Starting a new business is always an exciting prospect for an individual and there are several types of business entities to choose from. When you start your business, you will have to decide on which type of business entity you will be, whether it is a sole proprietorship, partnership, limited liability company (LLC), corporation, or non-profit. The type of business structure you wish to select will depend on several factors or aspects, including the nature of the workforce within your organization, the goal of the company and so on.
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Each and every legal structure for business entities has its own advantages and disadvantages, so it is best to eliminate the ones that simply would not fit with your organization before choosing your preferred business type.
If you are having a hard time deciding which type of business to start with, do not worry. In this article, we are going to provide you an insight on what business entities are. We will also share with you a couple of pros and cons for each type of business entity and guide you on how to choose the best business entity type.
A business entity is a separate and distinct legal organization created to conduct business and establish legal relationships. There are many significant considerations as to the type of business entity that will best suit the business you wish to conduct.
Depending upon the type of business entity, creating a business entity offers personal protection to the business owner, dictates the amount and types of taxes paid and controls how the business operates and functions internally.
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In the United States State governments recognize more than a dozen different business entity types, but the average small business owner chooses between these six – sole proprietorship, general partnership, limited partnership (LP), limited liability company (LLC), C-corporation, and S-corporation. Among these options, there is no specific “best” choice for all small businesses.
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We will cover the advantages and disadvantages of each business entity type and guide you on how to determine what is best for your company.
The following represents a summary of the different types of business entities available as well as the advantages and disadvantages of each.
A sole proprietorship (SP) is the simplest form of business. Actually, a sole proprietorship is the default form that you will have if a person begins conducting business without taking any steps to form a recognized business entity.
If you start a new business and are the only owner, then you automatically become a sole proprietor under the law. There is no need to register a sole proprietorship with the state, though you might need local business permits or licenses depending on your industry.
Freelancers, consultants and other service professionals work as sole proprietors commonly, but it is also a viable option for more established businesses, such as retail stores, with one person at the helm.
Sole proprietorships are by far the most popular type of business entities in the United States because of how easy they are to set up. There is a lot of overlap between your personal and business finances, which makes it easy to launch and file taxes.
The problem is that this same lack of separation can lead to you in legal trouble. If a customer, employee, or another third party successfully sues your business, they also are able to take your personal assets. Because of this risk, most sole proprietors gradually converting their business to an LLC or corporation.
The forming cost of a sole proprietorship is $0. There is no tax liability is mandatory when transferring assets between the business and the owner because the business and the owner are one and the same, so legally no transfer occurs.
More importantly, these same benefits can be achieved with other business entities without all the personal liability and risk faced by the owner of a sole proprietorship.
Sole Proprietorships are generally disfavoured. The owner and the business are treated as one and the same.
Generally, the owner of any business personally takes on all of the risks of the enterprise without any of the protections that other business entities afford.
That’s why creditors of a Sole Proprietorship can pursue collection against both the business assets and the business owner’s personal wealth.
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Partnerships have a lot of similarities with sole proprietorships. However, the key difference is that the business has two or more owners. There are two kinds of partnerships, such as general partnerships (GPs) and limited partnerships (LPs). And all partners actively maintain the business and share in the profits and losses.
As the same as a sole proprietorship, a general partnership is the default mode of ownership for multiple-owner businesses—there’s no need to register a general partnership with the state.
Many individuals prefer to form partnerships in order to lower the risk of starting a business. So, instead of going all-in on your own, having multiple people sharing the struggles and successes can be very helpful, especially in the early years.
A general partnership is easy to start up and you do not need to register your business with the state.
Also, no corporate formalities or paperwork, such as meeting minutes, bylaws, etc., are required. You do not need to absorb all the business losses on your own because the partners divide the profits and losses. And yes, owners can deduct most business losses on their personal tax returns.
In a general partnership, each owner is personally liable for the debts and other liabilities of the business. In some states, however, each partner may be personally liable for another partner’s negligent actions or behavior, this is usually called joint and several liabilities.
Disputes and clashes among partners can unravel the business, though drafting a solid partnership agreement can help you avoid this. It is more difficult to get a small business loan, land a big client and build business credit without a registered business entity.
A Limited Partnership (LP) is a partnership of one or more people and one or more limited partners. General partners have responsibility for managing the partnership business and are personally liable for the obligations of the business.
Each and every limited partnership must have at least one general partner. The limited partners do not take part in managing the business and their liability for business obligations is limited to the extent of their capital contributions to the business.
Limited Partnerships are treated as pass-through entities for tax purposes. Limited partners can limit their liability. General partners are vested with management control.
This type of structure is capable to work well in the context of real estate and venture capital where the business needs the benefits of partnership taxation and where the managers need to be vested with strong managerial discretion over the investment funds provided by passive investors.
General partners are exposed to unlimited personal liability. Most of the benefits of an LP can also be found in a Limited Liability Company (LLC), without exposing any of the business owners to personal liability.
A limited liability partnership (LLP) is a type of business entity in which the owners of the business share the profits and losses of the business. Conventionally, all owners of a partnership are personally liable for all debts and obligations of the partnership as well as for obligations and liabilities created by the conduct of other partners.
However, a limited liability partnership is an offshoot of a business partnership whereby the liability of each partner is limited.
A partnership is an LLP after filling out an application of registration with the Oregon Secretary of State. Registration as an LLP is restricted to professional partnerships rendering professional services, such as lawyers, doctors, and accountants.
A partner is not liable for the wrongful acts of other partners. And an LLP is a pass-through entity, which means all of the tax benefits and liability pass through the entity to the partners individually, thus avoiding double taxation.
With an LLP, each partner is still liable for his or her own negligence, wrongful acts, misconduct, and omissions, as well as for the wrongful acts of any person under the partner’s direct supervision.
