Choosing the right business structure

Accountant & Bookkeeper Guides

8 min read

Sometimes businesses outgrow themselves. They take on more partners or bigger projects, with more risk. Suddenly the old business structure doesn’t give enough protection to the owners. Don’t forget to check that your clients are set up in the best way possible.

What is a business structure?

Whether you’re speaking to a first-time startup, an old client with a new venture, or an established business, it pays to think about business structure. There are six types, offering different levels of:

  • legal protection

  • administrative simplicity

  • tax exposure

The choice your client makes will affect their rights and responsibilities. Their options are to be a:

  • Sole proprietor

  • Partnership

  • Limited Liability Company (LLC)

  • Limited Liability Partnership (LLP)

  • S-Corporation

  • C-Corporation

Business structure can change

The first impulse for many small businesses is to opt for sole proprietorship or partnership. These simple structures will serve them well initially and, for many, it’s all they'll ever need. But business structure is a bit like insurance. You should review it regularly because you can get caught out if the nature of the business changes substantially.

If a business starts doing higher-stakes work – where failure could lead to expensive lawsuits – they’ll want more protection.

Simplicity versus protection

Generally speaking, the simplest business structures provide the least protection for owners. People choose these structures because there’s less administration and taxes are straightforward. But those business owners are personally liable if the business gets into legal or financial difficulty.

As the business grows, those risks may become untenable. And obviously some types of businesses deal with big legal and financial risks from day one. It’s important to set up a structure that protects the owners. However, as the level of protection grows, so too do the administrative and tax obligations.

Business structure is a bit like insurance. You should review it regularly because you can get caught out if the nature of the business changes substantially.

1. Sole proprietorship

A simple, flexible business structure with few formal requirements.

In a nutshell:

  • Owned and operated by one individual.

  • If the owner has no employees, they don’t need a federal permit.

  • If the owner hires employees or contractors, they’ll need a federal Employer Identification Number.

Tax requirements:  

  • The business doesn’t pay tax directly on income.

  • Income is reported on the owner’s Schedule C (Form 1040).  

Liabilities:

  • Unlimited liability – the owner is accountable for the business’s debts and legal issues.

More than 70 percent of American businesses fall into this camp. State and local governments may require licenses or registrations for certain business types, but there are no federal requirements – other than tax.

Pros:

  • Easy to set up and manage, with very few regulatory requirements.

  • “Pass-through” taxation, where income is simply declared on the owner’s return.

Cons:

  • Owners can be personally liable for any wrongdoing by the business.

  • Owners are personally responsible for all debt incurred by the business.

2. Partnership

Set up for two or more owners, partnerships have relatively few formal requirements. The partners needn’t have an equal share of profits or responsibilities.

In a nutshell:

  • The business is shared by two or more owners.

  • It requires a partnership agreement document that defines the business arrangement.

Tax requirements:

  • The business doesn’t pay tax on income.

  • Income is reported on each partner’s individual tax return (Schedule K-1, Form 1065).

Liabilities:

  • Joint liability – partners are accountable for the business’s debts and legal issues. They are also responsible for the other partner’s malpractice or negligence.

Like sole proprietorships, partnerships are generally easy to set up and manage. But they have a few more requirements.

Partnership agreement

A cornerstone of the partnership – and any business entity involving more than one person – is a partnership agreement document that includes the details of the business arrangement. A partnership agreement should include:

  • the ownership percentages of each member of the partnership

  • which person is the primary business officer

  • what investment has been made by each partner

  • how the partnership can be ended

  • details on how bookkeeping and finances will be managed

  • how salaries or withdrawals of funds will be managed

  • how disputes will be resolved

Partners are not protected from litigation under this business structure. If the partnership is sued for $250,000 but only has $150,000 in assets, the partners must cover the remainder. Homes, cars and other personal assets can be lost as a result.

Types of partnership

You can set up two different sorts of partnership.

  1. General partnership
    Profits are shared proportionately and everyone has the same legal position.
  2. Limited partnership
    At least one “general partner” controls the partnership and carries most of the liability. Limited partners have less control and are less liable for litigation or debts of the business.

Pros:

  • They’re simple to manage, with only slightly more regulatory and reporting requirements than sole proprietorships.

  • “Pass-through” taxation, where income is simply declared on the partners’ returns.

Cons:

  • Partners are generally liable for debts and litigation.

  • All partners can be affected if one of them has ineffective tax strategies.

  • It can be complicated to end the partnership.

  • The partnership must file a 1065 and each partner must also file a Schedule K-1 (Form 1065).

