People usually don’t think of a side gig or an occasional contracting job as a real business. But they are. They are usually sole proprietorships. In the previous blog entry, we went over the four most popular types of business structures: the sole proprietorship, the partnership, the LLC, and the corporation. Now, we’ll help you pick the best form of business structure for your small business.
Of course, the best legal structure for your business is not always the best legal structure for someone else’s business. Picking the best form of business structure depends on factors like the type of business you intend to run, whether you expect to have co-owners, your ambitions for expanding your business, and so forth.
So, let’s look at the factors more closely and see which legal structure is the best for your business.
Go With a Sole Proprietorship If You’re the Only Owner and the Business Is Not Likely to be Sued
Go with a sole proprietorship if:
- You’re just starting the business
- Don’t want to invest too much of your own money at this point
- Expect to have very little business liability
- Do not expect to have investors
- Want an uncomplicated way to pay taxes
- Do not expect to hire employees any time soon or plan to use contractors
What are the Pros and Cons of a Sole Proprietorship?
The sole proprietorship is the easiest type of business entity to form. All you have to do is to start doing business as yourself or under a trade name, and you’ve started a sole proprietorship.
Paying taxes is very easy for a sole proprietor. Once you start to make money, you’ll have to pay your taxes every quarter, and then make a final report on your personal tax return at the end of the year. You can use software such as QuickBooks Self Employed to calculate your quarterly taxes, so you don’t over or under pay.
The biggest negative of doing business as a sole proprietor is that your entire life savings are exposed to liability if someone sues you based on your business dealings.
How to Decide if You Should Do Business as a Sole Proprietor
To decide whether or not to go with a sole proprietorship, think about your expected business liability. This includes any debt the business might incur. It also includes liability from a product you made or for accidents like getting into a car crash when you’re making a delivery.
With some businesses, the liability is fairly small. For instance, if you make handcrafted journals and sell them on Etsy, it’s pretty unlikely that you’ll hurt someone with your journal. On the other hand, you might be an Uber driver who works 12 hour days, seven days a week. Then, the odds of you getting into a car accident is pretty high. So, whether or not you run your business as a sole proprietorship depends on the type of business you plan to run.
If you’re just starting out but expect to have some business liability, seriously consider forming an LLC instead.
If You and a Friend Want to Go into Business Together, You Can Start a Partnership, but This Is Not Always the Best Form of Business Structure
Go with a partnership if you:
- Want to start a business quickly with one or more persons
- The business is expected to have few liabilities (or liability that you can’t waive, like a lawyer’s professional liability)
- The pass-through tax structure is important to you
- Understand that default partnership laws can be difficult to work with or you are willing to pay a lawyer to draft a detailed partnership agreement to override the default laws
- You trust that your partner won’t agree to a business deal that could create liability for the partnership without talking to you first (because the law will hold you responsible for it)
What are the Pros and Cons of a Partnership?
In the US, partnerships are easy to form—it can be as simple as a handshake. Default laws govern how the partners work together. But these default laws are often not the most convenient. So, people tend to use partnership agreements to override the default laws.
It is best to get a lawyer to draft your partnership agreement. Note, though, if you’re already paying a lawyer, they can help you with other business formats that might suit your needs better.
One of the biggest drawbacks of a partnership is that you are personally responsible for the liabilities of the partnership. This means that, if the partnership cannot repay a debt and you’re the only partner who has the money, you end up having to pay all the debt.
The biggest advantage of a partnership is its pass-through tax structure. The partnership doesn’t pay income tax. Instead, the profits are divided up amongst the partners, and the partners pay their own income taxes individually.
How to Decide if You Should Do Business as a Partnership
It’s very tempting to start a business as a partnership if you’re working with a couple of good friends. However, disagreements inevitably arise. Without a formal partnership agreement, both the partnership and the friendship might end badly.
Mostly, professionals like lawyers and accountants tend to form partnerships. Even then, these professionals often use hybrid formats like the PLLC or the LLP, both of which limit liability better.
Our advice is to stay away from partnerships if you’re a small business. Partnerships have their uses, but mostly by larger businesses. If you want to go into business with friends or investors, think about going with an LLC or a corporation instead.
An LLC Is Often the Best Form of Business Structure if You Run a Small Business by Yourself or with a Few Others
Go with an LLC if you:
- Run the business yourself or with just a few active or passive investors
- Wish to have a simplified pass-through tax structure (not all LLCs qualify)
- Wish to limit your business liability
- Are willing to spend some money to set up the LLC (with or without the help of a lawyer)
- Do not expect to do business internationally
What are the Pros and Cons of an LLC?
