Types of business structures: how to choose the right one for your business

What is a business structure?

By ‘business structure’, we’re talking about the legal structure of a business. The main types of business structures are sole trader, partnership, and company.

Choosing a business structure for your small business affects your admin burden, your business’s taxation, legal status, daily operations, and your personal liability.

Types of business structures

Here’s a comparison of the different types of business ownership.

What is a sole proprietorship?

A sole proprietorship is a single-owner business. It doesn’t have to be a single-worker business, though, so you can hire staff.

Advantages of a sole proprietorship

It’s easy to set up as a sole proprietor and your tax obligations are straightforward – you declare income and expenses on Schedule C of your personal tax return.

Disadvantages of a sole proprietorship

A sole proprietorship doesn’t have any special legal status, so you (if you’re the owner) are personally responsible for what the business does – if the business gets into debt or legal trouble, so do you. Liability insurance is therefore important to mitigate risks.

What is a partnership?

A partnership business structure is a business that’s owned by two or more people. There are no rules on how it’s divided – one partner can own 99% of the business.

Advantages of a partnership

A partnership is easy to set up, although you should have an official operating agreement that sets out the agreement between partners. Your tax obligations are simple, too: the partnership files its tax return, and the items on the return appear in the partners’ personal tax returns.

Disadvantages of a partnership

If the business gets into financial or legal strife, the partners do too. You could also get into difficulty if another partner does something wrong, so proper insurance is essential.

What is an LLC?

An LLC (limited liability company) is legally separate from its owner or owners, which means owners are less exposed to the business’s legal and financial risks. LLCs are governed by state law, therefore requirements and regulations can vary. It's the most common type of new business entity formed today, since it has flexible options for ownership and taxation. LLCs with more than one owner should also have a partnership agreement.

Here’s how to start an LLC.

Advantages of an LLC

You may have some legal and financial protection if things go wrong – a lawyer can give you the lowdown. Tax can be quite simple if you’re taxed as a sole proprietor.

Disadvantages of an LLC

It typically costs more to operate as an LLC than as a sole proprietor or partnership due to state fees and reporting requirements. There will also be more admin, such as filing formation documents or complying with state rules.

What is an ‘S corporation’?

An 'S corporation' (S corp) is not a business structure, but a tax designation. It’s an LLC or corporation that is taxed as a “pass-through” entity, meaning the S corp does not pay tax on profits (and losses) but passes them directly to shareholders who report them on their individual tax returns and then pay personal taxes on this income. S corps are limited to 100 shareholders and all must be U.S. citizens or residents.

Advantages of an S corporation

One reason to form an S corp is to avoid double taxation. Because an S corp passes its income (or losses) to its shareholders, it typically doesn’t pay corporate taxes. And since an S corp is a tax designation applied to a corporation or LLC, the underlying legal entity provides some legal and financial protection if things go wrong – a lawyer can advise you.

Disadvantages of an S corporation

The legal side of incorporation and IRS compliance can get quite complex, and there’s plenty of admin and paperwork to do.

What is a ‘C corporation’?

A ‘C corporation’ (C corp) is a legal entity that is separate from its owner or owners. Unlike an S corp, a C corp is taxed at the corporate level instead of being “passed-through” to shareholders. This results in double taxation because profits are taxed when the company pays income taxes and when shareholders receive dividends.

Advantages of a C corporation

C corps can benefit from the separation between owners or shareholders and management. Shareholders can invest in the company without managing it, while management can run the company efficiently without needing shareholder approval. C corps can also raise capital more easily through sale of stock.

Disadvantages of a C corporation

Double taxation can make C corps expensive depending on how profits are managed and distributed. The requirement to keep detailed records and hold annual meetings also adds admin time and costs.

The risks of not choosing a business structure

If you don’t formally choose a structure for your business, you may face:

1. Unlimited personal liability: Your personal assets – such as your home or savings – could be seized to satisfy business debts or legal judgments. Here’s more about personal liability.
2. Tax implications: Your personal income and business income will be treated as the same, so you might pay more tax than you need to.
3. Difficulty raising capital: Potential investors and bank lenders might be discouraged if you don’t have a formal business structure.
4. Limited growth potential: Have visions of expanding? To make significantly higher sales? Your scope may be limited without the right business structure.

What happens if you don’t choose: default business structures

If you start a business and don’t choose a business structure, your business will default to a sole proprietorship (or a general partnership if there are multiple owners). This means you're personally liable for all debts and obligations of the business, and your personal assets could be at risk.

Choose the right business structure for your small business

Here are the things to think about when choosing between the various business entity types.

Understand your liability risks

Think about what it means to be responsible for your business’s debt. You need to balance the risk of personal responsibility with other factors. An example is the ‘sole proprietorship vs LLC’ decision: while sole proprietors are exposed to more financial risk, an LLC comes with disadvantages like higher costs and more admin.

Consider your control and decision-making preferences

How many people will be running the business? Will you want to grow your leadership team and number of owners? For instance, when you’re weighing up the benefits of a corporation against those of a partnership, think about how you’d like to distribute power and responsibility.

Work out your funding needs

Even the smallest businesses need cash to get started. Corporations can issue shares, making it easier to raise capital, while other business types (such as sole proprietorship) may struggle to secure large loans. If you don’t need much funding, it may come down to a choice between an LLC or sole proprietorship.

Plan for future growth

Flexibility is the key to meeting the evolving needs of your business. Maybe you’ll want to sell it one day? Or maybe it’ll diversify or double in size? Your choice of structure must give you room to develop, so compare the different legal structures for businesses – for instance, corporations let you transfer ownership and manage growth more easily.

Can you change your business structure?

Yes – you’re not locked into one structure. Many businesses start out as sole traders or partnerships and grow into companies. You might change your business structure if the business grows and you take on more complex projects with more financial or legal risk.

Simplify your business finances with Xero

Choosing the right entity for your business is just the start of building your company.

Xero software streamlines your financial admin so every step of the process is faster – whether it’s sending invoices, managing cash flow, or creating customized reports.

Automatic calculations always put the latest numbers at your fingertips, while Xero’s cloud-based platform means everything you need is in one secure, accessible place. Less admin means more time for the rest of your business. That’s why small businesses love Xero.