What Business Entity Should I Choose?
In easy-to-understand language, a business entity is a group formed by one or more people to conduct business, trade, or engage in similar activities. There are different kinds of business entities, such as sole proprietorship, partnership, LLC, and corporation, each defining the organization’s structure and tax obligations.
When launching a business, one of your initial tasks is to select the right structure for your company, which is essentially choosing the type of business entity you want to establish.
Sole Proprietorship
A sole proprietorship is the most straightforward form of a business entity, where a single individual (or a married couple) owns and operates the business. If you start a new business and are the sole owner, the law automatically considers it a sole proprietorship. Registering a sole proprietorship with the state is not required, although you may need to obtain local business licenses or permits depending on your industry.
Sole proprietorships are often chosen by freelancers, consultants, and other service professionals. However, it can also be a suitable option for well-established businesses, such as retail stores, with a single person in charge of the operations.
Pros
- Starting this business entity is a breeze since you don’t have to register it with the state.
- There’s no need to worry about corporate formalities or extensive paperwork, like meeting minutes or bylaws.
- When it comes to tax deductions, you can deduct most business losses on your personal tax return.
- Filing taxes is a straightforward process: just complete and attach Schedule C-Profit or Loss From Business to your personal income tax return.
Cons
- Being the sole owner, you bear full personal responsibility for all of the business’s debts and liabilities. In the unfortunate event of a lawsuit against your business, your personal assets, such as your car, personal bank accounts, and even your home in certain situations, can be at risk.
- Since there’s no clear separation between you and the business, obtaining a business loan and raising capital becomes more challenging. Lenders and investors generally prefer LLCs or corporations with a distinct legal structure.
- Additionally, without a registered business entity, establishing business credit becomes more difficult, which can hinder your ability to access favorable financial opportunities.
Sole proprietorships are highly favored in the U.S. due to their effortless setup process. The merging of personal and business finances makes it simple to initiate the business and handle tax filings. However, this integration also presents a downside as it can lead to legal complications. Should a customer, employee, or any third party sue the business successfully, they have the authority to seize your personal assets. Given this potential risk, many sole proprietors ultimately choose to transform their businesses into LLCs or corporations to safeguard their personal assets.
General Partnership
Partnerships have several resemblances to sole proprietorships, but the fundamental contrast lies in the number of owners, as partnerships involve two or more individuals jointly running the business. There are two primary types of partnerships: general partnerships (GPs) and limited partnerships (LPs). In a general partnership, all partners are actively involved in managing the business and share both its profits and losses.
Similar to a sole proprietorship, a general partnership automatically becomes the default ownership structure for businesses with multiple owners, eliminating the necessity to register it with the state.
Pros
- Starting this business entity is simple since you don’t have to register it with the state.
- You won’t have to deal with corporate formalities or extensive paperwork, such as meeting minutes or bylaws.
- One advantage of having partners is that you don’t have to bear all the business losses alone; instead, the losses are shared among the partners.
- Additionally, owners can deduct most business losses on their personal tax returns, which can be beneficial for their overall tax situation.
Cons
- Each owner bears personal liability for the business’s debts and other obligations.
- In certain states, each partner may be held personally liable for the negligent actions or behavior of another partner, which is referred to as joint and several liability.
- Disagreements and conflicts among partners have the potential to disrupt the business significantly. However, creating a well-structured partnership agreement can assist in preventing such issues.
- Establishing a registered business entity can be vital for securing a business loan, attracting prominent clients, and establishing a strong business credit profile, making these tasks more challenging without proper registration.
Indeed, forming partnerships is a popular choice for mitigating the risks associated with starting a business. By having multiple individuals share the challenges and triumphs, the burden is distributed, which can be particularly advantageous during the initial years of the venture.
However, selecting the appropriate partner or partners is of utmost importance. Disagreements and conflicts among partners can severely hinder a business’s growth, and certain state laws hold each partner wholly accountable for the actions of others. For instance, if one partner enters into a contract and breaches its terms, the third party can personally sue any or all of the partners involved. Hence, a thoughtful and well-aligned partnership is crucial for the success and stability of the business.
