Guide to Structuring Your Business
Whether you are starting a business or simply growing, it’s a good time to consider and reevaluate whether your business is operating under the best legal structure. But let’s start with the basics.
Note: Because your business structure can have major impacts on your financial and legal situation, it is very important to discuss with a lawyer and tax professional.
What is a business structure?
A business structure is the particular form, recognized by the law, in which a business operates.
The most common examples are sole proprietorships, partnerships, LLCs, S corporations, and C corporations. What’s the difference between these? The main distinction is whether it is a formal entity or not.
The basic idea is that if you start doing any business activity on your own, but you don’t form an “entity,” you are a business without a formal entity. There are two types of informal business structures: sole proprietorship and general partnership. If you are the only owner of the business and you haven’t formed an entity, you are automatically a sole proprietor or sole proprietorship. If you start doing any business activity with one or more others, but you don’t form an entity, you are automatically a “general partnership.”
1. Structuring your business as a “non entity”
If you don’t form an entity, you are generally considered either a sole proprietorship or general partnership.
What is a sole proprietorship?
A sole proprietorship simply is the name given to a business that is operated by an individual person who has not formed an “entity.” Sometimes people refer to this situation as a “DBA,” but this is not quite accurate. A DBA is not a business structure, although many sole proprietorships need to obtain a DBA (however, many do NOT).
In this business form, your personal assets (such as house, car, etc) are subject to be taken if the business cannot meet its financial obligations.
What is a general partnership?
A general partnership is simply the designation of a business that is operated by more than one “person” (which can mean either a human or a legal entity), and which has not formed its own “entity.”
In this business form, the personal assets (such as house, car, etc) of each of the partners are subject to be taken if the business cannot meet its financial obligations.
Sometimes people refer to this situation as a “DBA,” but this is not quite accurate. A DBA is not a business structure, although many general partnerships need to obtain a DBA (however, many do NOT).
For tax purposes, the partnership itself is not taxed, but each owner is taxed individually in proportion to their share of the assets.
2. Structuring Your Business as an Entity
So what exactly is a business entity?
A business entity is generally distinguished from “non entities” of a sole proprietorship (for sole owner) or partnership (for multiple owners). Business entities comes in various forms, depending on whether you are a solo owner or there are multiple owners. These are generally “limited liability” entities, meaning that they limit the liability of the owners so that only the business assets (not the owners’ personal assets) are to be used in case the business cannot meet its financial obligations. See more on limited liability, below.
Once created, these have a “life of their own” and are a separate thing from the owners, though the owners control and carry out activities of the entity. Here are the main forms.
Formal structures for solo owners:
- Corporation (S corporation or C corporation)
- Limited liability company (LLC)
Formal structures for multiple owners:
- Corporation (S corporation or C corporation)
- Limited liability company (LLC)
- Limited partnership (LP) – only the “limited partners” have limited liability, while the “general partner” does not have limited liability
- Limited liability partnership (LLP) – generally only for certain professionals such as architects, lawyers, etc.
What is an LLC?
“LLC” stands for Limited Liability Company. This is a proper business entity, created by filing a document usually called “Articles of Organization” (varies by state) with the state department that handles business issues (usually called the state Secretary of State). It is similar to a corporation, but (usually) somewhat simpler to form and operate, with (usually) less paperwork necessary.
An LLC is usually taxed the same as a partnership, however it can also choose to be taxed as an “S corp” or “C corp.”
What is a corporation?
A corporation is a proper business entity, created by filing a document usually called “Articles of Incorporation” with the state department which handles business issues (usually the state Secretary of State). Compared to an LLC, it is (usually) a bit more complex to form and operate with (usually) more paperwork required.
For tax purposes, the default is that a corporation is considered a “C Corporation,” but the corporation can also choose to be taxed as an “S corporation.” As a C Corporation, the corporation itself is taxed on its earnings, and then when the income of the corporation is passed to the owners of the corporation, the owners are taxed as individuals. This situation is known as “double taxation.”
What is an “S corporation”?
