entities.
  • S corporations often must pay taxes if they sell or distribute to any shareholders any assets that have appreciated in value before the conversion to an S corporation. And S corporation shareholders who directly or indirectly own more than 2% of the stock in the S corporation (at any time during the year) or who own stock with more than 2% voting power in the S corporation are generally not eligible for certain tax-advantaged benefits, such as company-paid health insurance.
  • These benefits are generally treated as Form W-2 wages for federal tax purposes.

B corporation

A benefit corporation or B corporation is a business entity that has two purposes: turning a profit — like a for-profit corporation — and promoting the public good, like a nonprofit. The directors of a B corporation are responsible for reporting how they are supporting the public good to their shareholders.

Pros
  • A B corporation allows the shareholders to do well by doing good, generating profits while contributing to society.
  • The purpose-driven nature of a B corporation can help in building a strong culture that attracts employees and customers who believe in its mission.
Cons
  • B corporations are not available in every state.

Closed corporation

A closed corporation, also known as a privately held company, is one with a small number of shareholders, who are typically managers, owners and families closely associated with a business.

Pros

  • Businesses that structure themselves as a closed corporation gain the liability protection that comes with a corporate structure. Because these corporations are not publicly traded, they offer flexibility that publicly traded companies do not have, without the same reporting requirements to shareholders.
Cons
  • It may be harder to raise funds in a closed corporation than in a publicly traded one because they cannot sell shares to the public.
  • Since a closed corporation is not publicly traded, if a shareholder wants to cash out, they generally must sell the shares to the remaining shareholders. This can pose a challenge if those shareholders are not ready or willing to buy them out.

Open corporation

This is a type of corporation that sells its shares on a public stock exchange, such as the New York Stock Exchange or the NYSE American (formerly the American Exchange). Some open corporations sell their shares through private, over-the-counter transactions. Generally, small businesses are not structured as open corporations, but if a small startup scales up, it may aim to become a publicly traded corporation one day.

Pros
  • The ability to raise funds from the public on a large scale makes open corporations attractive to small companies with a big vision for growth. Because the shares are publicly traded, shareholders have a lot of liquidity.
Cons
  • There are steep compliance and reporting requirements for open corporations. The leaders of an open corporation have to answer to the shareholders, meaning they have less autonomy than in a closed corporation.

Nonprofit

A nonprofit organization is a structure for organizations whose purpose is promoting social causes or advocating for a group that needs help. A nonprofit organization may be eligible for tax-exempt status under section 501 of the Internal Revenue Code. It is different from a nongovernmental organization (NGO), which has a similar purpose but operates outside of the borders of the U.S.

Pros
  • Nonprofits do not have the pressure to turn a profit that small businesses do. The tax exemptions that may come with nonprofit status generally make them less costly to run.
Cons
  • While laws governing nonprofit corporations vary from state to state, a nonprofit generally cannot be owned by its founders and cannot be sold. If it is dissolved, it must give its assets to another like-minded nonprofit organization. Nonprofits also face considerable public scrutiny from those who want to make sure they are living up to their purpose.
  • Even if an entity has tax-exempt status, annual IRS as well as state reporting requirements may apply depending on the entity’s annual gross receipts.

Choosing the right business structure

Clearly, there's a lot to consider when an aspiring business owner is choosing a form of business. You'll need to think ahead and choose a business structure that can grow with your business, or consider whether you should change your business structure as you grow. This is a big decision that can greatly affect your business, and you should consult with a qualified attorney as well as a qualified tax advisor to choose the best business structure for your needs and goals. As you make your decision, consider factors such as flexibility, complexity, liability protection, implications for your taxes, and permits and licensing requirements.

 

Once you’re ready to get started and have identified the best structure for your business, third-party providers specializing in business formation can help streamline the process and get you the documentation you need, depending on the business structure you choose.

 

To learn more about the steps to launch a new business, including how to form your business with an exclusive offer from Incfile, visit The Bank of America Start a Business Center.

Back to Homepage

Explore more

Why and how to keep your personal and business finances separate

    

How your business structure can affect your taxes

    

Important Disclosures and Information

Bank of America does not deliver and is not responsible for the products, services or performance of Incfile. You are responsible for separately purchasing Incfile’s products or services. Bank of America and/or its affiliates or service providers may receive compensation from third parties for clients' use of their services. Internet access may be required. Internet service provider fees may apply.

 

Bank of America, Merrill, their affiliates and advisors do not provide legal, tax or accounting advice. Consult your own legal and/or tax advisors before making any financial decisions. Any informational materials provided are for your discussion or review purposes only. The content on the Center for Business Empowerment (including, without limitations, third party and any Bank of America content) is provided “as is” and carries no express or implied warranties, or promise or guaranty of success. Bank of America does not warrant or guarantee the accuracy, reliability, completeness, usefulness, non-infringement of intellectual property rights, or quality of any content, regardless of who originates that content, and disclaims the same to the extent allowable by law. All third party trademarks, service marks, trade names and logos referenced in this material are the property of their respective owners. Bank of America does not deliver and is not responsible for the products, services or performance of any third party.

 

Not all materials on the Center for Business Empowerment will be available in Spanish.

 

Certain links may direct you away from Bank of America to unaffiliated sites. Bank of America has not been involved in the preparation of the content supplied at unaffiliated sites and does not guarantee or assume any responsibility for their content. When you visit these sites, you are agreeing to all of their terms of use, including their privacy and security policies.

 

Credit cards, credit lines and loans are subject to credit approval and creditworthiness. Some restrictions may apply.

 

Merrill Lynch, Pierce, Fenner & Smith Incorporated (also referred to as “MLPF&S" or “Merrill") makes available certain investment products sponsored, managed, distributed or provided by companies that are affiliates of Bank of America Corporation (“BofA Corp."). MLPF&S is a registered broker-dealer, registered investment adviser, Member SIPC, and a wholly owned subsidiary of BofA Corp.

 

Banking products are provided by Bank of America, N.A., and affiliated banks, Members FDIC, and wholly owned subsidiaries of BofA Corp.

 

“Bank of America” and “BofA Securities” are the marketing names used by the Global Banking and Global Markets division of Bank of America Corporation. Lending, derivatives, other commercial banking activities, and trading in certain financial instruments are performed globally by banking affiliates of Bank of America Corporation, including Bank of America, N.A., Member FDIC. Trading in securities and financial instruments, and strategic advisory, and other investment banking activities, are performed globally by investment banking affiliates of Bank of America Corporation (“Investment Banking Affiliates”), including, in the United States, BofA Securities, Inc., which is a registered broker-dealer and Member of SIPC, and, in other jurisdictions, by locally registered entities. BofA Securities, Inc. is a registered futures commission merchant with the CFTC and a member of the NFA.

 

Investment products:

 

Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value