Businesses come in many shapes and forms.
Whether its a small landscaping company or an expansive technical service company, all businesses fall into their various categories that are tethered to specific sets of rules and regulations.
As you nurture your dream into a profitable business you will have to make many decisions.
Deciding which business entity is best for you will be one of the more important ones.
In this article, we’ll present the basic pros and cons of each type of structure so you can make the best possible decision for your business.
However, please keep in mind that you should always follow up with a lawyer should you have any concerns about your business or what type of entity you should choose.
The Legal Importance of Your Business Entity
As you form your business, it’s a good idea to take time to formally structure your business.
The type of entity you select will bring about rules for how you and your business will be taxed, distribute profits, collect investments, and dissolve.
Most importantly, it will establish how liable you will be as a business owner in the event of a business-related lawsuit.
Businesses that are never formally structured into LLCs or other business types will default to either sole proprietorships or partnerships (as explained below).
Although it’s easy to continue doing business without any formal structuring, these two business types offer very little protection in the event something goes wrong with your business.
For example, if a sole proprietorship is sued due to an accident or faulty product, the owner will be jointly liable for any losses incurred by the lawsuit.
Put another way, there is no legal distinction between the owners and the business for sole proprietorships and partnerships, meaning that you’ll be on the hook for any liability issues that may arise in the course of running your business.
For this reason, there are two very important decisions you need to make as you continue to grow your business:
- When do I want to formally structure my business?
- Which business structure do I want to commit to?
We’ll provide the information you need to consider these questions below, but keep in mind that choosing the right time and type the first time will save you a great deal of money and work in the long run.
Sure, you may choose to restructure your business if you aren’t satisfied with its current structure, but that can have unintended consequences.
Some states and localities have additional restrictions when it comes to restructuring and you may be forced to dissolve your business in order to reform it as the right structure.
Similarly, if you don’t fully understand the characteristics of the business structure you’re choosing for your company, you might run into legal trouble and fines.
Each entity has its own special rules on everything from taxes to management. Ignorance to these rules can come back to bite you.
So take the time to read up on each type, run through questions with your lawyer, and start your business on the right foot.
The first type of business entity we’re going to discuss is the sole proprietorship.
As previously mentioned, businesses with no formal structure default to sole proprietorships if owned by one person or partnerships if owned by two people.
The only real requirement to become a sole proprietorship is that you must have sold a product or service at least once.
This structure holds you as the center of the business, and does not create a separate legal entity.
Meaning, all your assets are connected to the business with no legal shield in-between.
As you might imagine, this can have a very serious effect on your finances if your business incurs debts or losses.
Sole proprietorships, as well as partnerships, LLCs, and S corporations, are considered “pass through entities.”
These entities allow the income to flow through the business untaxed before it is taxed at the personal rate of the business owner.
Due to the vulnerability inherent in them, sole proprietorships are not a good idea for more risky business ventures. Should the business fail after a lot of personal investment, you will feel all of those losses.
However, straightforward and low-risk businesses may find use for this structure as it is incredibly easy to form and pretty straightforward to manage.
If you run your own power washing business and most of your capital infrastructure (your truck, trailer, power washer, and equipment) is paid off, then a sole-proprietorship makes sense.
However, if you are starting a brewery with expensive equipment, rent for a large brick and mortar location, and a decent amount of loans, a sole proprietorship will not provide the protection you need.
Regardless, sole proprietorships can provide a quick and simple entity for you to test your business idea before taking it in full gear.
For example, the owner of the brewery may envision their brewery being anchored by some excellent barbecue to go along with their creative brews.
As a sole proprietorship they might test out these recipes on a small scale in their community, and if successful build hype for the eventual brewery.
- No government setup fees or costs.
- Pass-through entity means few tax complications.
- Not restricted by formal business structures and rules.
- Easy record-keeping and bookkeeping.
- Full personal liability should something go wrong.
- No access to business loans or other means of raising money.
- Seen as unprofessional for anything larger than a business working out of a personal garage.
If you and one or more other people are running a business together, you may structure your business as a partnership.
This is a good option for professional groups with multiple owners, like a law firm.
Additionally, this business structure is also a good fit for those who would like to test out their business idea before using a more formal structure (as with the sole proprietorships above).
There are a few different types of partnerships, each with varying risks and benefits:
- General Partnerships — General partnerships are essentially sole proprietorships that are expanded to cover two or more owners. All of the information about sole proprietorships listed above applies to general partnerships as well. As such, all of the partners are jointly liable if anything goes wrong with the business.
- Limited Partnerships — Limited partnerships are like general partnerships, but with an added layer of liability protection. In a limited partnership there are essentially two “levels” of partner: general partners and limited partners. In most cases the general partner position remains the same as in the bullet point above, while the limited partners take a more hands-off role. Limited partners do not manage everyday operations and their assets are not connected to the business in the same way the general partners’ are. This is a common situation in cases where a limited partner would like to be financially invested in the business without taking on any responsibility or liability in the business itself.
- Limited Liability Partnerships — In a limited liability partnership, each interested partner takes on an equal role in the business without placing their own assets at risk due to their partners’ mistakes. Think of a limited liability partnership as a collection of sole proprietors that share resources. Each individual partner may still be sued if they are acting unlawfully or negligent in their role, but the assets of the other partners are protected from the damage the guilty partner brings. This type of partnership is popular for professionals who come together to form a single cohesive business, such as a law firm or a medical practice.