The limited liability company (LLC) is a relatively new business format. It is best suited for a single or a small group of owners operating a small business.
Like the sole proprietorship and the partnership, owners of the LLC can often pay their income taxes using their individual tax returns. Superior to the sole proprietorship and the partnership, the LLC can insulate its owners from business liability.
One of the cons of an LLC is that you have to treat the LLC as a “person” separate from yourself (and all other owners). You’ll have to be careful to keep the LLC’s assets separate from your personal assets and keep good company records.
The LLC is a little bit more expensive to set up and maintain. The filing fees to form an LLC can cost a few hundred dollars. The LLC might also have additional taxes to pay, depending on the state where you formed the LLC.
How to Decide if You Should do Business as an LLC
The LLC might be the right business format for you if you need to limit business liability or if you have co-owners to the business.
Sometimes, providing a perfectly innocent service or selling a perfectly innocent product can create business liability. After all, if you accidentally switched the sugar and salt amounts in the chocolate cookies you sell, you might have a lot of angry customers who want to be compensated. In that case, it’s better to know that the LLC can insulate you a little bit from that liability.
If you have investors or co-owners, the LLC is a better business format than the partnership. You can have an unlimited number of owners (called members) to the LLC. This gives you a lot of flexibility for adding investors. If an investor wants to exit, you can also remove members of an LLC fairly easily.
The Corporation Is the Most Well-Accepted Form of Business Structure Around the World That Limits Liability and Allows Easy Transfer of Ownership
Go with a corporation if you:
- Expect to have investors who plan to exit the business after a period of time
- Want to limit your business liability
- Have ambitions to expand domestically, internationally, or both
- Do not mind putting in a few thousand dollars to set up the entity
- Do not mind spending time to keep up with corporate records (including meeting minutes) and financial records
What are the Pros and Cons of a Corporation?
Most businesses will probably eventually graduate to a corporation. One major advantage of the corporation is that there is a robust set of laws around the world governing the obligations and liabilities of corporations. The laws create certainty on what you can and cannot do, and most businesses like certainty.
Another advantage is that it’s very easy to transfer all or part of the ownership of a corporation just by selling the corporation’s stock. So, if you expect to have investors—especially investors who wish to exit after a set amount of time—it might make sense to simply start out as a corporation.
The corporation is a little complicated and pricey to set up and maintain. This is why it’s probably not the best business format for novice business owners.
One of the most important reasons for setting up a corporation is the corporation’s ability to shield business liability from its owners (called shareholders). To keep up this shield, you have to keep good corporate records (including annual shareholder minutes) and not mingle corporate funds with your personal funds. Depending on how much help you have to run your business, this could be a pro or a con.
How to Decide if You Should do Business as a Corporation
If you run a small business and want to limit your business liability, you’re basically picking between an LLC or a corporation.
If you plan to remain small or have just a few owners, you’re probably better off as an LLC. However, if you have big ambitions to grow and maybe attract investors like venture capitalist firms, you should seriously consider starting off as a corporation. The corporation will be more complicated to set up and maintain. But the big investors will probably require it.
The Best Form of Business Structure for Your Business Can Change as You Grow, so Make the Best Decision for Now and Focus on Building Your Business Instead
At the end of the day, the best form of business structure for you depends on the type of business you intend to run, how many investors you expect to have, and how much money you can invest initially. As long as you pay attention to business liability and tax structure, it’s not too hard to pick the best business format for your business.
As your business grows, you may outgrow the form of business structure you started out as. The best example of this is going from a sole proprietorship to an LLC or a corporation. Sometimes, as your business expands into new areas, you might form a partnership with another business. Your LLC or corporation can even own other LLCs or corporations.
As a small business just starting out, you don’t need to worry about all this. Consult with a lawyer and an accountant if a business opportunity that needs a more complex business structure ever comes up. You can pick the format best for taxes and limitation of liability at that time.
Right now, just focus on building the best business you can build, and you’ll be alright.
Next Steps for Starting a Business:
The next step in starting a business is to settle on a name for your business.
But, our next blog entry is actually on the concept of limitation of liability. This is such an important concept that I want you to have a real gut feel for it. The blog entry is designed for those of you who are new to running a business. If you’ve been running businesses for many years, it might be too basic for you.
Moving on to naming your business, whether you’ve decided on a sole proprietorship or corporation, you’ll need to put down a business name for various document filings with the government. So let’s look at how to find a great name for your business.
DISCLAIMER: This article does not constitute legal advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer. Only lawyers properly licensed in your state/country are qualified to give you legal advice.
Questions? Comments?
