One of the first things you have to do when starting your business is choose its business entity, sometimes referred to as its “legal structure. ”Your business entity makes a difference in the way you file and pay your taxes, and it also makes a difference when you apply for a loan. It’s important to choose the best one for your business, but luckily, it’s not as complicated as it might seem.
Start by asking yourself some basic questions…
Having the answers to these questions will give you a good starting place for jumping into the information below.
- How many owners does your business have?
- Will they have equal shares and responsibilities, or will some be acting mostly as investors only?
- How large is your business going to be?
- Do you plan to go public?
- How much risk are you likely to face in your profession?
- Will you have an accountant to help you through tax season?
- How important is it to you to protect your assets from any business risk or debt? (In other words, how much liability are you willing to take on?)
- How much autonomy do you want in making business decisions?
Now that you have some idea of what factors will go into your decision, let’s break down the differences between the business entities.
Incorporated or Unincorporated?
The first distinction is between an incorporated and an unincorporated business.
Incorporating a business means that you’re separating it and its affairs—its taxes and its litigation—from your own personal ones. So if your business gets sued, and it’s incorporated, you’re not getting sued—only your business is.
If it’s not incorporated, unfortunately, your personal assets have no protection.
You certainly don’t have to incorporate your business. If you don’t, your taxes will be easier because you won’t have to pay separate taxes for your business—you’ll only pay tax on the profits that have been passed through to you personally.
Sole proprietorships, which are the most popular legal structure for small businesses—over 70% of businesses in the USA are sole proprietorships.
With a sole proprietorship, you’re the only owner of the business… And there’s no difference between you as a person and you as the business owner: you’re entitled to all the profits, but you’re also responsible for the debts, losses, and liabilities.
A sole proprietorship is the easiest form of legal structure to put in place, which is why it’s so popular. You only need to get a license or a permit and then register your business with the government. There are also fewer forms required—especially at tax time, where you only have to file a Schedule C in addition to your personal tax return in order to report business income—and less administrative work is required.
Sole proprietors also don’t need to report their business decisions to shareholders or board members, and they have the freedom to work jobs outside of the company without having to justify their time. For this reason, many freelancers, consultants, and contractors choose to be sole proprietors.
The major downside of a sole proprietorship, though, is that you’re unprotected. If your business is sued, let’s say, for a breach of contract, your personal assets—like your car, your house, or your retirement account—might be on the line in order to satisfy the claim.
So if you’re in an industry where lawsuits are a very real threat—like food service or child care—a sole proprietorship can be a huge risk.
It’s also harder to find financing for your business as a sole proprietorship. That risk that we just talked about isn’t too appealing for lenders, either: they want to know that you’ll pay them back in full and on time, and the risk that you’ve taken on in not incorporating makes you a less credible borrower. Any personal catastrophe you might confront will affect your business, and vice versa.
In the case of either scenario, you might be left unable to make loan payments. And lastly, a sole proprietorship doesn’t look as official, which might make finding and keeping clients more difficult. Sole proprietorships are best for individuals who don’t confront a lot of risk and who are unlikely to need external financing—think freelance editors or consultants.
A partnership is very similar to a sole proprietorship—it’s also unincorporated—except that, well, it’s not “sole.” In a partnership, two or more people share the ownership, profits, and losses of a business.
Usually when we talk about partnerships, we’re talking about a general partnership, and the profits, liabilities, and management responsibilities are shared equally among partners.
However, they don’t have to be shared equally: ownership percentages can be fiddled with, especially when it comes to applying for a loan. Some owners might prefer to have less than 20% ownership so that they don’t have to personally guarantee a loan.
Like sole proprietorships, partnerships are fairly easy to set up and maintain, with the added complication of figuring out how to divide responsibilities and profits. But they’ve also got many of the same downsides: the partners are personally liable for any business debts or lawsuits.
In a partnership, the business itself doesn’t pay any tax—remember that it’s not incorporated, so it’s not a separate entity.
Instead, the profits “pass through” to the partners, who will report them using a Schedule K form and their own personal tax return.
A limited partnership is a partnership with two different types of partners: general partners, who are owners and managers and are liable for the business, and limited partners, who have fewer liabilities but also fewer responsibilities.
The limited partners are basically investors in the business, and they can leave freely without dissolving the partnership. The downside of a limited partnership is that it’s more expensive to form than a general partnership.
General partnerships are essentially sole proprietorships, except that they’re run by two or more people. They’re right for people who want an easy business structure, don’t confront much risk, and are planning to share ownership of the business.
On the other hand, limited partnerships are a better option for people who plan to have very unequal management or ownership of the business.
A Limited Liability Partnership (LLP) is technically a different type of partnership, but it’s more complicated than that. In an LLP, the same tax benefits as a general partnership apply—the business is only taxed once, rather than twice, because it’s not its own entity—but the liability of each of the partners is limited, meaning that they’re somewhat more protected than in a general partnership.
