The legal structure you choose for your business is one of the most important decisions you will make in the startup process. There are four basic types of business entities, each of which has its own pros and cons.
Your choice of structure can greatly affect the way you run your business, impacting everything from liability and taxes, to control over the company. The key is to figure out which type of entity gives your business the most advantages when it comes to helping you to achieve your organizational and personal financial goals.
Types of business entities
1. Sole proprietorship
This is the simplest form of business entity, and it is used by more than 70 percent of businesses in the United States, according to the Small Business Administration. With sole proprietorship, one person is responsible for all of a company's profits and debts.
This entity is owned by two or more individuals. There are two types: general partnerships, where all is shared equally; and limited partnerships, where only one partner has control of its operation, while the other person or persons simply contribute to and receive only part of the profit. Partnerships carry a dual status as a sole proprietorship or limited liability partnership (LLP), depending on the entity's funding and liability structure.
3. Limited liability company (LLC)
A limited liability company is a hybrid structure that allows owners, partners or shareholders to limit their personal liabilities while enjoying the tax and flexibility benefits of a partnership. Under an LLC, members are protected from personal liability for the debts of the business, as long as 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 that is separate from its owners. It has its own legal rights, independent of its owners — it 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. However, many people fail to consider the differences between them. For instance, while S and B corporations provide certain tax advantages over C corporations, there are certain eligibility requirements that your company must meet.
"A common misconception is that all types of corporations are the same," said Jennifer Friedman, CMO of the small business segment of Wolters Kluwer's BizFilings and CT Corporation. "A C corporation is different from an S corporation, but most people don't even know that there are different types until they start doing research." [See Related Story: How to Start a Business: A Step-by-Step Guide]
Factors to consider
For new businesses that could fall into two or more of these categories, it's not always easy to decide which one to choose. You need to consider your startup's financial needs, risk and the ability to grow. It can be difficult to switch your legal structure after you've registered your business, so choosing correctly at the start is crucial.
In regard to startup and operational complexity, there is nothing simpler than a sole proprietorship. You simply register your name, start doing business, report the profits and pay taxes on it as personal income. 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. Corporations and LLCs have various reporting requirements with the state and federal governments.
A corporation carries the least amount of personal liability, since the law holds that it is its own entity. This means that creditors and customers can sue the corporation, but they cannot gain access to any personal assets of the officers or shareholders. An LLC offers the same protection, but with the tax benefits of a sole proprietorship. Partnerships share the liability between the partners as defined by their partnership agreement.
An owner of an LLC will pay taxes, just as a sole proprietor does — all profit is considered to be personal income and is taxed accordingly at the end of the year.
"As a small business owner, you want to avoid double taxation in the early stages," Friedman told Business News Daily. "The LLC structure prevents that, and makes sure you're not taxed as a company and as an individual."
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.
If it is important for you to have sole or primary control of the business and its activities, a sole proprietorship or an LLC might be the best choice for you. 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 a board-directed entity. 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 off establishing a corporation, which has an easier time of obtaining outside funding than does a sole proprietorship. Corporations can sell shares of stock, securing additional funding for growth, while sole proprietors can only obtain funds 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
To operate legally, every business must be licensed. 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 is legally registered, you may need specific permits.
"States have different requirements for different business structures," Friedman said. "Depending on where you set up, there could be different requirements at the municipal level as well. As you choose your structure, understand the state and industry you're in. It's not a 'one size fits all,' and businesses may not be aware of what's applicable to them."
It's important to note that the structures discussed here only apply to for-profit businesses. If you've done your research and you're still unsure about which business structure is right for you, Friedman advised speaking with a specialist in business law.
For more information on the types of business structures you can choose, visit the Small Business Administration website.
Additional reporting by Marci Martin and Nicole Fallon Taylor. Some source interviews were conducted for a previous version of this article.