What is a business entity? It’s an organization founded by one or more natural persons to facilitate specific business activities or to allow its owners to engage in a trade. Corporations, limited liability companies, partnerships and sole proprietorships are types of common business entities.
Choosing the right business entity for your small business is an important decision, and while there are a million things that need to be done when you’re starting out, this isn’t a step to be ignored or taken lightly. The type of business structure you choose will have an impact on your day to day operations, legal, tax and liability issues. It’s pretty much the rule that everyone makes mistakes in business, but you can avoid some issues when starting out without a little bit of planning.
So, put some thought into the business type that will best suit you. Here is a run down of the four most common types of business entities along with some pros and cons.
Sole Proprietorship
A sole proprietorship is the easiest business entity to get started; you simply decide to be a business and you are. If you start a new business by yourself, you are by default operating a sole proprietorship. There’s nothing to register with the state; though there may be local licenses and permits required depending on the type of business you are operating. It’s quite possibly the most common type of business entity used, and is very common among freelancers, service providers and consultants with a single owner. It does however come with a major inconvenience - there’s no limited liability for the owner personally; if you’re a sole proprietor you’re on the hook for all the business liabilities. So if a client, vendor or anybody else sues the business, they’re also going to be able to take your personal assets. It’s common for businesses that start out as sole proprietorships to transition into a more formal business entity (such as a corporation or limited liability company) as they grow and become more formal operations.
Pros:
- Easy to get started and operate.
- No corporate paperwork or formalities.
- Simple taxation - you report all of your business income or loss on your personal taxes.
- Management flexibility - you get to be in complete control.
Cons:
- The owner remains personally liable for lawsuits, debts and liabilities of the business.
- Not having a formal, separate business makes it harder to get business financing or raise capital.
- Uncertain business life - the death, physical impairment, or mental incapacitation of the owner can result in the termination of the business.
- Less businesslike in appearance - unlike a corporation or LLC, sole proprietorships are often viewed as less professional.
Partnership
Partnerships have a lot in common with sole proprietorships, there’s just more than one owner. Typically, all partners are actively involved in managing the partnership and share in the profits and losses. It’s common for people to form a partnership in order to limit some of the risk involved in starting a sole proprietorship. A partnership is the default business entity when two or more people want to start a business and similar to a sole proprietorship, there is no need to register with the state - you decide you’re in business and you are. The flip side of that is partnerships share the same major disadvantage that sole proprietorships have - personal liability for company debts and obligations. It’s important to think carefully about who you enter into a partnership with and how you will settle any disputes that may arise (because they will come up). Choosing the right partners is an important step.
Pros:
- Easy to start up, no state registration required.
- No corporate paperwork or formalities required.
- Risk minimization - you aren’t in it alone and have a partner to split responsibilities and loses with.
Cons:
- Each owner is personally liable for the business’s debts and other liabilities.
- Disputes between partners can unravel the business (though you can plan for this with a solid partnership agreement).
- It’s more difficult to get a business loan and build business credit without a registered business entity.
Limited Liability Company (LLC)
A limited liability company (LLC) may be the most flexible business entity. It takes a lot of the positive features from some of the other entities and discards a lot of the negatives; making it a very popular form of business structure. There are fewer paperwork and formal requirements than a corporation, you get the limited liability that a sole proprietorship can’t provide and have several options when it comes to handling taxes. It gives you the benefit of looking like a more legitimate, established business as opposed to a sole proprietorship. LLC’s are extremely popular among small and mid-sized business owners. They allow for sole owners or multiple owners and can be set up to have a longer lifespan than a sole proprietorship.
Pros:
- Owners don’t have personal liability for the business’s debts or liabilities.
- Tax flexibility - can be taxed as a pass-through entity (meaning there is no tax at the company level) or as a corporation; allows you to pick what works best for you.
- Not as many corporate formalities as compared to a corporation, easy to get setup.
- Credibility - partners, creditors, suppliers and vendors may look more credibly on your business when it’s an LLC as opposed to a sole proprietorship.
Cons:
- More expensive than starting a sole proprietorship, and it does require registration with the state.
- Limited capital opportunities - it may be difficult to raise investment capital as an LLC.
- Taxes - make sure you understand how your LLC is getting taxed and are aware of and how the self-employment tax may apply to you.
Corporation
A C-corporation is an independent legal and tax business structure that is entirely separate from the company’s owners. The owners (called shareholders), a board of directors and the officers have control over the company and are the decision makers. It’s possible to have a single person fill all those roles and there are businesses registered as corporations that only have one owner. This type of entity comes with more paperwork, more registration requirements, more expenses and more formalities than the other ones discussed here. The requirements for setting up and maintaining a corporation will vary by state, but in general it’s a more formal process than other types of business entities.
Pros:
- Owners don’t have personal liability for the business’s debts and liabilities.
- C-corporations are eligible for more tax deductions than any other type of business.
- C-corporation owners pay lower self-employment taxes.
- You have the ability to offer stock options, which will help if you need to raise money in the future.
- Organization - corporations have an established structure from top to bottom (shareholders, board of directors, officers), which gives each group defined roles and responsibilities.
Cons:
- The process is more time consuming, expensive and involves more paperwork.
- Potential for double taxation - the company pays taxes on earnings and then shareholders pay taxes on the dividends they receive.
- Regulations may not provide for as much flexibility in operations as other types of entities.
Have questions about business entities or want to discuss any legal or risk management questions? Contact us to schedule a free consultation.