When you start a new business, one of the first things you will need to do is choose what type of legal business entity to establish. There are many different types of business entities, and the most common are sole proprietorships, partnerships, corporations, and limited liability companies. The legal business entity you choose will impact everything from the amount of tax you pay to the amount of paperwork you file. It will also dictate your exposure to liabilities as well as how you attract investors and organize your operations.
Before choosing a business structure, it’s useful to understand the benefits and drawbacks of each type of legal business entity. This guide (and accompanying business structure chart) will explore the different forms of business entities and show you how to choose a business entity that’s best for your needs.
How to Get Started Choosing a Business Structure
Choosing a business structure suited to your needs can help you minimize taxes, manage personal liability, get the right financing, and set clear expectations for how the business is run. Because different forms of business entities have different advantages and disadvantages, your decision should be tailored to your situation: there is no one-size-fits-all solution or “best” business entity to choose, and every business owner has to weigh the benefits of each before making the choice that’s right for them.
As you familiarize yourself with the different business structures available, consider these questions:
…will you run the business by yourself, or partner with others?
…which state will you operate or file in?
…how much personal liability are you willing to take on?
…how do you plan to attract investors (if any)?
…how much recordkeeping and reporting are you ready to do?
…how can you best manage your tax responsibilities?
We’ll touch on these questions as we discuss the different options available to you. First, let’s look more closely at the most common business entity examples.
What are the Different Types of Business Entities?
The most common types of business entities are sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). While there are a few others, these are the ones new business owners most commonly consider.
- A sole proprietorship is the simplest and most common legal business entity. It gives you, the sole business owner (or married couple), complete control of business operations. On the other hand, it also makes you fully responsible for any liabilities, debts, or financial obligations.
- Advantages of sole proprietorships: Sole proprietorships are simple and uncomplicated legal business entities, and many business owners start with this business structure for that reason. A sole proprietorship gives you total control of your business, and you can report all profits and losses on your individual income tax return. When you start your business as the only owner, you are automatically considered to be a sole proprietorship: you don’t have to file any special forms to establish this legal business entity.
- Disadvantages of sole proprietorships: With full responsibility comes full liability: if your business accrues debts, losses or outstanding financial obligations, you will be personally responsible for those. You may also have fewer funding sources available to you, as banks and investment firms are reluctant to loan money to sole proprietorships.
- A partnership is formed when two or more people decide to run the business jointly, sharing both the profits and losses. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, all partners are involved in the operation of the business. A limited partnership, on the other hand, consists of both owner/operators as well as passive, or “silent partners” who act as investors and do not take on personal liability.
- Advantages of a partnership: All profits and losses a partnership sustains “pass through” to the individual partners, who then report them on their own income tax forms. Just as with a sole proprietorship, there is no state paperwork required to be classified as a general partnership: it’s the default business entity for any business that has multiple owners. (Limited partnerships, on the other hand, do need to file state paperwork).
- Disadvantages of a partnership: Just as in a sole proprietorship, partners are on the hook for any financial obligations that the business accrues or lawsuits it faces. As a general partner, you can be sued or held liable for another partner’s negligent actions.
- A corporation is a separate legal entity, governed by the laws of the state in which it is incorporated. A corporation consists of owners/shareholders, the board of directors, and various officers. Even though there are many “roles” required in a corporation, one person can still technically be in charge of them all.
- Advantages of corporations: Because a corporation is treated as a separate legal entity, it offers limited liability to stockholders, meaning investors can’t be held responsible for any losses or debts beyond their invested amount. Corporations also make it simple and tax-advantageous to incentivize employees through equity compensation like options and restricted stock, and offer a variety of tax deductions that other business entities don’t.
- Disadvantages of corporations: A significant drawback of corporations is the cost to establish them, as well as the paperwork and record-keeping required. Because of its status as a distinct legal entity, a corporation’s income is also essentially taxed twice: first when it is earned, and second when it is distributed to stockholders. (This challenge can be eliminated if a corporation chooses to be treated as an S-corporation, but that comes with its own set of limitations).
