Before you can get your business off the ground, you have to determine which type of business ownership entity best fits your company. This decision can be intimidating for many first-time owners, but we will try to make it easy by giving you all the tools you need to structure your business for success.
After learning a little about how each structure works, we will go over the advantages and disadvantages of each and what factors go into determining what type of business entity is right for your organization. Then, all you have to do is apply for the paperwork and your business will be up and running in no time.
Types of Business Ownership Entities
The type of business structure you choose will affect how your business is run, who can own it, how you can secure business loans and how owners can be held liable for certain debts and actions of the company. It will also determine how your business is taxed and whether the company pays those taxes or they are “passed through” to the business owner(s).
States recognize more than a dozen types of business entities, but most small business owners only need to concern themselves with a few:
- Sole Proprietorship
- General and limited partnerships
- Limited Liability Company (LLC)
- C-Corp and S-Corp
Each of these has its advantages and disadvantages. Weighing the pros and cons, and applying them to what you imagine for your small business, is the best way to find the right fit.
Advantages and Disadvantages of Business Entity Types
Some of the types of business entities available to you share similarities, but each has a distinct set of attributes that can make it the right choice. Understanding what sets them apart is the first step in deciding what makes sense for your company.
Sole Proprietorships are the most simple and common way that small businesses are structured. You may not know it, but if you are currently doing any business activities, you are already running a sole proprietorship. They are common for smaller, home-based businesses and some larger, low-risk companies.
As a sole proprietor, you as a business owner are not looked at as a separate entity from your business. This means that you are responsible for all debts and liabilities the company may face, but you are in full control of your business.
|Easy and inexpensive to set up||Very high risk. Owner assumes full liability, even for employee actions|
|You are in complete control of all business activities||Complete control comes with the burden of making every decision and being responsible for all successes and failures|
|Business losses can be deducted on the owner’s personal tax return||Funding can be difficult because you cannot sell shares|
Sole proprietorships are beneficial because of their simplicity and what they allow the owner to do. All you have to do is choose a name (if other than your own) and procure any licenses and permits you may need for your industry. Taxes for sole proprietors are comparatively low and are “passed through” to your personal taxes using the “Schedule C” and 1040 forms.
On the flip-side, this type of business structure comes with inherent risk. Since you and your company are one and the same, all debts and liabilities fall back on you, the owner. This can leave you open to lawsuits that can put your personal assets in jeopardy. Paying for those debts can be tough, too, because you cannot sell shares to investors and some lenders see a higher potential risk with sole owners.
General and Limited Partnerships
Partnerships are similar to sole proprietorships, but they are for businesses with two or more owners. They are a common business entity for ownership groups like you would see in law firms, as well as owners that want to test the waters before expanding into a larger corporation.
Ownership and liabilities in general partnerships are structured like a sole proprietorship, but split between the owners. It is considered a jointly-owned company, so the split of potential risk and reward are equally shared among owners.
|Easy and inexpensive to set up||High risk. Owners assume full responsibility for debts and liabilities|
|Owners have equal say in business activities||Sharing full control can become messy and cause problems|
|Owners can report company losses for personal tax purposes||Owners pay taxes on company profits|
Unlike general partnerships, limited partnerships do not spread the power and liabilities equally among all owners of the business. The general partner is an owner in charge of running the operations, making decisions and managing all aspects of the company. Silent partners, however, act as investors to help fund the company and allow the general partner to run the business accordingly.
|Silent partners are free of liability for any debts and judgments||General partners alone incur the full risk of debts and liabilities|
|Investors are attracted because they are only on the hook for their original investment||Silent partners do not have the power to determine what is done with their investment|
|General partners do not lose controlling stake when raising capital||Can be more expensive and complicated to create than other entity types|
Both of these types of partnerships offer distinct attributes that can attract owners, whether they want to control the business or just own a stake in them. “Pass through” taxes are important for managing owners, and the liability exemptions in limited partnerships make them attractive to investors.
Operations can get messy, though. Having too many owners with an equal say (or an angry investor who disagrees with your company’s use of funds) can put a wrench in your plans.
Corporations, unlike sole proprietorships and partnerships, are legally considered a separate business entity from the owner. This distinction makes the company itself liable for debts and judgments against it.
Ownership and operational structures are a big difference in the way corporations work. Shares can be made public to raise capital. Bylaws and boards are put into place to make sure those who run the business are working in the interest of all with a stake in the company. Larger companies that may eventually want to go public should consider forming a corporation.
