With so many complexities involved in launching a new business, the last thing you need is confusing information about which entity to choose.
In simplest terms, a business entity (also called a business structure) refers to the structure of a business. The type of business entity you choose influences everything from day-to-day activities, taxes, and personal liability.
Choosing a business entity is one of the first things you do when starting your own business.
I will cover the basics of business registration, the different types of business entities, the pros and cons of each, and how to choose an entity that is best for your company.
Registering a business ensures no one else can open a company in the same structure. By registering your business, it becomes a legal entity with specific legal rights.
Choosing the best business structure is about finding a balance that’s right for you. Your choice of business structure determines how you register and operate your business, setup costs, how you file your taxes, which taxes you’ll pay, and your level of personal liability
That depends on which business structure you choose and your location. For example, if you operate as a sole proprietorship using your legal name, you’re not required to register anywhere.
And for many small businesses, registering your business name with your state and local governments is sufficient.
When you know which business structure to use, your legal requirements will become clear.
There are more than a dozen different types of business entities in the U.S. But most SMBs (small and medium-sized businesses) choose from the five most common options: Sole Proprietorship, general partnership, limited partnership, limited liability company (LLC), and C corporation
Let’s review each one to understand which is right for you.
A sole proprietorship is the simplest business entity in which one person is the sole owner. Many freelancers, consultants, even a one-man retail store, and other service professionals commonly work as sole proprietors.
There is no need to register with the state, however, depending on your industry and location, you might need a local business license or permit. You can find that out by looking at your state’s website.
1. Simplicity. If operating under your legal name, you can begin business immediately.
2. You’re the boss. All decisions are yours to make.
3. Pass-through taxation. Also called a flow through entity, any income your business makes passes directly to you. Plus, it qualifies you for a 20% tax deduction (qualified business income deduction).
4. Reduced hassle with the IRS. You’re not required to provide end-of-year balance sheets or file an end-of-year financial statement.
1. Legal liability. Since there is no legal distinction between you and your business, you are personally liable for all the business’s debts and liabilities.
2. Access to funding. Investors are less likely to lend to an individual, so it might be difficult to get a business loan.
3. Public perception. Depending on your business, clients often prefer working with registered companies.
Partnerships are similar to sole proprietorships, except it has two or more business owners. Each person actively operates in the business, as well as share the profits and losses of the business.
Many people form partnerships to lower the risk involved in starting a new business. And having business partners can be very helpful when getting started.
1. Simplicity. Partnerships are an uncomplicated business to start, and they are relatively simple to run.
2. Partners control the business. A partnership allows the owners to run the company directly and allocate profits as they see fit.
3. Flexibility. Partners can share duties, so everyone works to their strengths.
4. Reduced liability. The more partners involved, the less liable you’ll be if things go wrong.
5. Pass-through taxation. Partnerships are pass-through entities and can qualify for a 20% business income deduction. Each partner only pays tax on the percentage of profit taken from the business.
1. Legal liability. All partners are accountable for the company’s debts and liabilities.
2. Conflict. We all have our own opinion on how to run a business; the more partners there are, the more opinions (and possible disputes) there may be.
Since a general partnership is the default mode of ownership, there is no need to register with the state. You may have to file a doing business as (DBA) when registering your name. Check that out on your state registration website.
Limited partnerships (LP) have one general partner with full liability, and all other partners have limited liability. Limited (or silent) partners provide capital but have limited control over the company; they are also not responsible for any debts beyond their initial investment.
LPs are a good option for those who want the simplified taxation of a general partnership and are looking to raise capital investment.
1. Raising investment. You can raise money from investors who serve as limited partners while you maintain authority over business operations.
2. Pass-through taxation. LPs are pass-through entities, simplifying taxation and enabling you to claim the 20% QBI deduction. However, LP tax treatment varies from state to state, so check out your state website for more information.
1. Liability. General partners are personally responsible for any debts and other liabilities.
2. Limited availability. Not all states allow the formation of an LP, and some reserve it for certain types of businesses.
3. Complex to set up. Establishing an LP can be complicated and requires state-by-state research. Any limited partners’ investment and shares are seen in law as securities, making them subject to state and federal security regulations.