While this isn’t a complete list of every partnership variation, these are the most common you’ll find in Virginia.
- All the pros of a sole proprietorship.
- Access to additional capital through shared financial responsibilities.
- Division of labor can lead to specialization.
- Generally informal arrangements.
- Lower percentage of the overall profit.
- Liability for the actions of your partners.
- Chance for conflict with your partners.
Limited Liability Companies (LLCs)
An LLC offers a great middle ground for businesses that are too complex to be a sole proprietorship or partnership, but still novel or small enough that full incorporation doesn’t quite make sense.
An LLC is made up of “members” who collectively own the LLC.
The members have the flexibility to decide how they will make decisions and divide responsibilities and the freedom to alter this as their business progresses.
The result is a business structure that protects the assets of its members from lawsuits and debts while remaining highly customizable and adaptable.
For this reason, LLCs are the most common type of business in Virginia, as well as the structure that most attorneys will recommend for new and growing businesses.
Additionally LLCs usually adopt one of two main management formats: member-managed or manager-managed.
These decisions along with many of the other important decisions members make are advised to be recorded in an operating agreement.
- Members aren’t personally liable for the actions of the company.
- Pass-through federal taxation on profits.
- Inherently flexible structure that best suits businesses with less than a few hundred employees.
- Easy to start and maintain with limited administrative costs.
- There are limits to your limited liability, such as in the case of piercing the corporate veil.
- You have to pay a self-employment tax.
Corporations are good business structures for larger businesses, often with many employees.
Of course other businesses may find their structure useful.
Tightly held family businesses sometimes turn to corporations while young, ambitious companies often benefit from the ability to raise capital by selling shares.
Regardless of the type of business, every corporation receives a high amount of protection from the business’s liabilities.
The corporation is an entirely separate legal entity that owns the business. The corporation is in turn owned by its shareholders who elect a board to oversee the corporation.
Often this board appoints officers to manage the affairs of the business for the corporation.
As you can see, the shareholders are well insulated from liability of the business in this format.
Due to this structure of leadership, corporations often require meticulous bookkeeping.
Meetings are held regularly, the meeting minutes are recorded and archived, and voting happens in a well-established system with archived results.
These formalities are required when a business forms a corporation, and can be time-consuming and more expensive to do well.
To form a corporation, a business must adopt bylaws, issues shares of stocks to the owners, hold a meeting to create the board and then appoint officers, as well as hammer out all the details for how the corporation will function.
There are two types of corporations, both named after the tax code they are tethered to:
- C Corporation — C corporations are what most think of when they imagine a standard corporation. These corporations are allowed to issue shares and issue various classes of shares (for example, preferred and regular stock of a company). These corporations also must pay taxes at two separate stages. First the corporation pays taxes on its income, and then the shareholders must pay taxes on the income they receive from the corporation. These conditions are largely what separate a C Corporation from an S Corporation.
- S Corporation — S corporations vary from C corporations in that they act as “pass-through” entities. The income that the corporation receives isn’t taxed, but the shareholders who receive this income must pay taxes on this income. However, the requirements to become an S Corporation are tighter than those for a C Corporation. For example, the business cannot have more than 100 shareholders, and all of them must be U.S. citizens. The corporation must also only issue one class of stock. These problems, among others, can lead to problems in acquiring financing, so S Corporations are often a careful balance between the tax benefits and additional restrictions placed on them by their structure.
Finally, note that corporations are often incredibly complex affairs, and in most cases an LLC would be the preferable structure over incorporation.
- Strong liability protections.
- Flexible income and salary options.
- Easy financing through the sale of stock and other methods.
- Expensive to set up and maintain due to legal requirements and reporting costs.
- Double taxation leads to income tax at the personal and business levels.
Co-ops are democratically run businesses. They are usually defined by the “one member, one vote” rule that guides their meetings and elections.
The members all jointly own the co-op and generally form the co-op to accomplish a common goal or uphold a common ideal.
The profits are distributed to the members, but interestingly enough, the members are usually all customers of the co-op.
What emerges is a community based business that serves more to provide services to the members and the community it resides in rather than to turn a profit.
Co-ops are commonly associated with common good projects like providing environmentally sustainable food at affordable costs while trying to preserve fair payment for the farmers and food producers who contributed.
Oftentimes these businesses will also provide education and voluntary service to the community.
Membership to the co-op is often open and voluntary, but can require a contribution to the co-op to prevent a free-rider issue from occurring.
However, even in such cases, membership is not needed to use the service.
- Lower costs when compared to the individual business costs of each collective member.
- Invested employees and community lead to a captured audience.
- Reduced liability proportional to your ownership of the business.
- Tax advantages and access to business grants.
- Legal restrictions based on the specific city or county you’re operating in.
- Not as profitable as other business structures.
- Funding challenges due to the inherently local interest of the business.
An important part of starting or growing a business is deciding what type of structure you want to operate your business under.
The most common solution is to register the business as an LLC due to the variety of tax and liability advantages such a structure provides.
However, while LLCs are usually the best option, there are certainly cases where another structure would work better.
Of course this looks different for various types of businesses.
If you have any questions or concerns regarding your small business, get in contact with a lawyer. Their guidance can prevent the penalties and restrictions that can come with restructuring or forming incorrectly.