Your choice of legal business structure sets the shape and path of your new venture. Each type — sole proprietorship, partnership, limited liability company or corporation — has advantages and disadvantages when it comes to complexity, liability, taxes, control and capital investments.
"Your decision about what type of business entity to form can be as crucial to your business success as your marketing, hiring or sales decisions," author Anthony Mancuso wrote in "LLC or Corporation?: How to Choose the Right Form For Your Business" (NOLO, Edition 6, 2014). The key is to figure out which type of entity gives your business the most advantages to help you achieve your organizational and personal financial goals.
Types of business entities
Knowing the defining characteristics of each business entity type provides a foundation on which to balance the pros and cons of each choice:
This is the simplest form of business entity; it is used by more than 70 percent of businesses in the United States, according to the Small Business Administration. Sole proprietorship is used by businesses owned by one person who is responsible for all of its profits and debts.
This entity is owned by two or more individuals. There are general partnerships and limited partnerships. In a general partnership, all is shared equally, whereas in limited partnerships, one partner has control over operations, and the other(s) contribute only assets to receive part of the profits. Partnerships carry a dual status as a sole proprietorship or limited liability partnership (LLP) depending on its funding and liability structure.
Limited liability company (LLC)
A limited liability company is an entity that combines a sole proprietorship with the limited liability of a corporation. The owners, partners or shareholders of an LLC are protected from personal liability for the debts of the business, providing it cannot be proven that they have acted in an illegal, unethical or irresponsible manner in carrying out the activities of the business.
The law regards a corporation as an entity separate from its owners. It has its own legal rights, independent of its owners; can sue, be sued, own and sell property; and sell the rights of ownership in the form of stocks. There are several different types of corporations, including C corporations, S corporations and B corporations. While S and B corporations provide certain tax advantages over C corporations, there are certain eligibility requirements your company must meet. For example, an S corp must be a domestic company with no more than 100 shareholders, and a B corp must have a social or environmental objective built into their business model. Click the links above for more information on each type of corporation.
Factors to consider
It's not easy to decide which entity to use. Several factors must be weighed, such as startup money, risk, liability and the ability to grow. Are you worried about losing personal assets? Setting up a corporation minimizes personal risk but provides less control and more tax exposure. Do you want total control and you're not afraid of risk? A sole proprietorship is the easiest to operate, and doesn't require you to file any paperwork with the government, other than your personal tax return at the end of the year.
Partners provide more funding streams and idea generation but may hinder growth in the event of a dispute. Does your business concept require a large influx of other people's money? Corporations raise money more easily, by selling stock and approaching venture capitalists. To make a final decision, it is critical to know what you want from your company now and in the future. You can turn a sole proprietorship into a corporation very easily, but the reverse is not true. Choosing correctly at the business's inception dictates your course of action, saves money and eliminates backtracking.
In regard to startup and operational complexity, there is nothing simpler than a sole proprietorship. You simply start doing business, report the profits and pay taxes on it as personal income. Conversely, however, it can be difficult to procure outside funding. Partnerships, on the other hand, require a signed agreement to define roles and percentages of profits, and LLCs and corporations are filed with the state and federal governments.
A corporation carries the least amount of personal liability, as it is regarded as its own entity by the law. This means that creditors and customers can sue the corporation but not gain access to any personal assets of the officers or shareholders. An LLC offers the same protection but with the fluidity of a sole proprietorship. Partnerships share the liability between the partners as defined by their partnership agreement.
An LLC will pay taxes as a sole proprietor does — all profit is considered personal income and is taxed accordingly at the end of the year. Partners in a partnership also claim their share of the profits as personal income. Your accountant may suggest quarterly or biannual advance payments to minimize the end effect on your return.
A corporation files its own tax return each year, paying tax on profits after expenses, including payroll. If you pay yourself from the corporation, you will pay personal taxes, such as Social Security and Medicare, on your personal return for what you were paid throughout the year.
Either a sole proprietorship or an LLC might be a good choice for you if it is important for you to have sole or primary control of the business and its activities. You can negotiate such control in a partnership agreement as well. A corporation is constructed to have a board of directors that makes the major decisions that guide the company. A single person can control a corporation, especially at its inception, but as it grows, so does the need to operate it as such. Even as a small corporation, the rules intended for larger organizations — such as keeping board-of-directors notes of every major decision that affects the company — still apply.
If you need to obtain outside funding sources — like investor or venture capital, bank loans and other avenues for money — you may be better suited as a corporation, which has an easier time doing so than a sole proprietor. Corporations can sell shares of stock, securing additional funding for growth, while sole proprietors can obtain funds only through their personal accounts, using their personal credit or taking on partners. An LLC can face similar struggles, although, as its own entity, it is not always necessary for the owner to use his or her personal credit or assets.
Licenses, permits and regulations
Regardless of which type of entity it is, every business must be licensed to operate legally. Depending on the type of business and its activities, it may need to be licensed at the local, state and federal levels. In addition to ensuring that your business entity has its basic legal registration, you may need specific permits. Regulations vary by industry, state and locality, and it is essential to understand the licensing rules where the business is located. Failure to comply with licensing and permit regulations can lead to legal action, fines and closure of the business.
It's important to note that the structures discussed here only apply to for-profit businesses. Please visit this Business News Daily article if you are planning to start a nonprofit organization. If you're still unsure of which business entity to choose, speak with a legal professional to help you decide.