Which Business Entity is Right for Your Company?
What is a Business Entity?
One of the first steps you will take when starting a business is determining your company structure or entity. The business entity you choose affects several aspects of your operation, such as how much you pay in taxes, required paperwork and your personal liability.
How to Choose the Right Business Entity
Several variable should be considered when selecting your entity of choice. Depending on the state you’re operating your business in, it could be difficult to convert to a different structure in the future, so it’s important to choose the correct entity the first time around.
Here are key things to consider:
The number of owners affects which structure a business should follow. When shareholders become involved, that becomes an additional consideration. If you want to form an S corp, for instance, there’s a cap on how many shareholders your company would be allowed to have.
Some business structures protect you from being personally liable for your business’ debts, while others do not. If you are personally liable, that means you are responsible for the obligations of the business and the actions of your business partners.
Tax requirements vary for each business entity. Depending on the type of business you form, you may end up paying self-employment tax or facing double taxation. It’s possible for business owners to combine entities to change their tax status. For example, you could set your business up as an LLC, but be taxed as an S corp. However, such arrangements can be tricky to establish. You could work with a tax attorney, business counselor or accountant if you are considering this arrangement.
Types of Business Entities
Business owners can choose from a range of entities when setting up shop. Here’s a description of some of the most common business structures used today.
One of the most appealing features of a sole proprietorship is maintaining complete control over the business. Anyone that is offering their services in exchange for money is automatically branded as a sole-proprietorship even if they don’t register as a business. As a sole proprietor, your business assets are not separate from your personal assets, which means you can be held personally liable for business debts.
A sole proprietorship would be the right choice for a low-risk business and an owner looking to test their concept before expanding the operation. However, sole proprietorships usually cannot sustain long-term growth, explained Bala Subramanian, a N.J.-based small business mentor for SCORE.
Partnerships are simple business structure where two or more people own a business together.There are two common types of partnerships:
- Limited partnership – One general partner has unlimited liability while the others have limited liability. Profits are passed through to everyone’s personal tax returns and the general partner also must pay self-employment taxes.
- Limited liability partnership – All partners have limited liability and are protected from being responsible for the company’s debts and the actions of other partners.
Partnerships are great for businesses that are already up and running and has more than one owner. It can also be a good idea for professional groups, like practicing attorneys. A partnership could be the ideal choice for a group of owners who want to test their business before forming a more formal company. Once you’re ready to change structures, an LLC structure would protect your personal assets and allow you to pay a lower tax rate than you would with a corporation.
Limited liability companies (LLC)
An LLC is regulated at the state level, and ownership may include individuals, corporations, other LLCs and foreign entities. LLC owners are called “members” and there is no limit on the number of members that can be involved. Most states also allow for single-member LLCs where there is a single business owner.
In most instances, an LLC shields you from personal liability, protecting things like your car, house and savings in the event of a bankruptcy or lawsuit. LLC members are required to pay self-employment tax and make their own contributions toward Medicare and Social Security. However, profits and losses from the business pass through to your personal income without facing corporate taxes, meaning you would pay a lower tax rate than owners of a corporation.
Depending on the state you’re operating in, some LLCs have a limited lifespan. Several states require an LLC to be dissolved and re-formed as a new entity if a member joins or leaves the company. LLCs are a good choice for owners that want to protect their assets and pay a lower tax rate than they would with a corporation.
A corporation, also called a C corp, is the standard structure for a corporation. C Corps operate independently from its shareholders, allowing them to continue operations if a shareholder leaves the company or sells their shares. There is also no limit on the number of shareholders allowed.
C corps come with limited liability, which means the owners are not liable for the company’s debts. C corps may also be subject to double taxation: income tax from profits and on dividends paid to shareholders.
Corporations makes sense for businesses that need to raise money, plan to go public or sell in the future. Subramanian covered a few scenarios where a C-corp would makes sense:
- Business owners who want to grow quickly may want to consider becoming a corporation.
- Owners of medium- or high- risk businesses could choose a C-corp designation if they plan to go public or be sold.
- Businesses looking to raise money would benefit from being a C corp because they could raise funds through the sale of stock.
C corps will require more detailed record keeping, such as maintaining extensive records, financials and operational processes.
S corps also act independently from its owners and can continue operating if a shareholder leaves the company. Unlike C corps, S corps have a 100-person cap on shareholders, and all shareholders must be U.S. citizens. S corporations must file with the IRS, which is different than registering at the state level, and also has limited liability.
Owners can avoid double taxation with an S corp, which is one of the main attractions of this business structure. Profits are taxed at the corporate tax rate and dividends are taxed at a rate based on the individual shareholders’ income. S corps act as pass-through entities because the company’s profit is passed to the shareholders’ personal income tax. However, some states tax S corps on profits exceeding a certain limit while other states treat S corps the same as C corps, subjecting them to the same taxes.
According to the IRS, you can file for an S corp if you meet the following:
- Be a domestic corporation
- Have allowable shareholders
- May be individuals, estates and certain trusts
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Only one class of stock
- Be an eligible corporation
A benefit corporation, also called a B corp, is a for-profit business but it is driven by mission as well as profit. B corps differ from C corps in their purpose and transparency, but both types of corporations are taxed the same. In a B corp, shareholders are responsible for holding the company accountable to producing public benefit in addition to financial profit. B corps may be required in some states to turn over annual benefit reports that show their contribution to the community.
Nonprofits are formed for charitable, educational, religious, literary or scientific-work purposes. Although nonprofits follow organizational rules similar to C corps, they don’t pay state or federal income taxes. Nonprofits must file with the IRS to be tax exempt. The Internal Revenue Code 501(c)(3) is most commonly used to grant nonprofits tax exempt status. Nonprofits are also barred from distributing profits, including among members or political campaigns.
Comparing business structures
Here’s a look at the different features of each entity and how they compare:
|Sole Proprietorship||One person||Unlimited personal liability||Personal tax only|
|Partnership||Two or more people||Unlimited personal liability, unless the business is a limited partnership||Personal tax
Except for limited partner(s)
|Limited Liability Company (LLC)||One or more people||Owners not personally liable||Self-employment tax
Personal tax or corporate tax
|C Corporation||One or more people||Owners not personally liable||Corporate tax|
|S Corporation||One or more people but no more than 100; All must be U.S. citizens||Owners not personally liable||Personal tax|
|B Corporation||One or more people||Owners not personally liable||Corporate tax|
|Nonprofit Corporation||One or more people||Owners not personally liable||Tax exempt, but corporate profits can’t be distributed|
Which Entity is Right for Your Business?
As outlined above, the business structure you choose depends on your risk level, the number of employees and taxes you’re willing to take on as a business owner.
Your choice also depends on how quickly you want to grow. If you’re not sure how fast you want to grow your company, or how large you want it to be, you could begin operating as a sole proprietorship or a partnership and change structures at a later time, Subramanian said.
“You can start small,” he said. “You can always move up the ladder.”
Before making your selection, it’s important to complete a business plan to determine your costs and your strategy to become profitable.
“From there, it’s easier to decide what to do,” he said.