Owning your own small business is an exciting prospect. As a small business owner, you enjoy a level of freedom and control that simply can’t be obtained otherwise. However, certain responsibilities come with owning a business. Among these responsibilities are the legal obligations that your business incurs. The type of business structure you choose to register significantly impacts how these legal responsibilities play out.

To help you with this important decision, let’s examine some of the most common legal structures for small businesses.

Sole Proprietorships

A sole proprietorship is one of the easiest business entities to form. Technically, you aren’t even required to register your business as a sole proprietorship at all. If you’re an entrepreneur who owns and operates a small business by yourself and you haven’t registered a different type of business structure, your business is automatically considered a sole proprietorship.

Sole proprietorships are great options for business owners who don’t plan to expand the operation beyond themselves due to how easy they are to set up. They also don’t require you to pay any corporate taxes — instead, you’ll report the money you earn from your business on your personal tax return as self-employment income.

The only major disadvantage of a sole proprietorship is that it provides no legal separation between your business and you as an individual. You can be held personally liable for your business’s legal obligations, including debts.

Some common examples of sole proprietorships are small local businesses like bookstores, computer repair shops, or independent tutoring services. Most freelancers who work from home are also considered sole proprietors.

Partnerships

A partnership might be your best option if you aren’t planning on running your business alone. Partnerships come with the obvious advantage of a combined skillset; if you’re working with a partner, you can lean on their abilities and experience to supplement your own. As the saying goes, two (or more) heads are better than one. Make sure you and your partner(s) have a shared vision for the business — many burgeoning companies have crashed and burned simply because their founders couldn’t agree on business decisions.

Regarding legal responsibility, a general partnership operates almost the same way as a sole proprietorship. As an owner, you are liable for the business’s debts and other legal obligations, but the responsibility is split evenly between you and your partners. This helps dilute (but not eliminate) your personal responsibility. There are also limited partnerships, under which some partners enjoy a lesser degree of liability but also get a smaller slice of control over the business.

The partnership structure is most commonly used by groups of individuals with particular skills who want to combine their knowledge and resources to create a more attractive business—for example, a law firm or a real estate agency.

Corporations

Businesses that plan to raise money from investors or go public (sell shares publicly on the stock market) often incorporate. Forming a corporation is wise for small businesses with their sights set on a significant expansion. As a corporation, your business can collect resources from outside investors or sell stock and funnel that capital back into the company.

Corporation owners are also given the most liberal liability protections. If your business is registered as a corporation, it’s an entirely separate entity from you as an individual, meaning you can’t be held personally responsible for the business’s financial obligations. 

This protection is essential for people who own multi-million dollar companies, but it may be overkill for many small businesses that plan to stay small. Massive companies like Apple, Google, and Amazon are familiar examples of corporations.

Limited Liability Companies (LLCs)

An LLC is a middle ground between a partnership and a corporation. LLCs are privately owned by groups of partners (just like a partnership), but all partners are protected from legal liability (just like a corporation). 

One of the most significant differences between a corporation and an LLC is how the business’s taxes are handled. A corporation’s shareholders must pay a special corporate tax rate on the dividends they receive from the business’s profits over and above the tax on income that the corporation has to pay. At the same time, LLC partners can take advantage of pass-through tax laws, under which the business’s taxes “pass-through” the corporate tax level and are filed only as personal income tax. 

(There are two kinds of corporations: S corporations and C corporations. The difference between an S corporation and an LLC is that an S corporation is still a public company with a board of directors, whereas an LLC is a private company.) Owners of S corporations are also granted pass-through tax status.

Corporations often set up subsidiaries as LLCs. For example, Sony is a massive corporation, but its digital entertainment branch, Sony Interactive Entertainment, is registered as an LLC. Organizing subsidiaries as LLCs is common practice because an LLC is much easier to set up than a corporation but offers similar legal protection and tax benefits. Corporations can quickly expand their reach by using an LLC structure for their subsidiaries without increasing taxes or legal liability.

An LLC is the most complex business structure available to small businesses but also offers the most significant degree of legal protection. If you’re opening your own small business, you’ll most likely want to start as a sole proprietorship or partnership with the possibility of expanding into an LLC.

Which Structure Should You Choose for Your Small Business?

In most cases, a sole proprietorship or a partnership is all you need for a small business. These two structures are relatively easy to set up and provide what you need to start doing business on a small scale. If you plan to expand your business into a larger company, it’s probably worth looking into the special legal protections an LLC can offer you. 

Corporations are by far the most complex type of business structure. It would be best if you didn’t worry about incorporating unless you have lofty goals for your business, including completing funding rounds with investors and possibly going public on the stock market. If your enterprise reaches this point, you have more than just a small business on your hands.

Join NFICA for $5 a year

With the National Federation of Independent Contractors Association, you can have that peace of mind to keep saying, “I can do this!” We offer life insurance at rates not available to the general public, discounts on business tools through BenefitHub and WorkingLive, competitive rates on Telemedicine, and health products that include critical illness, accident, and hospital indemnity insurance! See what we have to offer.