If you’re considering starting a business, one of the most important aspects of the process is choosing a legal structure that makes the most sense based on current and future plans. Determining the type of business entity is important because it determines the paperwork and fees involved, and the taxes that may affect your entity. The business structure also determines how much personal liability you have, and whether you can take on investors.
Before making this decision, fully understanding business entities and the ramifications of each one is key. It’s also important to consider your capabilities, the associated taxes, personal liability, and the record-keeping involved. There are different types of business structures to consider based on your profession and industry. Then, consider how many owners will be part of the business and your finances.
Ask yourself the following questions:
- How flexible does the business structure need to be? Will there be one, or multiple business owners?
- What needs are you anticipating for the future?
- Are costs a big factor?
- Are you comfortable with assuming liability?
- Is tax liability a factor?
There are four main business entities that may work for your business, but each has its pros and cons:
This is a business owned by one person and it does not have to be registered with the state. The unique thing about a sole proprietorship is that the business and owner are one and the same. When it comes to taxes, the business income and losses are reported on their personal tax return.
The owner of a sole proprietorship also assumes personal liability for any debts, lawsuits, court judgments, or obligations related to the business. If the business is forecast to remain small enough that it is unlikely that the business will be sued, or you won’t need to worry about huge business loans or investors, this may make sense.
To some, it is an advantage because the owner has complete control and receives 100% of any profits made in the business.
A partnership is owned by two or more people. They may elect to become a corporation or limited liability company, also known as an LLC. Depending on the type of partnership, you may not have to register with the state because the partnership begins when the individuals start doing business together.
With a partnership, each owner pays taxes on their portion of the business income on their personal tax returns. They also hold personal liability for any claims and business debts against the partnership. As a partnership, they may qualify for a pass-through tax deduction of 20%. Partnerships can be successful and have great growth potential when done correctly. When forming a partnership, an attorney should be consulted because an agreement should be in place to protect the interests of all parties. As with a sole proprietorship, there is no limited liability protection, decision-making and profits must be shared, and the partnership is vulnerable to the actions of each partner.
There is another option in this category called a limited partnership. They can be complicated to set up and are not generally conducive to small business owners. In this instance, there is a general partner who solicits investments from others who are called the limited partners. In this business entity, the general partner controls the day-to-day and has personal liability for any business debts (does not apply if the general partner is an LLC or corporation).
Limited partners have limited control over the day-to-day operations and do not have personal liability for any business debts or claims. Paperwork and filing fees apply to limited partnerships and if there are conflicts with how the business is being run, this could cause complications.
Limited Liability Company (LLC)
One of the most common and basic question that arises is what is an LLC? Let’s try and simplify the answer: A limited liability corporation (LLC) is one of the most common business entities for small businesses. The advantage is that the personal liability of the owner is limited when it comes to business debts and any judgments against the business.
This business structure must be registered with the state but is relatively simple to accomplish. In terms of taxes, an LLC operates like a partnership – each owner reports any business income on their personal tax return and must pay taxes on their share of that income. The cost to form an LLC varies based on the state. Most small businesses are LLCs, but there are also some large corporations that choose this business entity.
LLCs are great for entities with more than one owner who may have personal assets they want to protect from creditors, may have substantial business debt, and may be at risk of being sued by customers. This entity has a flexible ownership and management structure, but it is very important to have everything in writing to keep things in order if the business owners disagree about something. With a written agreement in place, they can always refer to what was agreed upon in the beginning.
A corporation is more complicated and costly than an LLC, but the structure helps in limiting the personal liability of the owners regarding debts and court judgments against the business. This entity is also separate from the people who own and manage it. Personal tax returns are not used to pay tax on any of the profits, but the owners will pay taxes on the money drawn from the corporation. This is usually salaries, bonuses, and any other financial transactions that are personally beneficial.
A corporation can sue another company or person, own and sell property, and sell stocks. The legal rights are completely independent of any of its owners. The fees to file and costs vary based on the state. There are different types of corporations: C corps, S corps, B corps, closed corporations, open corporations, and nonprofit corporations.
Corporations have the advantage of limited liability for their stockholders, continuity in keeping the corporation going even when the owners are deceased or shares are transferred, and it is easier to continue raising capital for the business from investors.
The most popular corporations are C, S, and nonprofit. C corporations are owned by the shareholders and taxed as separate entities. They have an unlimited number of investors, which is why many big businesses are listed on the stock market. S corporations are designed to help small businesses avoid double taxation. In this instance, the owners also have limited liability protection. Nonprofit corporations have tax exemptions because they are formed to help others.
Each type of business entity may be required to have certain licenses and permits. In most instances, they are also required to have an Employer Identification Number (EIN) to identify their businesses with the Internal Revenue Service (IRS).
While you review these business entities, knowing that you can change your mind as you grow, or your liability changes are key. You can start as a business entity and then convert it to something else if needed. There are many individuals that started as a sole proprietorship and changed to an LLC or corporation because it fits their needs.
Working with a business attorney or tax professional when making your final decision can help save time and money.