- A limited liability company (LLC) combines some of the benefits of a corporate structure with those of a partnership. For example, it offers limited liability as well as the ability for business owners to choose how profits are distributed and how management allocates profits and losses.
- Advantages of limited liability companies (LLCs): The IRS lets you choose how you want your LLC to be taxed, either as a “pass through” entity like a sole proprietorship, or as a separate entity like a corporation. For example, an LLC taking advantage of the “pass-through” business structure can eliminate the double-taxation faced by corporations. Profits and losses can then flow directly to the individual equity holders. Like corporations, LLCs also shield owners from personal liability.
- Disadvantages of limited liability companies (LLCs): LLCs that want to attract venture capital may be required by their investors to convert to a corporation, which can add time and expense, especially when the company needs to quickly obtain capital.
How to Choose a Business Entity
Once you are familiar with the pros and cons of each legal business entity, including how it will impact taxation and your exposure to liability, you can make the best choice for your circumstances. Before making your decision, consider the following questions:
- How much legal liability are you willing to take on? If your business has a high risk exposure or the potential to sustain significant losses, then you’ll likely want to shield your personal assets by choosing a business structure like a corporation or LLC. In that case, nobody would be able to seize your personal assets in case of a lawsuit or legal action. Sole proprietorships and partnerships, on the other hand, leave your personal assets exposed to these risks.
- How can you best manage your tax responsibilities? While corporation earnings are taxed twice, you can often get the advantages of a corporation while eliminating double-taxation by forming an S-corporation. Corporations also benefit from tax advantages and deductions that sole proprietorships and partnerships don’t have access to: be sure to consult a legal advisor to understand these nuances. On the other hand, if simplicity is your goal, then a sole proprietorship or partnership may be the right choice because you would list any business profits or losses on your individual tax return.
- How much paperwork will be required? Record-keeping, reporting requirements, and paperwork come at a high cost, especially if you choose a corporation as your legal business entity. Ask yourself if the advantages of this entity will outweigh the time and cost of the required business administration. A sole proprietorship, for instance, can give you more breathing room to focus on growing your business rather than keeping up with forms and filings.
Which Type of Business Structure is Right for Me?
While many business owners will choose their business entity, and fill out the related paperwork, on their own, you may find it useful to consult a legal advisor before committing to a decision. In either case, you may find this business structure chart useful:
|Sole proprietorship||Full exposure: your personal assets (like your home, car, and bank accounts) can be seized in a lawsuit.||You file all profits and losses on your individual tax return and are taxed accordingly.||No special business record-keeping or state registration is required: individuals or married couples who start a business are automatically classed as sole proprietors.|
|Partnership||Full exposure for general partners: your personal assets (like your home, car, and bank accounts) can be seized in a lawsuit. You can also be held legally responsible for another partner’s actions. (Limited partners, on the other hand, are not exposed to these risks.)||You file all profits and losses on your individual tax return and are taxed accordingly.||No special business record-keeping or registration is required: multiple individuals who start a business are automatically classed as a general partnership (unless they opt for a limited partnership format, which does require some paperwork).|
|Corporation||Limited exposure: your personal assets cannot be seized in case of legal disputes.||Corporations offer a variety of tax advantages, but are also double-taxed (on earnings and dividends) unless they are an S-corporation.||Extensive record-keeping and reporting is required. Requirements vary by state, but prepare to hold regular board and shareholder meetings, create bylaws, and keep meeting minutes.|
|Limited Liability Company (LLC)||Limited exposure: your personal assets cannot be seized in case of legal disputes.||You can choose to have LLC income and losses “pass through” to individual business owners.||Reporting requirements vary by state but are far less complex than for corporations.|
Choosing the right business entity from the start can ultimately save you time, cost, and future headaches. At PaySimple, we are committed to supporting your business as you go from first idea to first sale, and on to sustained growth.
Now that you know how to choose a business entity, you may want to start thinking about how you’ll start accepting those first customer payments! PaySimple can make that process easy, seamless, and professional, whether your customers prefer to pay in-person, online, one-time, or with automatic monthly billing. To find out more or get started, see what a difference PaySimple can make.