Forming an LP is dependent on your state and industry. Generally, it will require specific licenses and permits. Find out which ones you need by looking at the SBA Business Licenses and Permits search tool.
An LLC is a popular business structure for those in a high-risk business, owners with personal assets they want protected, and for those who want to pay a lower tax rate than they would with a corporation.
1. Limited liability. Your personal assets (vehicle, house, savings account, etc.) are not at risk. However, if you sign as a guarantor to obtain a loan, you are liable for the amount borrowed.
2. Public perception. People often hold an LLC in higher regard than a non-legal business entity, making it easier to gain a prospective client’s trust.
3. Taxation flexibility. You can choose to pay taxes as a sole proprietorship, meaning you`re seen as a pass-through entity and can qualify for the 20% QBI deduction. However, you can choose to be taxed as a corporation, offering flexibility as your company grows.
1. Setting up and filing fees. Depending on your state, it can cost anywhere from $100 to $1,000 to register an LLC.
2. Minimum annual tax. Your state might have a minimum yearly tax charge, regardless of whether you turn a profit.
3. Annual report filing. Most of the 50 states require LLCs to file an annual report. Failing to file often leads to penalties, late filing fees, and in the worst-case scenario, your LLCs dissolution.
To form an LLC you must file articles of organization with your secretary of state and provide an LLC operating agreement.
If you’re a one-member LLC, the IRS treats you as a sole-proprietorship when it comes to taxes, meaning the LLC doesn’t pay taxes and doesn’t have to file an annual return. As a sole owner, you can report your profits and losses using Schedule C, submitting it with your personal 1040 tax return.
A corporation is a legal entity that is separate from its owners. A C corp is fully independent from the shareholders, so if a shareholder leaves the company or sells their share, the C corp can continue business as usual.
It’s important to note that there are other corporations, including an S corporation, B corporation, close corporations, and nonprofit corporations.
1. Limited liability. A corporation is a separate legal entity with assets and liabilities of its own. The liability of its shareholders is generally limited to the amount they invested in the business.
2. Access to capital. C Corporations can acquire financial capital by issuing stock to other businesses or individuals, both domestic and foreign. Shareholders can receive payments in stock benefits and buy stock at fixed prices.
3. Self-employment taxes. Shareholders who actively work in the business are taxed as employees, thus avoiding self-employment tax. Profits can remain in the corporation as equity and be distributed as shares and dividends.
1. Complexity and costs. Forming and maintaining a corporation is complex and expensive.
2. Two-layered taxation. Corporations pay a double tax. Profits are subject to corporation tax, and shareholders who earn a dividend or take a salary pay personal income tax.
3. Less control. As ownership is shared among shareholders and governed by a board of directors, no single person controls the business.
4. Regulatory requirements. There are a lot of federal and state regulations placed on a corporation and they are closely scrutinized. Corporations must disclose annual earnings and internal governing documents to its shareholders.
Registering a C corporation varies between states, but all require you to file Articles of Incorporation and issue stock percentages to its shareholders. Forming a corporation is a complicated procedure that must adhere to numerous state and federal conditions, making it an expensive and time-consuming process that requires a legal team to implement. All corporations are regulated under their state’s corporate law.
Choosing a business entity is one of the first important decisions a new business owner makes.
By referring to this guide, you’ll be able to determine which structure is right for your business. And, of course, if you need specific help for your business, it’s best to consult a legal or financial professional.
It’s all about balancing what’s good for you and your business now, and you can always upgrade your structure in the future.
This portion of our website is for informational purposes only. The content is not legal advice. All statements, opinions, recommendations, and conclusions are solely the expression of the author and provided on an as-is basis. Accordingly, Tailor Brands is not responsible for the information as well as has not been evaluated the accuracy and/or completeness of the information.
Terry is a serial entrepreneur with over 25 years of experience building businesses across multiple industries – construction, real estate, e-commerce, hotelier, and now digital media. When not working, Terry likes to kick back and relax with family, explore Taoism’s mysteries, or savor the taste of fine Italian red wine.