Business Entity Type: Which is Right for You?

Business Entity Type: Which is Right for You?

When starting a business, one of the most important decisions you will make is choosing the right business structure. This will determine how your business is run, how much you and your business will owe in taxes, who runs the day-to-day operations, whether your personal assets are protected and much more.

Business entities are generally classified as formal entities or informal entities. Formal entities must be registered with the country to be created, while informal entities do not. In this guide, we’ll explore the advantages and disadvantages of the most common types of business entities so you can structure your business in the best way possible.

Types of informal business entities

Informal entities are the simplest way to start a business because they do not require you to register their existence with the state. As a result, it provides no liability protection because it does not create a separate legal entity in the eyes of the state. This means that sole proprietors and partners in a partnership can be held personally liable for any claims arising from the business.

Individual ownership

A sole proprietorship is a sole proprietorship owned and managed by only one person. In terms of taxes and liability, a sole proprietorship is the same as a sole proprietorship. That is, the employer can be held personally liable for the activities of the company since they are not two separate legal entities.

Most small businesses that are just starting out always start out as sole proprietorships. However, once these startups grow, they usually turn into a limited liability entity, such as an LLC.

Positives

  • Autonomy over business
  • State registration is not required for formation
  • There are no annual reporting requirements
  • Tax treatment of disregarded entities (pass-through taxation)

cons

  • Unlimited personal liability
  • Not suitable for raising capital
  • All administrative responsibilities lie with the owner alone

Partnership

A partnership is a business owned by two or more people who agree to share profits and losses together. A partnership shares many of the same features as a sole proprietorship, with the only difference being that a partnership allows for more than one owner.

A partnership, like a sole proprietorship, has more independence than incorporated entities, but you will split that independence with another partner. So, to settle any disagreements between partners, it is highly recommended that you and your partner sign a well-drafted partnership agreement before going into business together.

The standard form of partnership, often referred to as a general partnership, consists of at least two general partners who participate in the day-to-day operations of the business, sharing unlimited liability for the partnership’s liabilities. However, there are other forms of general partnership used for specific purposes, such as: limited partnerships (LP), limited liability partnerships (LLP) or even limited liability partnerships (LLLP). However, these variances are considered official entities because they must be registered with the state.

Positives

  • Autonomy over business
  • State registration is not required for formation
  • There are no annual reporting requirements
  • Tax treatment of disregarded entities (pass-through taxation)
  • Decision-making responsibilities become more manageable when shared

cons

  • Unlimited personal liability
  • Not suitable for raising capital
  • Possible disagreements between partners

Types of formal business entities

Formal business entities can only be created by submitting formation documents to the state. It will cost you some money in filing fees and reporting fees to keep the business in good standing with the state, so formal entities are generally more expensive than informal entities.

However, the biggest advantage of starting a formal business entity is that it provides liability protection to its owner(s). This alone will make the additional cost of incorporation worth it for business owners because it protects their personal assets from being at risk if a claim arises from the business.

Formal partnerships

As mentioned earlier, there are some additional differences to standard partnerships that are considered formal entities in that they must be registered with the country to be created.

Limited partnerships:

Some partnerships may be formed to include limited partners rather than just general partners. A limited partner is someone who partially owns the partnership, but is not involved in managing the business at all. Since they are not involved in running the business, silent partners have limited liability protection – meaning they are not liable for any debts of the business like a general partner.

You may also encounter a limited liability partnership (LLP), which is a type of entity shared between professionals such as lawyers, accountants, and doctors. Professionals use this type of entity because it protects partners from any liability arising from the negligence of other partners.

Limited liability companies

A limited liability company (LLC) is a type of formal business entity that combines the tax advantages of a sole proprietorship or partnership with the personal liability protections of a corporation. This is a popular business structure among small business owners as they can enjoy the benefits of being a large corporation without all the formalities of a corporation.

Each state has its own default rules governing LLCs, however the majority of rules can be tailored to your business needs through the operating agreement created by the LLC members.

