Different Types of Business Ownership and How to Choose the Right One
The legal structure of your new business might seem like a minor detail, but it can have a major impact on how your company runs and what your day-to-day operations are like. To protect yourself and your assets, it's important to know the different types of business ownership so you can understand your options and choose the setup that works for you.
You automatically become a sole proprietorship when you start operating a business solo, without filing any paperwork. As a sole proprietor, you own the business and are responsible for any debts and other obligations.
Although they're relatively simple, sole proprietorships tend to expose business owners to higher risk than other types of business ownership. For example, if a sole proprietorship fails, owners typically have to file for personal bankruptcy rather than business bankruptcy. Banks also tend to view sole proprietors as self-employed, which may make it tougher to qualify for financing. Depending on your situation, other structures may give you more options for growth down the line.
When you and at least one other person begin operating a business without forming a legal entity, its default status is a partnership. In this scenario, you're subject to what's called joint and several liability. This means you're responsible not only for all your debts and liabilities and those of the business, but also for those of your partners in their business-related activities. You may be able to reduce your risk through formal agreements with insurance requirements.
A limited partnership is different. This setup has one general partner who assumes primary liability. Then, there are limited partners who have limited liability and don't participate in managing the firm. To form a limited partnership, you'll need to register as this business type with your state.
Corporations are legal entities formed by filing articles of incorporation with the secretary of state. The law views a corporation as a separate legal entity with rights similar to those conferred upon individuals. Corporations can have only one or millions of shareholders, as with publicly traded corporations.
If you set up as a corporation, you must have a board of directors. Owners can be on the board of directors, but directors don't have to be owners, or vice versa. Having more people in the mix might increase complexity, but it can also help you bring new ideas and voices into the fold. A lone shareholder can occupy all the board or officer positions, or they can freely designate others.
Operating your business as a corporation provides myriad benefits, including shielding you from personal liability. You can bring on additional investors by issuing shares and can even treat various types of investors differently by creating distinct share classes.
C corporation vs. S corporation
A C corporation is the default status of all newly formed corporations. C corporations tend to be attractive to investors, and they don't place restrictions on who can be a shareholder. However, you're subject to double taxation, because you pay taxes at the corporate level and again when you take distributions.
S corporations' differentiating feature is that their income or loss flows through to the shareholders. The income is taxed at the personal level, not the company level. As such, many small businesses elect S corporation status. This structure has certain restrictions, including limiting the number of shareholders to 100 and forbidding foreign shareholders. Unless you intend to raise money, acquire other companies or rarely take distributions, most CPAs recommend becoming an S corporation.
Limited liability companies
Limited liability companies, or LLCs, have become increasingly popular over the past two decades. Their appeal is due to their flexibility, ease of use and strong asset protection.
LLCs are essentially hybrids of corporations and either sole proprietorships or partnerships, depending on whether it's a single-member or multi-member LLC. If your business will own many large assets, such as land, buildings or heavy equipment, an LLC may provide better protection of those assets than a corporation. To create an LLC, you'll need to file articles of organization with the secretary of state.
You can establish a nonprofit as an informal association, trust or corporation. Many alumni, hobby and similar organizations operate as informal associations. However, most nonprofits that actively solicit tax-deductible donations as 501(c)(3)s are corporations, because this form shields management, directors and volunteers from liability.
Charitable trusts are trusts, but foundations may be a corporation or a trust. Trusts are formal entities created by an attorney and filed with a court. They offer less liability protection but may well fit your needs. Meanwhile, nonprofit corporations are legal entities created by filing with the secretary of state.
Finding a fit for your business
Choosing from among these types of business ownership doesn't need to be daunting. Using the information provided, narrow your choices to one or two options. Then, discuss them with a small business attorney or a financial advisor, who can help you properly create and structure your business for long-term success.
Financial insights for your business
This information is provided for educational purposes only and should not be relied on or interpreted as accounting, financial planning, investment, legal or tax advice. First Citizens Bank (or its affiliates) neither endorses nor guarantees this information, and encourages you to consult a professional for advice applicable to your specific situation.