Limited Partnership
In contrast to a general partnership, a limited partnership (LP) is a registered business entity, necessitating the submission of paperwork to the state for its formation. Within an LP, there exist two distinct types of partners: the general partners who own, operate, and are liable for the business, and the limited partners, often referred to as “silent partners,” who act solely as investors.
Limited partners lack control over the day-to-day operations of the business and carry fewer liabilities compared to general partners. They primarily function as investors in the business and enjoy certain tax benefits due to their more passive role within the company.
Pros
- Absolutely, an LP can be an advantageous choice for raising capital since investors can participate as limited partners without incurring personal liability for the business’s debts and liabilities.
- For general partners, this structure allows them to secure the necessary funds to operate the business while retaining full authority and control over its operations.
- One notable benefit for limited partners is their flexibility to exit the partnership at any time without necessarily dissolving the entire business entity. This provides them with the option to withdraw from the partnership without affecting the overall existence of the LP.
Cons
- Indeed, general partners in a limited partnership are personally liable for the business’s debts and liabilities.
- When compared to a general partnership, creating a limited partnership is typically more costly as it involves additional formalities and requires filing with the state.
- Furthermore, it is essential for limited partners to be cautious about taking on an overly active role in the business. If they unintentionally become too involved in the business’s day-to-day operations or decision-making, they could potentially expose themselves to personal liability, negating the liability protection usually associated with limited partnership status.
Indeed, multi-owner businesses seeking investment opportunities often find limited partnerships (LPs) to be beneficial since investors can avoid personal liability for the business’s debts and obligations.
Additionally, there is another business entity structure known as a limited liability partnership (LLP). In an LLP, none of the partners are personally liable for the business’s liabilities, providing similar liability protection as an LP. However, LLPs are typically limited to specific professional service firms, such as law firms, accounting firms, and medical practices, where each partner seeks to avoid being held liable for the actions of others within the organization. For instance, in a medical practice organized as an LLP, if one doctor commits malpractice, the other doctors can protect themselves from being held personally liable for that incident.
C Corporation
A C corporation is a distinct legal entity separate from its owners. The corporation’s control lies with the shareholders (the owners), a board of directors, and officers. Although it is possible for one person to hold all these positions, allowing you to be in complete charge of the corporation.
Operating as this type of business entity entails adhering to numerous regulations and tax laws. Incorporation methods, fees, and necessary forms vary from state to state. Thus, compliance with state-specific requirements is essential when establishing a C corporation.
Pros
- The owners (shareholders) of a C corporation are shielded from personal liability for the business’s debts and obligations.
- C corporations enjoy a broader range of tax deductions compared to other business types.
- C corporation owners benefit from lower self-employment taxes, providing potential cost savings.
- As a C corporation, you have the advantage of offering stock options, which can serve as a valuable tool for raising capital in the future.
Cons
- Incorporating a business as a C corporation is costlier compared to sole proprietorships and partnerships, with filing fees ranging from $100 to $500, varying by state.
- C corporations encounter double taxation, as the company pays taxes on its corporate tax return, and then shareholders pay taxes on dividends on their personal tax returns.
- Owners of C corporations are unable to deduct business losses on their personal tax returns.
- C corporations are subject to numerous formalities, including conducting board and shareholder meetings, maintaining meeting minutes, and establishing bylaws. These formal requirements contribute to the overall complexity of running a corporation.
When small businesses are considering how to structure their company, they often overlook C corporations, but as the business grows and requires increased legal protections, they can become a viable option. The most significant advantage of a C corp is the limited liability it offers. If the business faces a lawsuit, the plaintiff is restricted to seizing business assets to cover the judgment and cannot go after the owner’s personal assets, such as their home or car.