An “S corp” or “S corporation” is simply a corporation that has filed paperwork to be taxed only through the owners, and not the entity itself. This avoids the “double taxation” of C corporations. This is often a way to save on taxes, but discuss with a tax professional for your particular situation. See our Guide to S Corporations for more.
3. Choosing a Business Structure
Which business structure is best for my business?
Though it may seem confusing, it can generally be boiled down to 2 questions:
1. How much taxes will you pay under each structure? This will depend on your unique circumstances. With an LLC or corporation (probably S corp), you may be able to pay less in taxes (particularly self-employment taxes) than under a partnership or sole proprietorship. Or you may end up paying a bit more, but it could be worth it to secure asset protection (see #2, below). You should definitely talk to a qualified tax professional (such as an accountant) about this.
2. If your taxes will increase with an LLC or corporation, are you willing to pay extra in order to protect your personal assets from business debts and obligations? If your taxes will be the same or will decrease by forming an LLC or corporation, it’s pretty much a no-brainer to set up one of those structures.
But even if your taxes will increase, you may still want to do either an LLC or corporation because under either of these structures you will be able to protect or shield your personal assets from the debts or obligations (including lawsuits) of the business. This is known as “limited liability.” See more, below.
If you aren’t willing to pay more for this asset protection, you will probably want to stick with a sole proprietorship (if an individual) or a general partnership (if 2 or more business owners).
Can I change the business structure?
Yes, you can change your business structure, but the process varies by state. Sometimes it is quite simple, other times it is highly complex.
4. Limited Liability
What is limited liability?
When it comes to a business structure, limited liability generally refers to shielding the personal assets of the business owners from business obligations. In other words, if a limited liability business is sued, and the business must make some sort of payout, the payout would be limited to the amount of money the business has. Any money or assets that the business owners have as individuals (such as in a personal bank account) would generally not be subject to the lawsuit.
Can a business lose limited liability?
Yes! If an LLC or corporation does not follow the proper formalities and paperwork, it can lose its liability shield for its owners. In particular, LLCs and corporations must have a separate business bank account, otherwise the owners risk losing their limited liability.
See more at our Legal Guide to Business Banking.
5. Pass Through Taxes
What is “pass through” taxation or a pass-through entity?
“Pass through” tax treatment simply means the business income is not taxed at the company level, but passes through to the owners of the business. Each owner is then taxed according to their share of the business.
The following by default have pass-through taxation: Sole proprietorships, partnerships, LLCs, S corporation.
6. Privacy and Disclosure of Business Owners and Other Info
Can I use a mailbox service or virtual address for my business?
Many home-based businesses use a mailbox service or other mailing address in order to not have to disclose where the business owner lives. A business generally may use a physical mailbox service (e.g. UPS Store) or virtual mailbox service for many business purposes, including the public address it shares with clients and customers. However, banks and some government agencies require a physical address where the business actually operates or where the business owner(s) live.
Banks will not disclose this information to the public, but some governments do make this information publicly available. Be sure to check with each institution on what their rules are.
Do I have to disclose who are the owners of my business?
In most states, you are not required to disclose to the public who are the owners of an entity, including corporation or LLC. However, under a new federal law, the Corporate Transparency Act, most new companies will be required to disclose this information to the federal government, particularly the Financial Crime Enforcement Network (FinCEN). This information would not be available to the general public.
What is a shell corporation?
The term “shell corporation” is not a legal term, but usually refers to a company that is set up for the express purpose of hiding its activities and connections to individuals and other companies. It is often used to launder or hide money that is derived from illegal activities.
7. Other structural issues
What is a subsidiary?
A subsidiary is a business that is owned by another “parent” company (for example, Alphabet is the parent company of Google). It is mainly used to separate different product lines for accounting and legal protection. For example, if you want to prevent any legal or financial risks of one product from affecting another product.
What is a franchise?
A franchise is generally when a business licenses its business model to independent operators. Usually the franchisor does not own the franchises, but will exert certain standards to ensure that the reputation of the business is protected. Franchise structures are frequently found in the fast food restaurant industry.
For help with your business structure, contact a business lawyer.
For more information specific to the state of California, see our Guide to California Business Structures.