Choosing the right legal entity is an important consideration when starting a business. Among other things, your choice of business entity has both tax and liability consequences, but knowing which entity is the best choice might not be obvious to a new business owner.
With that in mind, here are some of the most common business entities to consider. Because every business is different, make sure and consult your CPA or attorney to get his or her advice regarding what would be the best fit for you and your business.
A sole proprietorship is the easiest and most common way to start a small business. Starting a sole proprietorship doesn’t require a formal filing with your state and is the simplest business entity available to a business owner. The business owner is personally responsible for all the debts, losses, and liabilities of the business. Because of how easy it is to start, it is often the default entity for many Main Street business startups.
Benefits of a Sole Proprietorship:
- Easy to form—Other than obtaining a business license and making sure there isn’t someone else in your area doing business with the same name (you can do a business search and verify that nobody else in your area is using your name by contacting your state), there is no formal filing requirement to form a sole proprietorship.
- Tax preparation is easy—Because there is no need to file a separate tax return for a sole proprietorship, you can fulfill the tax reporting requirements on your personal taxes.
Drawbacks to a Sole Proprietorship:
- Personal liability—Probably the single biggest drawback is that all business liability is the business owner’s personal liability. In other words, if the business is sued, he or she is personally liable and personal assets are at risk. This also applies to any liability resulting from the actions of an employee.
- Raising capital can be problematic—Because there is no equity to sell a potential investor, it can be difficult to raise equity capital; and lenders are sometimes hesitant to approve a small business loan to a sole proprietor because of limited options for recourse in the event of a default.
There are two general types of partnerships and in many ways a partnership is similar to a sole proprietorship, with the exception that profits, debts, and liabilities are shared among the partners—as determined by the type of partnership.
A general partnership assumes that all profits and liabilities are shared equally among the partners while a limited partnership allows some partners to have limited liability and a limited share of profits depending upon the ownership percentage of the individual partners.
Benefits of a Partnership:
- Easy to form—Like a sole proprietorship, a partnership is easy and inexpensive to form.
- You’re not in it alone—Partners not only share financial responsibility for the partnership. They also share the challenges associated with running a small business, so you can leverage the combined experience of all the players and potentially complement each other’s strengths or weaknesses.
Drawbacks to a Partnership:
- Joint and individual liability—Similar to a sole proprietorship, liability for the business is shared by the individual partners. What’s more, partners are not only liable for their own actions, but also the actions of other partners and employees. Additionally, the personal assets of all partners can be used to satisfy any of the partnership’s debt or legal liability.
- Taxes become a little more complicated—In a partnership, taxes are paid by the individual partners on their personal taxes. This requires some additional reporting to the IRS, although the business itself doesn’t pay income tax.
- Your profits are not all your own—Because partnerships are jointly owned, each partner must share in the profits of the business in accordance with their ownership percentage.
Corporation (C Corporation):
Unlike a sole proprietorship, a corporation is a separate entity owned by shareholders rather than an individual business owner. Sometimes referred to as a C Corporation, it’s the corporation that is responsible for the debt and liabilities of the business.
A corporation is a more complicated business entity that will likely require the help of an attorney or CPA to form and carries with it more sophisticated tax and legal requirements. Because of this, most corporations tend to be larger businesses.
Advantages of a Corporation:
- Limited liability—One of the biggest advantages of a corporation is that individual shareholders are not personally liable for the actions of the corporation. In other words, the corporation is responsible both legally and financially for business obligations. Individual shareholders are generally only held accountable for their investment in stock of the corporation. Individual shareholder’s personal assets are not typically in jeopardy in the event of a lawsuit.
- Corporations file their own taxes—Corporations file taxes separately from their shareholders/owners. Individual shareholders pay taxes on their salaries, bonuses, or dividends.
- Generating capital is easier—Corporations can generate capital by selling shares of stock to investors; and are more likely to find success at the bank when looking for a small business loan.
- Employees can benefit—Corporations can compensate key employees by offering partial ownership through stock options
Drawbacks to a Corporation:
- Administrative requirements—The benefits associated with a corporation require yearly administrative operations and tax costs that are not required of other business entities like a sole proprietorship or a partnership. For example, because of additional regulation, federal, state, and local governments require additional recordkeeping.
- Double taxation—Corporations can sometimes result in double taxation. Once when the company reports a profit and again when dividends are paid to shareholders.
Limited Liability Company (LLC)
Think of an LLC as a business entity that provides many of the liability protections of a corporation, but acts more like a partnership. Unlike a corporation however, the “members” of an LLC (the term for the “owners” of an LLC) account for profits, losses, and taxes personally, in a similar fashion to that of a partnership.
The members of an LLC can be individuals, a partnership, a corporation, or even another LLC. Because every state may treat the specifics of forming an LLC differently, you should consult your CPA or attorney to create this type of business entity.
Advantages of an LLC:
- Limited Liability—In most instances, members of an LLC are protected from personal liability in the same way shareholders in a corporation are. In other words, if the LLC is sued, members are usually exempt from personal liability.
- No “corporate” tax—Because the IRS does not recognize an LLC as a business entity for tax purposes, an LLC is not taxed. Members pay federal taxes as the appropriate individual, partnership, or corporation (depending upon who the members are). While the federal government doesn’t tax an LLC, there are some states that do. You’ll want to consult with your CPA to see if your state does.
- Fewer record keeping requirements than a corporation—Starting an LLC is much easier and many of the operational burdens associated with a corporation do not exist for an LLC.
- Accessing capital is easier—An LLC is more likely to find success when looking for a small business loan.
Drawbacks to an LLC:
- Members pay self-employment taxes—The members of an LLC are considered self-employed and are required to make the appropriated self-employment tax payments to Medicare and Social Security. The net income of the LLC is subject to this tax.
An S corporation, like an LLC, allows shareholders to avoid the double taxation sometimes associated with a C Corporation by passing the responsibility for taxes to the individual shareholders through a special IRS election. Although the S Corporation is considered a separate entity and limits the personal liability of its shareholders, they may not necessarily be entirely immune to personal liability. You should consult with your attorney to learn more about the limits to liability protection.
Forming an S Corporation requires that you have previously formed a C Corporation. Once the corporation is formed, the shareholders can elect to become an S Corporation. Every state treats how S Corporations are taxed differently, so you should consult with your tax attorney or CPA to determine what the tax ramifications are in your state.
Benefits of an S Corporation:
- Limited liability—Like a C Corporation and an LLC, an S Corporation provides liability protection to its shareholders.
- The S Corporation doesn’t pay taxes—Like an LLC, the tax burden for an S Corporation is passed on to the shareholders.
- Accessing capital is easier—An S Corporation is more likely to find success when looking for a small business loan. Because the S Corporation has been around for a long time and in many ways is designed for small businesses, lenders are familiar with the structure and often prefer to deal with S Corporations over a sole proprietorship, a partnership, or even an LLC.
Drawbacks to an S Corporation:
- Administrative requirements—Like a C Corporation, there are additional regulation and operational requirements associated with an S Corporation. For example, annual shareholder meetings and additional record keeping are required.
- There are shareholder compensation requirements—The IRS takes notice of shareholders who are paid low salaries and high distributions and may reclassify non-salary compensation as salary if they perceive abuse.
Your choice of business entity can impact how you run the administrative side of your business, how you pay your taxes, as well as your exposure to personal liability. What’s more, it can even make a difference when it comes time to apply for a small business loan.