“Limited liability” here refers to the fact that each partner’s personal assets are protected from the other partners. These legal structures are often used for law, architecture, and accounting firms.
In a general partnership, there’s no legal protection of personal assets, but in an LLP, personal assets are safe. The partners are protected from each other’s potential mistakes.
There are a number of downsides to LLPs, however. They’re complicated to get into in detail, but many states strictly regulate which types of companies are allowed to form LLPs and have complex laws stating exactly what types of risk partners are liable for.
They can also be expensive: you’ll need to pay a yearly registration fee to your state and might be susceptible to other taxes. LLPs can work well for professionals in industries like law, architecture, or accounting who want to join forces with other professionals in order to improve their reputation and diversify their client base.
If we made a scale of business entities, with “least complicated” on one end and “most complicated” on the other, C-corporations (also known as regular old corporations) would be on the “most complicated” end.
Corporations are separate legal entities, so there’s no crossover between the owner’s personal assets and the shareholders’ business profits and liabilities. The most significant downside of corporations is that they’re double-taxed. The business itself is its own tax entity, so it’s taxed by the IRS first. Then the dividends that trickle down to the shareholders—reported as profit on their personal tax returns—will also be taxed.
The other downside is that they’re time-consuming and expensive to set up and operate—think board meetings, running decisions by shareholders, and plenty of fees and paperwork. Corporations have more potential for raising capital because they’re the only business structure that’s allowed to sell stock, which can be attractive to both investors and employees.
Corporations are best for larger, more established companies with more employees, especially if they’re planning to take the company public.
S-corporations are special types of corporations that take away the dreaded double taxation of regular C-corporations. The corporation itself doesn’t pay taxes. Instead, shareholders pay taxes only once—on the profits that have passed through to them.
S-corporations also have stricter qualification requirements than C-corporations—for example, there’s a limited number of shareholders, and only one class of stock can be offered. Otherwise, they’re the same as C-corporations, with the same downsides (expensive and complicated ) and the same upsides (extremely limited liability, the ability to sell stock). If you’re a bigger company that would like to incorporate and sell stock but wants to avoid double taxation, an S-corporation might be the right fit for you.
This is the last one, we promise. We saved it for the end because in order to understand an LLC, you need to understand the more straightforward business entities.
A Limited Liability Company (LLC) is technically incorporated, but in terms of structure, it falls somewhere between corporations and unincorporated entities like partnerships and sole proprietorships.
It’s one of the most popular legal structures for small businesses because it’s flexible and relatively easy to manage, but it also gives owners some protection for their personal assets. Just like in a limited liability partnership, the partners (or “members” for an LLC) are legally protected, in terms of their personal assets, from any debt or lawsuits that the company have to deal with.
LLCs can also be just one person, so if you’re worried about the legal implications of a business project and don’t want to be personally liable, you could set up an LLC to protect yourself. It’s easier to form than an S-corp—it requires fewer registration forms and less money paid upfront in registration fees and costs.
Taxes for an LLC are “passed through,” just like sole proprietorships and partnerships, to each member, who will report their profits on their personal income statements. The LLC isn’t regarded as its own tax entity by the IRS, although some are taxed as corporations, depending on the number of members and the choices you made when setting up the LLC.
LLCs are a great choice for many small businesses because they’re less expensive than corporations (although more expensive than partnerships and sole proprietorships) and offer you valuable legal protection, which will also make it easier for your business to acquire financing.
However, it also dissolves fairly easily: if a member leaves the LLC, you might have to close out the business and form a new LLC with the remaining members. It’s also not a good choice for any company looking to go public someday, because you can’t sell stock as an LLC.
LLCs are the best option for many small businesses, except those who want to take their companies public.
What do I do once I’ve chosen my business entity?
Once you’ve decided on the best legal structure for your company, it’s time to make it official by filing the correct paperwork.
The exact process will depend on both your state and your legal structure, so we can’t be too specific here—but check out the SBA’s helpful page for a state-by-state breakdown.
You’re a sole proprietor by default, so if you’re a business but you haven’t filed any other legal structure paperwork—congratulations, you’re already a sole proprietor! However, you still need to apply for necessary licensing and permits.
In a general partnership, you’re not technically required, legally, to develop a legal partnership agreement…But you should.
On the legal side of things, you’ll need to register your business with your state through the Secretary of State’s office, establish a business name, apply for all the relevant licenses and permits, and register with the IRS.
An LLP will draw up a Limited Liability Partnership Agreement to define the specific roles and protected assets of each partner, and then file a Certificate of Limited Liability Partnership.
For an LLC, after choosing your business’s name, you should file Articles of Organization with your state’s Secretary of State, create an Operating Agreement (not legally required, but highly recommended), and obtain licensing and permits. You might also need to advertise the formation of your LLC in your local newspaper.
And for a corporation, you’ll create your business name and file “articles of incorporation.”
For an S-corporation, you’ll first file articles of incorporation and then file Form 2553 with the IRS to be considered an S-corporation.
Written By Gretchen Schmid, Originally Posted on Fundera.Com