C-corps are the standard designation for a corporation. C-corps have strong regulations and fees associated with running them, but they do have advantages that can appeal to your business.
|Owners have limited personal liability||Complicated and expensive startup and maintenance|
|Owners are eligible for more tax deductions and lower rates||The corporation pays taxes separately from owners, which can be complicated|
|Benefits can be deducted as business expenses||Subject to higher regulations and scrutiny from government|
The limited liability of corporations and lower tax rates can be appealing, but the way the taxes are paid can cause issues for some owners. C-corps are taxed based on their earnings, then the owners must also pay taxes on dividends distributed between them. This “double taxation” that comes with the company being considered a separate entity makes some choose to turn their corporation into an S-corp.
From liability and operational standpoints, S-corps are similar to C-corps. They are, however, generally much smaller companies with less complicated internal structure. Finances and power usually work similarly to a sole proprietorship.
To qualify to be run as an S-corp, your business must meet a few criteria:
- Be an eligible company (some financial institutions, international sales corporations and insurance companies are ineligible)
- Be a domestic company
- Have no more than 100 shareholders- cannot include partnerships, corporations or non-resident aliens
- Have only one class of stock
If they qualify, many small business owners prefer S-corps because of their tax benefits, although those can come with certain requirements.
|Owners have limited personal liability||Complicated and expensive startup and maintenance|
|Owners share profits and report them on their personal taxes||Some tax benefits are only given to owners with more than a 2% company interest|
|Company losses can be used as deductions on the owner’s taxes||The stake an owner has correlates to the amount of profit they are entitled to|
Since S-corps offer owners the flexibility to have taxes “passed through” to their personal returns, they eliminate the double-taxation headache that pains owners of C-corps.
Limited Liability Companies
Limited Liability Companies, or LLCs, are a very flexible option for business owners. They provide more protection against debts and judgments the business incurs, and multiple tax options make LLCs a fantastic option for higher risk businesses with room for growth like construction and service companies.
|The company itself is held responsible for all debts and liabilities, not the owners||If the owner runs the business improperly, they can still be held personally liable|
|Less compliance and regulation than corporations||More expensive to start up and run than sole proprietorships and partnerships|
|Owners choose whether the company is taxed as a partnership or corporation||Owners are subject to “self-employment” taxes, which can be higher than corporations|
LLCs fall between sole proprietorships/ partnerships and corporations in a lot of ways. The mix of limited liability and the ability to designate the company under multiple tax classifications means a lot of flexibility for owners. Principal owners will be subject to paying Medicare and Social Security taxes, however, and will still be held liable if they are not careful with how they run their business.
What To Consider About Business Entities
Now that you know about what types of business ownership structures are available for your business, you can apply that knowledge to your own situation. There are a lot of different things to think about, but we have cut it down to 4 considerations you should weigh to find the right type of entity for your business.
Money drives everything when it comes to your business, and it starts with how you want your business to be taxed. If you want your business taxes to be reflected on your personal return, as well as possibly qualifying for a significant tax deduction, then you should consider “pass-through” business entities like a sole proprietorship, partnership, LLC or an S-corp. If you want your business to be treated and taxed as a separate entity, then a C-corp is for you.
Liabilities are the next important thing to consider. The more danger or risk involved in your industry, the less liability you want. For example, a construction company may be suited for an LLC or a corporation. Otherwise, you can be held personally responsible for any accidents incurred by your employees and others, let alone the debts the company accrues.
The possibility that your business will need to secure capital in the future will be an important consideration when making your choice. Traditional lenders look less favorably on businesses with higher risk to the borrower, meaning a sole proprietor who needs funding for equipment or expansion could be without the cash they need.
Corporations allow businesses to sell stock, so owners that envision an IPO in their company’s future may find it a better idea to classify as that type of business entity. If that is not a goal for you, it may be wise to consider one of the other options.
Expenses and Procedures
When starting a business your time and money are at a premium. How quick and easy the processes are help determine the right entity choice. The most simple choices are sole proprietorships and partnerships. They can be as simple to set up as filing a single document with your Secretary of State, and fees for partnerships can be minimal while sole proprietors need not pay anything at all.
LLCs can be very complicated, but generally set up is as simple as getting all the correct paperwork together and paying a small fee. Corporations are very complicated to start up, and running them requires creating bylaws and following strict regulations.
Choosing the Right Type of Business Entity
Now that you know all about the different types of common business entities, it’s time to make a decision. Consider what each structure means for your company now and in the future. Remember, things change so this decision is not always final. Growing your company can be made easier or more difficult based on how you choose to structure your business, so take the knowledge you learned today and make the choice that makes the most sense for you and your small business.