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.
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.
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.
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.
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.
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.
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.
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.
Are you thinking about becoming an S corporation? Read more to know what it is, how it's different from an LLC, and its pros and cons for your business.
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