Business Entity Types: How to Select Your Entity Type
When you start a business, it’s crucial to understand your options for selecting a business entity type. The business structure that you choose can significantly affect how you operate. Therefore, you should take the time to conduct thorough research and determine what will be best for you as an entrepreneur.
This blog post will review common business structures such as sole proprietorships, partnerships, and limited liability corporations. After you read this post, you should be able to determine which business structure will work for your new business.
Which Business Entity Should You Pursue?
To answer this question, you first should understand the differences between business entity types. The types of business organizations that exist are there to serve different purposes.
With this in mind, let’s review the types of business entities that you can consider as you start your business journey:
1. Sole Proprietorship
A sole proprietorship is the simplest business entity type to understand and is possibly the easiest way to start your business.
By selecting this format, you’ll have complete control over the entire business operation. Plus, there are very few forms to file with state agencies, so your legal fees will be lower.
When you pay taxes on your sole proprietorship, it’ll be done through your personal tax return. However, the one notable drawback is the unlimited personal liability.
You’ll be personally liable for all business activities, debts, and liabilities in this legal structure. If something goes wrong, your personal assets and reputation will be on the line.
In addition, you eliminate one way of raising funds for the business through issuing equity (i.e., stock options). This financing option isn’t available to sole proprietors.
If you want to go into business with someone else, there are two types of partnerships you can set up. These partnerships options are a general partnership or a limited partnership.
Both partnership forms create a legal entity for the business where the interest is transferrable to other parties. A general partnership is easier to establish because it requires less form filling. Also, like sole proprietors, the partners remain liable for business activities and debt.
On the other hand, limited partnerships include general partners and limited partners. Limited partners will have limited liability proportional to their investment in the business.
In addition, they’ll usually be more ‘hands-off’ in the company’s day-to-day running. All parties must sign written agreements with limited partnerships, and certificates should be filed with the relevant authorities.
Before forming a business partnership, it’s crucial that you fully understand and are satisfied with the partnership agreement because it will protect you in the future and ensure that the partnership is fair.
If you form a partnership and decide that it isn’t working out, you can check out this blog post to learn how to buy out a business partner.
A corporation is a complete legal entity, separate from its owners. You’ll own shares in the business, which will allow you to transfer ownership or raise additional money by issuing stock. In addition, this protects you from liability.
The drawbacks are that double taxation will occur, first on the business profits and then on dividends paid on shares or earnings you draw from the company.
An S-Corporation is a slight variation to the corporate structure. According to the National Small Business Association (NSBA), S-Corporations account for 33 percent of all small business structures.
The primary benefit of operating your business as an S-Corporation is that you won’t be subject to double taxation. If you form this type of corporation, you’ll need to report your profit and loss in the company on your personal tax returns.
In this structure, you must complete the same formalities as those who operate a standard corporation. Plus, you’ll be limited to the number and type of shareholders. There will also be limits on who can own the shares, restricting your fundraising capabilities.
5. Limited Liability Companies (LLC)
Limited liability partnerships are also known as a hybrid business structure. In this format, the company operates somewhere between a corporation and a partnership.
The business will be a separate legal entity, providing liability protection to the owners. It also allows taxes to be paid similarly to general partnerships through the business owner’s personal tax returns. In addition, there’s no limit to the number of owners, and you aren’t required to hold meetings.
However, forming an LLC can be complex, requiring significant legal fees and numerous documents that you must draft and sign. This level of complexity can make it challenging to attract funding from venture capitalists. In addition, the granting of share options or convertible notes can be difficult.
Conclusion: Chose the Business Form That’s Best for You
To give you an idea of how other small businesses work, here’s a summary of the types of business structures used by business owners (provided by the NSBA):
- Sole Proprietorship– 14 percent
- Partnerships– 3 percent
- Corporations– 18 percent
- S-Corporations– 33 percent
- Limited Liability Companies– 33 percent
Choosing between the different business organizations is crucial, although you can typically change your structure if needed.
However, it’ll probably disrupt your business, and you’ll incur additional legal and tax costs. Also, you should make sure that you research your state’s laws for each of these entities before moving forward.
Ultimately, considering the pros and cons of each entity type will allow you to make the correct business decision. If you have advice for new entrepreneurs that need help classifying their businesses, share your expertise in the comment section below!
Editor’s Note: This post was updated for accuracy and comprehensiveness in March 2022.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.