A limited liability company (LLC) is a business entity including one or more members who own the LLC. Usually, if all of the LLC formalities are followed, each of the members of the LLC is shielded from personal liability for the debts and obligations of the LLC.
An LLC is set up by filing Articles of Organization with the Secretary of State. The internal processing of the LLC and the relationships between LLC members are regulated by an LLC Operating Agreement.
An LLC is relatively inexpensive to form. Each member of the LLC has freedom of any personal liability for the debts and obligations of the business.
An LLC offers the most important flexibility in that the LLC members can agree on how to share profits, losses, and management of the LLC in whatever way desired.
An LLC is an entity for tax purposes, which ignores double taxation often incurred by corporations. It is usually the preferred business entity for real estate ownership.
A corporation is appreciated to an LLC when there is a prospect of investors in the business, or a public stock offering is likely. And corporation can also be preferred if a more complex and hard business structure is important.
A corporation is a business entity and shareholders elect a board of directors to oversee and manage the corporation. The directors make all the major business decisions.
The directors hire and fire officers. The officers are employees of the corporation that carry out the day to day operation of the business under the guidance of the directors. A corporation is formed by filing Articles of Incorporation with the Oregon Secretary of State.
Corporations typically have Bylaws which dictate how the corporation is to operate and function. Shareholders typically receive share certificates as evidence of their legal ownership interest in the corporation.
Corporations provide delegated management with investor ownership. Ownership in a corporation is transferable easily. A corporation is the business entity, that is necessary for any business that intends to make a public stock offering.
Specifically, corporate shareholders, directors, and officers do not have personal liability for the debts and obligations of the corporation. Shareholders of the corporation ready to lose only their investment in the corporation if the business fails.
It requires you to pay through the nose to form and maintain a corporation compared to other business entities. As owners of the corporation, shareholders have no rules and regulations over the management of the business.
A corporation is a taxable entity and the income earned by the shareholders is also taxable, thus creating double taxation. However, some corporations can make a Sub-S tax election whereby the Internal Revenue Service (IRS) will treat the corporation as a pass-through entity.
A C-Corporation or C-Corp is an independent legal business entity that exists separately from the company’s owners. Shareholders, who are the owners, a board of directors and officers have control over the corporation, though one person in a C-Corp can fulfill all of these roles, so it is possible to create a corporation with you in charge of everything.
There are many more regulations and tax laws that the company must comply with. for an example, methods for incorporating, fees and required forms, etc., vary by state.
Most small businesses pass over C-Corps when deciding on how to structure their business.
But, this can be a good choice as your business grows and you find yourself needing more legal protections. And the biggest benefit of a C-Corp is limited liability. If someone sues the business, they are limited to taking business assets to cover the judgment that is, they cannot come after your home, car, or other personal assets.
Shareholders as owners of the business entity do not have personal liability for the business’ debts and liabilities. C-Corporations have eligibility for more tax deductions than any other type of business. C-Corporation owners pay lower self-employment taxes. You have the ability to provide stock options, which can help you to make a huge amount of money in the future.
A C-Corporation type of business entity is usually more expensive to create than sole proprietorships and partnerships, which require filing fees that may range from $100 to $500, based on which state you are doing business in.
C-Corporations face double taxation, such as the company pays taxes on the corporate tax return and then shareholders pay taxes on dividends on their personal tax returns. Owners, however, cannot deduct business losses on their personal tax return.
There are many formalities that corporations have to meet, such as holding board meetings and shareholder meetings, keeping meeting minutes and creating bylaws.
An S-Corporation or S-Corp preserves the limited liability that comes with a C-Corporation but is a pass-through entity for tax purposes. This means that similar to a sole prop or partnership, an S-Corp’s profits and losses pass through to the owners’ personal tax returns. There is no corporate-level taxation for an S-Corp.
For organizing, as an S-Corporation or convert your business to an S-Corporation, you need to file IRS form 2553. S-Corporations is a good choice for businesses that want a corporate structure but like the tax flexibility of a sole proprietorship or partnership.
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Shareholders (also owners of the S-Corp) do not have personal liability for the business’ debts and liabilities. Also, there is no corporate taxation and no double taxation. An S-Corp is an entity, so the government taxes it much like a sole proprietorship or partnership.
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Similar to C-Corporations (C-Corps), S-Corporations (S-Corps) are more expensive to create than both sole proprietorships and partnerships because such type of business entity requires registration with the state, which is mandatory.
There are more limits on issuing stock in S-Corps than C-Corps. You still need to comply with corporate formalities, like creating bylaws and holding board and shareholder meetings in order to start an S-Corporation.
Things You Should be Knowing When Choosing Among the Types of Business Entities
Your choice of business entity is an extremely important one. It can influences how people perceive your business and have a big impact on your legal exposure and finances.
However, keep the following in mind when deciding among the different types of business entities:
(a) Sole props and general partnerships are good “starter” entities. (b) As your business grows and generates more income, consider registering as an LLC or corp.
(c) Think through the pros and cons of each business entity in terms of legal protection, tax treatment, and government requirements.
(d) Consult a business lawyer and accountant to get specific help for your business.
There is no one best business entity choice for all small businesses, but there is the best option for your small business right now. Use the tips above to figure out what that is.
With a better understanding of how the common types of business entities work and their respective pros and cons, you can now easily determine which of the different types of business entities works best for your small business.
The best course of action, if you can afford it, is to consult a business lawyer and tax professional on which structure is maximum for you, given where your business is currently and where you hope to take it.
Consulting with an attorney before starting a business is a good idea.
An attorney can elaborate on the above points as well as assist with protecting your rights, minimizing your personal risk should your business run into trouble and help determine which business entity is more beneficial from a tax standpoint.