The 5 Main Types of Business Ownership Structures
Starting a business involves many important decisions. One key choice entrepreneurs need to make early on is selecting the right legal structure for their new venture.
The business structure you choose impacts many factors – from day-to-day operations, to taxes, to how much of your personal assets are at risk.
Here we’ll compare and contrast the 5 primary options for structuring a business in the United States. Carefully considering the pros and cons of each will help you pick the one that best fits your enterprise.
1. Sole Proprietorship
The simplest structure for a small business is a sole proprietorship. This is when an individual launches a company and serves as the sole owner and operator.
Sole proprietors have complete control over their business. All profits earned flow directly to the owner, minus taxes. The business itself does not pay income tax; instead, the owner reports business profits or losses on their personal tax return.
A major downside is that the owner has unlimited personal liability for all debts and obligations related to the business. Their personal and business assets are one and the same. If the business runs into legal trouble or goes bankrupt, the owner’s home, car, and other possessions are all up for grabs by creditors.
Sole proprietors also take on tremendous risk because they’re solely responsible for the company’s success or failure. They must handle every aspect of operations on their own or contract out help. It can be daunting for one person to acquire expertise in so many areas like marketing, accounting, HR, etc.
Still, if you wish to maintain complete control over your business and keep things simple, a sole proprietorship may be right for you. It’s the easiest and cheapest structure to set up – you can just start conducting business under your own name. Minimal paperwork is required.
2. General Partnership
If you prefer to share ownership responsibilities with someone, you can establish a partnership. This involves two or more people going into business together.
There are two types of partnerships: general and limited. In a general partnership, each partner has an equal say in running the business and shares control. Partners split any profits and losses evenly. They also have unlimited personal liability for the business’s debts and legal issues.
Forming a partnership is easy and inexpensive. You simply register your business name and get a tax ID. A written partnership agreement isn’t legally required but is strongly recommended to avoid disputes. This document specifies each partner’s contributions, responsibilities, share of ownership, decision authority, and other terms.
Sharing ownership can help partners acquire capital and expertise. But personal conflicts can arise if partners have disagreements on how to operate the company. There’s also risk because each partner is financially responsible for the other’s bad decisions. Partners with unlimited liability exposure may take on more debt than they can handle.
So while partnerships do allow for divided responsibilities, they also require compromising, coordination, and complex interpersonal dynamics. Ensure you fully trust your prospective partner before linking your financial futures together.
3. Limited Partnership
A limited partnership structure adds a layer of personal protection over a general partnership. This arrangement contains one or more general partners who run the company and assume unlimited liability. But there are also one or more limited partners who simply invest money into the business and have limited legal and financial exposure.
Limited partners enjoy liability limited to their investment amount – even if the business fails or can’t cover its debts. They earn income from profitable operations but typically don’t participate in day-to-day management.
Meanwhile, general partners oversee operations and decision-making. They face unlimited personal responsibility for the company’s liabilities.
Forming a limited partnership is more complex than a general one. It requires filing a certificate with your state and drafting a formal partnership agreement. But it provides a way for non-managing partners to invest in the venture without taking on excessive financial risk.
4. Limited Liability Company (LLC)
A newer type of entity, the limited liability company (LLC) has grown hugely popular in recent decades. LLCs attract entrepreneurs because they combine desirable aspects of partnerships, corporations, and sole proprietorships.
Like a corporation, an LLC shields its owners from personal responsibility for the business’s debts and legal liabilities. The only money you can lose is the amount you invest in the LLC.
An LLC offers the management flexibility of a partnership. Member-owners divide up responsibilities, voting rights, and profit shares according to custom terms they establish. Day-to-day operations can be structured informally without extensive record-keeping and protocols.
Forming an LLC involves more paperwork than a sole proprietorship or general partnership. You must file articles of organization with your state and have an operating agreement. But LLC operating rules are flexible and requirements are simpler than for corporations.
For many small business owners, the liability protection benefit of an LLC outweighs the moderately more complex setup. LLCs also have certain tax advantages over corporations.
5. S Corporation
Finally, some businesses choose to incorporate as a standard C corporation or specialized S corporation. These are separate legal entities from their owners. Therefore, corporation shareholders aren’t personally liable for business debts.
Corporations can raise investment funds by selling stock shares in the company. They can have shareholders who simply invest in the company but don’t actively manage things. Corporations also continue to exist perpetually even as individual shareholders come and go.
But corporations require extensive record-keeping and must adhere to stricter regulations. There are numerous corporate formalities related to appointing director boards, shareholder voting, annual meetings, reporting requirements, etc. There are also double taxation issues – the corporation pays income taxes on profits, and then shareholders pay income taxes on dividends.
An S corporation offers some tax advantages not available for standard C corporations. But S corporations can only have a limited number of shareholders and certain shareholder restrictions apply.
For most small businesses, forming a corporation is overkill. Corporations become more useful once your company seeks outside investors and plans to eventually go public.
The ideal business structure depends on your goals, risk tolerance, and desired level of managerial control versus personal liability protection. Discuss options with your financial and legal advisors to determine the best entity type for your business at its current stage.
The Decline of Sole Proprietorships
Global data shows that sole proprietorships are decreasing in popularity. According to the World Bank, sole proprietorships made up 75% of American businesses in the 1980s. That number has since dropped to around 70% as of 2022. High liability exposure is deterring entrepreneurs from choosing this business structure.
The Rising Popularity of LLCs
Limited liability companies (LLCs) have exploded in popularity over the last 10 years. LLC filings in the US have increased by over 55% since 2010. Canada has seen a similar trend, with LLC annual growth around 10% in most provinces. LLC limits personal liability for owners, unlike sole proprietorships and partnerships. This advantage has fueled LLC demand.
Corporations Face Strict Regulations
Large corporations must adhere to complex regulations that vary globally. These strict requirements have caused small business owners to avoid the corporate structure. For example, corporations in China face over 30 regulatory procedures annually on average, the most worldwide. Many view corporations as burdensome compared to other structures like LLCs.
Reference:
https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
https://web.archive.org/web/20190709032528/https://www.ldoceonline.com/dictionary/business
https://www.doingbusiness.org/en/data/exploretopics/entrepreneurship
https://www.worldbank.org/en/publication/gfdr/gfdr-2016/background/trends-in-business-ownership
https://www.fundera.com/blog/sole-proprietorship-statistics
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