How to Understand Different Business Entity Types
When you start a business, it’s crucial that you fully understand your options when it comes to selecting a business entity type. The business structure that you choose can greatly affect how you operate, so you should take time to conduct research and determine what will be best for you as an entrepreneur.
In this post, we’ll review common business structures such as sole proprietorships, partnerships, and limited liability corporations. Once you’re finished reading, you should be able to determine which business structure will work for you.
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. Due to this, what’s right for one business owner, won’t necessarily be right for you.
With this mind, let’s review the types of business entities that you can consider as you start your entrepreneurial journey:
1. Sole Proprietorship
This is one of the easiest business entity types to understand and is possibly the simplest way to get your business up and running. By selecting this format, you’ll have complete control over the entire business operation. Plus, there are very few forms that you’ll have to file with state agencies, so your legal fees will be lower.
As 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.
In this legal structure, you’ll be personally liable for all business activities, debts, and liabilities. If something goes wrong, your personal assets and reputation will be on the line.
In addition, as a sole proprietor, you eliminate one way of raising funds for the business which is through the issuing of equity (i.e. stock options). This financing option isn’t available to sole proprietors.
If you want to go into business with someone else, then there are two types of partnerships you can set up – a general partnership or a limited partnership.
Both partnership forms create a legal entity for the business where interest can be transferred to other parties. A general partnership will be quicker and easier to establish as it requires less form filling. Also, like sole proprietors, the partners remain liable for business activities and debt.
Limited partnerships, on the other hand, are made up of general partners and limited partners. Limited partners will have limited liability proportional to their investment in the business and will usually be more ‘hands-off’ in the day-to-day running of the business. With limited partnerships, written agreements must be signed, and certificates should be filed with the relevant authorities.
Before forming a partnership, it’s crucial that you fully understand and are satisfied with the partnership agreement. This will protect you in the future and ensure that the partnership is fair.
A corporation is a complete legal entity, separate from its owners with Articles of Corporation having to be filed with the state. You’ll own shares in the business, which will allow you to transfer ownership easily or raise additional money by issuing stock. In addition, you’ll be protected from liability.
The drawbacks are that double taxation will occur; first on the profits of the business and then on dividends paid on shares or earnings you draw from the company.
An S-Corporation is a slight variation to the corporation structure. According to the National Small Business Association (NSBA), S-Corporations account for 33 percent of all small business structures.
The major benefit of operating your business as an S-Corporation is that you won’t be subject to the double taxation of a usual corporation. If you decide to form a s-corporation, you’ll need to report your profit and loss in the company on your personal tax returns.
In this structure, you’ll be required to 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, which may restrict your fundraising capabilities.
5. Limited Liability Companies (LLC)
Limited liability partnerships are sometimes referred to as a hybrid business structure, where 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 in a similar way to general partnerships through personal tax returns. In addition, there’s no limit to the number of owners, and you aren’t required to hold meetings.
However, setting up an LLC can be complex, requiring significant legal fees and numerous documents that must be drafted and signed. This level of complexity can make it difficult 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 are set up, here’s a summary of the types of business structures being used by small businesses (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 types of business organizations is a crucial decision. That’s not to say that you can’t change to a different structure later, but it’ll probably cause disruption to 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 right choice for your business’s future. If you have advice for new entrepreneurs that need help classifying their businesses, share your expertise with us in the comment section below!
Editor’s Note: This post was updated for accuracy and comprehensiveness in December 2020.
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.