When you’re looking to launch a new venture or take your existing small business to a higher level, it’s important to choose an ownership structure that can support your goals. The main considerations when choosing a structure for your business are simplicity, liability, control, financing, and taxes.
Here are the 10 types of business ownership and classifications:
- Sole proprietorship
- Series LLC
- C corporation
- S corporation
- Nonprofit corporation
- Benefit corporation
Common types of business ownership
The most common forms of business ownership are sole proprietorship, partnership, limited liability partnership, limited liability company (LLC), series LLC, and corporations, which can be taxed as C corporations or S corporations.
In addition, social entrepreneurs can choose from nonprofit corporations as well as benefit corporations and low-profit limited liability companies (L3Cs). States provide different business structures with unique requirements and privileges.
Some states, for example, provide special structures for professional firms such as professional LLCs (PLLCs) and professional corporations (PCs). Before making any decisions about your business structure, you’ll want to investigate the specific laws of your state.
It’s possible to form your business in a state other than your home state where the laws and small business taxes are more advantageous. This is not a simple decision, however, so you would want to do your research and talk to legal and financial advisors before making that call.
1. Sole Proprietorship
Sole proprietorship is the default structure of a business that hasn’t filed any paperwork to create a legal entity. It is the simplest form of business ownership, and the structure of choice for four out of five small business owners with no employees.
Advantages of a sole proprietorship
Sole proprietorship is a simple ownership type with several advantages, including the following:
- Simplicity: In most cases, sole proprietors operating under their own names can simply get to work without filing paperwork with the state. Sole proprietorships may be exempt from certain licensing and registration requirements such as obtaining a business license to sell online. This makes sole proprietorship the simplest and least expensive among the different types of business ownership.
- Control over the business: A sole proprietorship is owned by a single person. There’s no need to get consensus before making decisions about the business: It’s all yours.
- Pass-through taxation: Profits from a sole proprietorship pass through to the owner’s personal income, simplifying taxes significantly. As a pass-through entity, a sole proprietorship qualifies for the 20% qualified business income (QBI) deduction established under the 2017 Tax Cuts and Jobs Act. Tax software can help you ensure that you’re getting all of the tax credits and deductions your business qualifies for.
Disadvantages of a sole proprietorship
Sole proprietorships do have their disadvantages compared to other types of ownership.
- Legal liability: A sole proprietorship passes more than income through to its owner. Legally, the two are inseparable. That means any lawsuits or other claims against the business are launched personally against the owner. As a sole proprietor, you’re putting your personal assets on the line every day that you operate your business.
- Financial risk: In addition to legal risks, sole proprietors take on all financial risk of the business personally. Your home, bank accounts, cars, and other assets can be seized to satisfy claims by creditors if your business hits a rough patch financially.
- Access to funding: Because of their informal structures, sole proprietorships generally have a harder time accessing loans and investment capital than other business ownership types. This can make it difficult to provide competitive benefits such as small business health insurance.
Partnerships, often called general partnerships, are businesses with more than one owner. If you team up on a business venture without forming a legal business entity through the state, your business is a partnership by default.
While they don’t require formation paperwork, there may be limitations on naming a partnership in your state, which may necessitate filing a “doing business as” (DBA) name. Partnerships are usually founded on formal partnership agreements outlining the ownership share, rights, and obligations of each partner.
Partnerships are a popular type of company ownership for professional firms.
Advantages of a partnership
Partnerships provide some notable advantages, including:
- Simplicity: Partnership is a relatively simple structure since it doesn’t require formation paperwork. Depending on the number of partners and the terms of your agreement, they can also be relatively simple to run.
- Pass-through taxation: Partnerships are pass-through entities, with income passing through to partners proportionally based on share of ownership. If your partnership is split evenly down the middle, for example, 50% of the business’s profits would pass through to each partner’s personal income. Partnerships qualify for the 20% QBI deduction.
- Control over the business: Partnerships allow their owners to participate in the business directly and allocate profits and control according to their own wishes. New partners can be brought in relatively easily.
