When starting a business, one of the essential things to do is choosing the structure of your company or the business entity type. This is an important decision with several financial and legal implications for your business.
For instance, the amount of taxes you pay vary according to your choice of business entity. The type of business entity also impacts your funding options, such as getting approved for a business loan or raising capital through investors.
Typically, most businesses fall into the following five categories, though several other business entities are recognized in the US.
- Sole Proprietor
- General Partnership
- Limited Liability Corporation
- S Corporation
- C Corporation
But which entity type is right for your business? We’ll help you figure that out by breaking down the common business entity types and discussing their pros and cons.
Breaking Down The Common Business Entity Types
1. Sole Proprietorship
If you’re working as a freelancer or plan on starting a small operation, say an art studio or a boutique, this is an option worth considering. As a sole proprietor, you may even hire employees or contractors. However, if your income crosses a certain threshold, you’ll be required to incorporate your business.
The best part about a sole proprietorship is that it’s easy to set up without much paperwork involved. All you need are some local licenses and approvals, and you’re ready to fly.
The Upside
- A sole proprietorship is one of the most straightforward business entities to set up with little paperwork and low costs involved.
- Exiting a sole proprietorship is as easy as setting up one. As a single owner with no board or partner, you can dissolve your business at any time without any formal paperwork.
- Being the sole proprietor and owner, you can deduct your business losses on your personal tax return.
The Downside
- As the sole owner, you’re personally responsible for all the business cash flow debts and liabilities. Therefore, if someone files a lawsuit against your business and a judgment is passed in their favor, your personal assets could be attached to make good the fees and payments.
- Lenders and investors consider sole proprietorships to be riskier than other types of business entities, which might make it difficult to get a business loan or raise funds.
2. Partnership
A partnership is an entity owned by two or more individuals. There are two types of partnerships – general partnerships and limited partnerships. General partnerships are easier to set up, being the default entity type for businesses owned and managed by multiple owners.
A limited partnership, on the other hand, is a complicated structure with two types of partners. These are general partners (who assume liability and operate the business) and limited partners or investors. Furthermore, a limited partnership needs to be mandatorily registered, making it an expensive choice.
The Upside
- General partnerships are easy to start without any registration requirement. However, limited partnerships must be registered in the state.
- General partnerships don’t usually pay income tax. Instead, both partners must report their shared income or loss on their individual income tax returns. They can also claim business losses on personal returns.
The Downside
- Each owner is personally liable for each other’s business debts and liabilities, including negligent behavior in some states.
- Getting a business loan is often difficult for general partnerships, as they are not registered entities. On the other hand, a limited partnership is good for raising money as investors can serve as limited partners without being personally liable for the acts of the company.
3. C Corporation
A C Corporation is structured as a separate legal entity from the company’s owners. This means the corporation retains the profits and incurs losses and is also taxed separately from the owners. Additionally, the corporation takes the liability off individuals and partners, making it a preferred entity type for many small and mid-sized businesses looking at rapid growth and expansion.
The Upside
- In a C Corporation, owners don’t have any personal liability for the business’s debts and liabilities. This means there’s no need to worry about your personal assets being affected by debts, losses, or any lawsuits against your company.
- C Corporations are eligible for tax deductions at a rate of 21% currently, which is more than any other type of business.
- If your business grant for women is a C Corporation, you also have the option to raise stock options or bring on investors to raise funds.
The Downside
- Establishing a C Corporation is complicated and expensive, as it involves both the state and federal authorities.
- C Corporations also face double taxation. That’s because the company files a separate corporate tax return and the shareholders also pay taxes on dividends on their personal returns.
- Typically, a C Corporation is run by shareholders, a board of directors, and officers. This leads to a lot of formalities and paperwork, like formulating the company's by-laws, holding regular board and shareholder meetings, and maintaining the minutes of the meeting.
4. S Corporations
An S Corporation is an interesting business structure that retains the perks of a C Corporation while avoiding double taxation. In simpler terms, an S Corporation limits the owners’ liability while preventing double taxation. This is because the finances are passed on to the shareholders, which dispenses the need for filing corporate returns.
Indeed, S Corporations provide a significant tax advantage to businesses. However, there are some limitations attached to this type of entity. For example, an S Corporation cannot have more than 100 shareholders, and they must all be US citizens or residents.
While these restrictions don’t matter much to a smaller business, they can be limiting for a rapidly growing company.
The Upside
- No personal liability of owners for the business’s debts and liabilities.
- There is no corporate taxation or double taxation.
The Downside
- S Corporations are more complicated and expensive to create as compared to sole proprietorships and partnerships.
- Only US citizens can be shareholders in an S Corporation.
- Owing to the limitations on the number of shareholders, an S Corporation isn’t the right choice if you’re aiming at massive expansion.
5. Limited Liability Company (LLC)
An LLC is a hybrid company structure that provides the benefit of limited liability and greater flexibility. As an LLC, you may choose to be taxed as a corporation or opt for the income and loss to be passed on to individual owners, as in a sole proprietorship or partnership. Furthermore, they involve less paperwork and formalities than corporations, making it a viable option for small and large business entities alike.
The Upside
- There is no personal liability of owners for the business’s debts or liabilities.
- The flexibility to be taxed as a corporation or partnership.
The Downside
- The only major downside of an LLC is that it is more expensive to set up than a sole proprietorship or partnership as state registration is mandatory.
Choosing the Right Entity Type for Your Business
Choosing the right business entity becomes easy once you have a basic understanding of the available options. However, you should note that while sole proprietorships and partnerships require little or no legal assistance, for more complicated structures, it’s best to consult a lawyer or a tax professional to make an informed choice.
It is also possible to change your business's type in the future as your requirements change. For instance, you might want to bring partners and investors on board or change the way you’re being taxed.
The good thing is that it’s possible to change your business entity type anytime you like. You must nevertheless consult a professional to ensure you meet all the legal requirements to ensure a smooth transition. Additionally, a good accountant will help you keep your small business bookkeeping in order and ensure you keep up with the regulations surrounding your new entity.