From a tax perspective, corporations have both pros and cons. On one hand, there are more tax deductions available and fewer self-employment taxes to pay. On the other hand, offering dividends can lead to potential double taxation. However, owners who reinvest profits back into the business rather than taking dividends are more likely to benefit from the corporate structure.
Forming and maintaining a corporation can be complex, but there are online legal services available that can assist with these processes and make them more manageable for business owners. As a business grows and requires increased legal protections, considering a C corporation structure might become a wise choice.
S Corporation
Correct, an S corporation combines the advantage of limited liability, as seen in a C corporation, with the pass-through taxation feature of a sole proprietorship or partnership. This means that the profits and losses of an S corporation “pass through” the business entity and are reported on the owners’ personal tax returns. Unlike C corporations, S corporations are not subject to corporate-level taxation. Instead, the owners are individually taxed on the income earned by the business. This pass-through taxation can result in potential tax savings for S corporation owners.
Pros
- Owners (shareholders) of an S corporation are protected from personal liability for the business’s debts and liabilities.
- An S corporation enjoys the advantage of pass-through taxation, similar to a sole proprietorship or partnership. This means that the corporation itself is not subject to corporate taxation, and the profits and losses pass through to the owners’ personal tax returns, avoiding double taxation.
Cons
- Similar to C corporations, S corporations are costlier to establish than both sole proprietorships and partnerships, as they require registration with the state.
- S corporations have more restrictions on issuing stock compared to C corporations.
- Compliance with corporate formalities, such as creating bylaws and conducting board and shareholder meetings, remains necessary for S corporations, just as it is for C corporations.
Exactly, to become an S corporation or convert an existing business to an S corporation, you must file IRS Form 2553.
S corporations are often an appealing option for businesses seeking a corporate structure while still enjoying the tax advantages of a sole proprietorship or partnership. The pass-through taxation feature of S corporations allows owners to report business profits and losses on their personal tax returns, thereby avoiding double taxation, which can be advantageous for many small businesses. This tax flexibility makes S corporations an attractive choice for certain business owners.
Limited Liability Company
Indeed, a limited liability company (LLC) combines favorable aspects from various business entity types. Like corporations, LLCs provide limited liability protections to their owners, shielding them from personal liability for business debts and obligations. However, unlike corporations, LLCs entail less paperwork and ongoing requirements, making them resemble sole proprietorships and partnerships in that regard.
One significant advantage of an LLC is the flexibility it offers when it comes to tax treatment. Business owners have the option to choose how they want the IRS to tax their LLC. They can elect to be treated as a corporation for tax purposes or opt for pass-through taxation, where the profits and losses of the LLC pass through to the owners’ personal tax returns. This choice allows business owners to align their tax structure with their unique financial goals and circumstances.
Pros
- The owners of an LLC are shielded from personal liability for the business’s debts and liabilities.
- You have the flexibility to select the desired tax treatment for your LLC, whether it is taxed as a partnership or a corporation.
- Compared to S corporations or C corporations, LLCs have fewer corporate formalities to comply with, making them a more streamlined and straightforward business structure.
Cons
- Forming an LLC is costlier than establishing a sole proprietorship or partnership as it necessitates registration with the state.
LLCs are popular among small-business owners, including freelancers, because they combine the best of many worlds: the ease of a sole proprietorship or partnership with the legal protections of a corporation.
Doing Business As
A DBA (Doing Business As) name is when an individual or company operates under a name different from their legal name. This name is also known as an “assumed name,” “fictitious business name,” or “trade name.”
Businesses are not restricted in the number of DBAs or assumed names they can use. However, in most states, there is a requirement to register the DBA name by filing with the state. Without registration, a sole proprietor can only conduct business using their legal name, while corporations and LLCs can only operate under the name specified in their formation documents.
Pros
- Increased Flexibility
- Privacy Protection
- Targeted Branding
- Easy Legal Compliance
Cons
- Fewer Tax Benefits
- Fewer Liability Protections
- No Exclusive Rights to the Business Name
- Maintenance