Disadvantages of a partnership
Following are some drawbacks of partnerships:
- Legal liability: Like sole proprietorships, partnerships open the partners up to legal liability for the firm’s operations. Liability insurance can address these risks, but insurance has limits.
- Financial risk: Partners also take on financial liability for the business, putting their personal assets at risk in case of financial hardship or bankruptcy.
3. Limited Liability Partnership (LLP)
An LLP is a legal entity available in some states to provide the simplicity and pass-through taxation of a partnership while limiting liability for the partners. In addition to a formal operating agreement among partners, LLPs generally require registration with the secretary of state.
Where available, they are a popular type of business entity with professionals such as doctors, lawyers, accountants, architects, and engineers.
Advantages of an LLP
LLPs provide their owners with many advantages, including:
- Limited liability: Like an LLC, an LLP is a separate legal entity with its own assets and obligations. This protects partners from personal liability for legal and financial claims against the firm, although the degree of protection varies by state. Generally, the partners’ liability is limited to their investments in the firm. Partners may still be liable for their own personal errors and misconduct, so liability insurance is generally still required.
- Ownership and control: Like partnerships, LLPs allow owners to actively participate in the business and control how it is run.
- Tax options: LLPs may be considered pass-through entities, which can be advantageous for owners, particularly with the 20% QBI deduction. Their tax treatment varies by state, however.
Disadvantages of an LLP
Some limitations of LLPs include:
- Limited availability: LLPs are not available in every state, and they may only be available to certain types of businesses.
- Increased complexity: Because LLPs are treated differently in different states, partners will need to research their state requirements and tax laws thoroughly before choosing this structure.
4. Limited Liability Company (LLC)
An LLC is a legal entity formed by creating an LLC operating agreement and filing articles of organization with the secretary of state. LLCs allow business owners to retain some of the advantages of sole proprietorship while limiting legal and financial liability, making them a popular business ownership structure for small businesses.
When evaluating the advantages of sole proprietorship vs LLC, be sure to weigh all the pluses and minuses.
Advantages of an LLC
Limited liability is one of several benefits provided by an LLC:
- Limited liability: When you form an LLC, you create a separate legal entity with its own assets and obligations. Any legal claims against the business remain against the business, not its owners. Members of an LLC may still be liable for their personal conduct, however, so liability insurance is generally advised.
- Active ownership: LLCs allow ownership by two or more members who can exert as much control and involvement in the business as they like.
- Tax options: LLCs are pass-through entities, which can be advantageous for owners, particularly with the 20% QBI deduction. But LLCs also provide additional flexibility by allowing members to choose to be taxed as a corporation instead (see “corporations,” below). This is generally advantageous to larger firms, but it gives LLCs flexibility as the business grows.
Disadvantages of an LLC
Following are some of the limitations of LLCs:
- Complexity: LLCs must be formed by filing articles of formation with the state. You also have ongoing regulatory paperwork to attend to, including maintaining a registered agent to receive legal documents and filing periodic reports where required with the state. All of this adds up to extra administrative time and complexity.
- Administrative costs: An LLC costs more to create and maintain than a sole proprietorship. State filings generally require fees, and you may need software or support to complete them. You may need extra legal and financial guidance to ensure that you’re getting the most out of your choices as well, which can further add to the costs.
5. Series LLC
Currently available in 18 states and counting, series LLCs are an up-and-coming type of business ownership structure. Basically, they allow one parent LLC to form multiple internal LLCs in subsidiary fashion. These nested LLCs can be used to isolate liability for different business units.
Series LLCs are complex, but worth discussing with your advisors if your business has distinct units that might benefit from individual treatment.
Advantages of a series LLC
Series LLCs provide numerous benefits, including:
- Really limited liability: Each LLC within a series has separate members, assets, and liabilities.
- Active ownership: Series LLCs allow owners to actively participate in the operation of their individual LLCs.
- Tax options: Series LLCs retain the tax advantages and flexibility of traditional LLCs.
- Unified filing: Despite the multiple LLCs, a series LLC is required to register and file taxes just once through the parent LLC. The registrations and returns must encompass all LLCs, however, so they are still more complicated than a single LLC.