3. Limited liability company (LLC)

LLCs are a flexible business structure that can be treated as a sole proprietorship or partnership, depending on the number of shareholders.

In a nutshell:

  • Exists as a separate legal entity.

  • Number of owners can vary – one owner can still be an LLC.

  • Perceived as more credible by some institutions, including lenders.

Tax requirements:

  • The business doesn’t pay tax on income.

  • Income is reported on each owner’s individual tax return:

    • Schedule C for one owner

    • Schedule K-1 for multiple partners

Liabilities:

  • Limited liability – owners are not necessarily held accountable for business debts or legal issues.

With its combined benefits of simplified taxation and reduced liability, LLC is a popular business structure with enterprises of all sizes – from sole proprietorships to multinational companies.

The IRS doesn’t recognize LLCs so, for tax purposes, they can be treated as a sole-proprietorship, partnership or corporation.

Pros:

  • “Pass-through” taxation, where income is simply declared on the owner's, partners’ or shareholders’ returns.

  • Owners, partners or shareholders get some protection from the business’s liabilities.

Cons:

  • More expensive to set up and maintain.

  • Profits are subject to social security and Medicare taxes.

  • Employees who receive fringe benefits – like group insurance, medical insurance and parking – must treat these benefits as taxable income.

4. Limited liability partnership (LLP)

Partners in an LLP are generally not held accountable for another partner’s professional malpractice or negligence. For that reason, LLP business structures are popular with lawyers, doctors, architects and accounting firms (including the “Big 4”).

In a nutshell:

  • Exists as a separate legal entity.

  • Partners are usually required to be licensed in their field.

Tax requirements:

  • Income is reported on each owner’s individual tax return (Schedule K1, Form 1065).

  • Some states apply a franchise tax.

Liabilities:

  • Limited liability – owners are generally not held accountable for the business’s liabilities.

  • Some states require there to be one “general partner” with unlimited liability.

  • Some states require liability or malpractice insurance.

LLPs offer the same benefits and drawbacks as LLCs, but with more protection against malpractice and negligence. 

Pros:

  • “Pass-through” taxation, where income is simply declared on the partners’ returns.

  • More access to business credit.

  • Some protection from the business’s liabilities.

Cons:

  • Requires the formation of a legal entity in the state in which it’s located or does business.

  • Requires a formal structure including articles of organization.

5. S-Corporations

S-Corporations are formal business entities with legal requirements and increased protection for shareholders. This business structure has simple “pass-through” tax obligations but can’t have more than 100 shareholders, nor can they be sold to another business.

In a nutshell:

  • Exists as a separate legal entity.

  • Must be registered with state and federal agencies.

  • Owned by private shareholders.

  • Run by board of directors.

  • Must file annual reports.

Tax requirements and reporting:

  • Income reported on each shareholder’s individual tax return.

  • Salaries reported on W-2.

  • Profit distributions of shareholders reported on Schedule K1.

Liabilities:

  • Limited liability – shareholders not held accountable for the business’s debts and legal issues.

Pros:

  • There is no liability for shareholders for the actions or debts of the corporation.

  • “Pass-through” taxation, where income is simply declared on shareholder returns.

Cons:

  • More formal and complex than LLCs, LLPs or sole proprietorships.

  • Unable to “go public” and can’t be bought by another business.

6. C-Corporations

C-Corporations are formal business entities with legal requirements and increased protection for shareholders. C-Corporations pay taxes on business income and can be publicly floated.

In a nutshell:

  • Exists as a separate legal entity.

  • Must be registered with state and federal agencies.

  • Owned by public or private shareholders.

  • Run by a board of directors.

  • Must file annual reports.

Tax requirements and reporting:

  • The business pays taxes on its income – reported on Form 1120.

  • Salaries are reported on W-2.

  • Profit distributions to shareholders are reported on Form 1099-DIV. Shareholders must then declare this income and may be taxed on it.

Liabilities:

  • Limited liability – shareholders are not held accountable for the business’s debts and legal issues.

Pros:

  • There is no liability for shareholders for the actions or debts of the corporation.

  • The business can be publicly listed or sold to another business.

Cons:

  • More formal and complex than LLCs, LLPs or sole proprietorships.

  • Business income is taxed and dividends paid to shareholders may also be taxed.

Help your clients succeed by choosing the right business structure

No matter how big or small your clients are, choosing the right business structure is a key decision. The right structure can affect their tax obligations, ability to raise finance, personal tax liability and even relationships.

Whatever your choice might be, don’t forget to review the structure every few years and make sure it’s still appropriate.