Positives

  • It is taxed as a disregarded entity by default
  • Tax flexibility (some LLCs may choose S-corp tax status)
  • Flexible management and ownership structure (through an LLC operating agreement)
  • Provides limited liability protection

cons

  • Formation documents must be submitted to the country to be established
  • More expensive than informal entities (e.g. registration fees and publication requirements)
  • Transferring ownership interests is more difficult than other formal entities

S Corporation Status:

An S-corp is not a type of corporation. S-corp is a tax status created by the IRS to allow business owners to decide how to handle taxable income.

Some LLCs have the ability to choose how they want to be treated for tax purposes. By default, an LLC will be taxed like a sole proprietorship or partnership depending on the number of its members. Both sole proprietorships and partnerships have pass-through taxation, which is when the entity itself does not pay the taxes and, instead, the owner claims all business income on their personal income tax returns. LLCs may instead decide to be taxed as an S-corp. The LLC will still have pass-through taxes, but instead of members paying self-employment taxes on the entire company income, only the wages they pay are subject to the self-employment tax rate.


Companies

A corporation, sometimes called a C-corporation or C-corp, is a type of formal business entity that is best suited for companies looking to expand at a rapid pace because it can issue stock to fund growth.

As with forming an LLC, you will have to file formation documents (called Articles of Incorporation) with the appropriate government agency. However, companies have additional requirements for formation, such as drafting bylaws, appointing officers and board of directors, etc.

Positives

  • Provides limited liability protection
  • Ownership rights are freely transferable
  • Corporate actions lead to a predictable nature that investors prefer
  • Some corporations may choose S-corp status to be taxed as a disregarded entity

cons

  • Formation documents must be submitted to the country to be established
  • Double taxation (the entity pays corporate tax and shareholders pay federal income tax on dividends)
  • A rigid management structure leads to less autonomy
  • Expensive annual reporting and meticulous bookkeeping requirements

How to choose the best business entity for your business

Sole proprietorships are best suited for very new businesses because they are easy to form. However, it is highly recommended that you convert your sole proprietorship into an entity that provides limited liability protection once it begins to grow.

By moving to an entity like an LLC, you’ll get the same tax benefits you had with your sole proprietorship, but you won’t be subject to unlimited personal liability. Although this is more expensive than remaining as a sole proprietorship, most business owners find this beneficial.

You’ll want a partnership for the same reasons you want a sole proprietorship: ease and convenience. The only difference is that you want to start a business with someone else, not just on your own. However, this should be a temporary structure because once your business expands, you will need to protect yourself by forming an entity with liability protection.

An LLC is the most versatile form of business. If you want to be the sole owner of your company, create a single-member LLC instead of a sole proprietorship. You will gain the same tax benefits and independence, but your personal assets will be safe from debtors. If you want to start a business with some friends, create a multi-member LLC instead of a partnership for the same reasons. Many states recognize different forms of LLCs that may be a good fit for your business needs.

You should choose a company if you are looking for rapid growth because it excels at raising capital by attracting investors. Keep in mind that a corporation is usually subject to corporate tax unlike other types of entities. However, you can overcome this problem if you want to create a foundation with a charitable purpose. Nonprofit corporations are tax-exempt, easier to set up and will be recognized nationally – making them the preferred legal structure for a non-profit organization.

Remember that choosing the right entity type for your company depends on all the circumstances surrounding it. You can use one of the best LLC formation services for a fraction of the cost of hiring an attorney if you want personal, professional assistance in choosing the best way to organize your business.


Are you ready to learn more about what forming each business entity entails?

Almost all broad “business types” can be structured using any of the four basic structures. If you’re ready to learn more about how to start the configuration process, consider our affordable online configuration option today.

Legal Disclaimer: This article contains general legal information but does not constitute professional legal advice for your particular situation and should not be construed as creating an attorney-client relationship. If you have legal questions, you should seek the advice of an attorney licensed in your jurisdiction.

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