Disadvantages of a series LLC
Series LLCs have the following limitations:
- Complexity: Despite the unified filing setup, it’s considerably more complex to manage multiple LLCs with separate assets and owners than a single entity. Taxes in particular are complicated by the series structure.
- Administrative costs: The added administrative burden means additional cost and guidance from professional advisors. In addition, fees may be higher for forming a series LLC.
6. C Corporation
A corporation is owned by shareholders who may have varying levels of control and involvement in the everyday operations of the business. In the case of stock corporations, ownership is issued in shares of stock.
A corporation is formed by filing articles of incorporation with the state. The process of incorporation includes appointing a board of directors to oversee the business and establishing bylaws for its governance.
With governance managed through a board of directors and ownership distributed among shareholders, corporations represent a further degree of separation between the business entity and its owners.
By default, corporations are C corporations, so called because they are taxed under Subchapter C of the Internal Revenue Code (IRC). Unlike sole proprietorships, partnerships, and LLCs, C corporations are not pass-through entities.
Profits belong to the corporation and are subject to corporate income tax. They may also be distributed through dividends to shareholders.
Advantages of a C corporation
With their formal governance and ownership structures, corporations can sustain any level of growth. Generally, the structure becomes advantageous as a business grows larger. Some of the advantages include the following:
- Limited liability: Like an LLC, a corporation is a separate legal entity with assets and liabilities of its own. The liability of its shareholders is generally limited to the amount they have invested in the business.
- Self-employment taxes: Shareholders who work in the business are paid and taxed as employees, sparing them from self-employment tax. Income can be kept in the business as equity and distributed through shares and dividends, providing greater financial flexibility.
- Access to capital: C Corporations can access capital by issuing stock. They can make unlimited stock offers to individuals or businesses, including foreign or domestic investors. They can also issue multiple types of stock.
Disadvantages of a C corporation
Incorporation also has the following drawbacks:
- Regulatory oversight: Corporations are subject to greater scrutiny than LLCs, being required to disclose earnings, governing documents, and other information annually to shareholders and in some cases the public.
- Corporate tax: The profits of C corporations are subject to corporate tax. Shareholders who work in the business and take a salary, as well as shareholders who earn dividends, also pay personal income tax on their earnings. This results in two layers of taxation on the business’s profits.
- Complexity and costs: Corporations are more complex and costly to form and maintain than other business entities.
- Less control: Because ownership is spread among shareholders, and governance among a board of directors, corporations make it harder to exert individual control over the business.
7. S Corporation
Some corporations can enjoy the benefits of pass-through taxation by electing to be taxed as an S corporation. To qualify, the corporation may not have more than 100 shareholders and may issue only one class of stock.
Only individuals, certain estates and trusts, and certain tax-exempt organizations may own shares in an S corporation.
An S corporation is formed through the same steps as a C corporation, with an additional election made through a filing with the Internal Revenue Service.
Advantages of an S corporation
The advantages of an S corporation include:
- Limited liability: Like all corporations, S corporations limit the owners’ personal liability for the business’s debts and legal obligations.
- Access to funding: S corporations can attract investment capital and other funding.
- Pass-through taxation: S corporations qualify for pass-through taxation, which can reduce the tax burden for individual shareholders as well as for the business.
Disadvantages of an S corporation
Some of the drawbacks of S corporations include the following:
- Higher startup costs: Like any corporation, S corporations cost more to start and operate than LLCs and sole proprietorships.
- Increased complexity: S corporations must regularly report earnings and other information to shareholders.
- Limits on ownership: S corporations may be owned only by individuals who are U.S. citizens or residents, and they can issue only one type of stock.
8. Nonprofit Corporation
Most nonprofits are formed as corporations that apply for tax-exempt status under Section 501(c) of the IRC. Their entity formation process is the same as that of other corporations, with articles of incorporation filed with the secretary of state, a board of directors, and bylaws for governance.
Nonprofits may be formed solely for the tax-exempt purposes specified in Section 501(c), however, and they are subject to specific regulatory requirements in each state.
Contrary to popular belief, nonprofits can and should generate profits. The difference between a nonprofit entity and a for-profit entity is how those profits are invested. Rather than being distributed to shareholders, profits are reinvested in the nonprofit’s operations to serve its charitable mission.
Advantages of a nonprofit corporation
Nonprofit corporations provide significant advantages, including:
- Liability protection: Nonprofit corporations provide the same limits on liability as other corporations, protecting you from personal liability for the nonprofit’s operations.
- Tax exemption: Nonprofits may qualify for exemption from federal taxes as well as many state and local taxes. This allows nonprofits to stretch their budgets and apply maximum resources toward their missions. Federal tax exemption is not a blanket exemption from all taxes, however. Nonprofits that achieve federal tax-exempt status generally need to apply separately for exemption from state and local taxes such as sales tax.
Disadvantages of a nonprofit corporation
Some of the limitations of nonprofit corporations include the following:
- Limited activities: Nonprofits must limit their activities to the pursuit of charitable purposes.
- Limited access to funding: Nonprofit organizations rely on grants and charitable contributions to fund their operations.
- Increased regulatory oversight: In addition to the usual duties of corporations, nonprofits have unique registration and reporting requirements to manage at the state and federal levels.
9. Benefit corporation
Benefit corporations are corporations formed to serve a public benefit in addition to the usual corporate mission of earning profits. They are structured like other corporations with a board of directors and bylaws, yet the board is responsible for measuring and reporting on its social impact as well its financial performance.
Benefit corporations are an increasingly popular structure for entrepreneurs who want to do good while doing business.
Advantages of a benefit corporation
Benefit corporations provide the following advantages:
- Limited liability: Like any other corporation, a benefit corporation limits its shareholders’ liability for financial and legal claims.
- Access to funding: Benefit corporations can take advantage of investor capital and revenue from commercial activities to accomplish their social missions.
- Profit distribution: Like other corporations, benefit corporations can distribute profits to shareholders as dividends.
Disadvantages of a benefit corporation
Following are some of the drawbacks of a benefit corporation:
- Varying regulations: Benefit corporations are currently available in 35 states. This from B Lab shows where they are available. Each state has its own rules for what types of social benefits qualify and how they must be measured and reported, which means additional complexity in forming and running the business.
- Increased regulatory oversight: Benefit corporations must meet all of the usual regulatory requirements of corporations plus report on their social and financial impact annually to shareholders.
- Corporate tax: Benefit corporations are subject to federal corporate income tax.
10. Low-Profit Limited Liability Company (L3C)
L3C is a relatively rare business type that combines the legal structure of an LLC with the charitable mission of a nonprofit. An L3C can distribute modest profits to its members, yet this must always be secondary to the primary purpose of furthering a charitable mission.
L3Cs may not be formed for political or legislative purposes.
L3Cs were conceived as an investment vehicle for foundations, which must give 5% of their assets to a charitable program or(PRI) each year. That plan ran into some hurdles with the IRS, however, and the L3C structure has not been widely adopted as a result.
Advantages of an L3C
An L3C offers some advantages:
- Liability protection: L3Cs provide the same limits on liability as LLCs, protecting you from personal liability for the business’s operations.
- Flexible ownership: Members of an L3C can maintain ownership and control and actively participate in the day-to-day operations of the business.
- Pass-through taxation: L3Cs qualify for pass-through taxation.
Disadvantages of an L3C
Following are limitations of an L3C:
- Lack of tax exemption: L3Cs do not qualify for federal tax-exempt status, and are therefore less attractive than incorporation for social enterprises.
- Regulatory uncertainty: Because the IRS has not officially sanctioned L3Cs as PRIs for foundations, their usefulness and longevity are uncertain. They are currently permitted in only nine states.
Choose the best ownership type for your business
As you can see, every business structure poses different benefits and limitations. To find the best option for your situation, you’ll need to answer fundamental questions about your business.
What is your vision for running the company? How big is your business now, and what are your business development plans? What are your corporate and personal tax rates and how do the various options shake out for your bottom line?
What kind of funding do you need? Once you’ve answered those questions, consult with your legal and financial advisors to ensure that you set your business up for long-term success.
View more information: https://www.fool.com/the-blueprint/types-of-business-ownership/