When launching your own business, one of the first decisions you will need to make is what type of entity to form. Which entity you choose will influence how much personal liability you assume, how you will be taxed, how you are obligated to compensate your employees, and more. As such, taking the time to think through the best option for your business is a vital step you should never skip.
Here, we share an overview of the five most common entity structures. However, while this is meant to give you a basic primer on the entity types, you should ideally consult an experienced business planning attorney before making a final decision and filing your corporate paperwork. An attorney can help you ensure you are priming your business for success while putting the proper legal safeguards in place.
The Five Most Common Entity Types
If your business is fairly typical, it will most likely take one of these five legal entity forms: a sole proprietorship, a limited liability company (LLC), a partnership, a C corporation, or an S corporation.
#1: The Sole Proprietorship
A sole proprietorship is the entity type that offers the most administrative ease: there is no formal legal structure, but rather, one person owns and controls the business. To form a sole proprietorship, the business owner need not file any official paperwork with the Secretary of State’s office. This is because from a legal and a taxation perspective, the individual and the business are deemed one and the same. Practically, then, the business owner of a sole proprietorship is personally responsible for all of the business’s debts, losses, and liabilities. Additionally, the owner pays all taxes and reports profits and losses on Schedule C of his income tax return – there is no separate corporate entity filing.
While this is certainly the simplest way to run a business from an administrative perspective, there are clear drawbacks, namely, the lack of liability limitation. Since the business owner and the entity are deemed the same, any legal action leveled at the business will attach to the individual as well. This means that any judgment creditors of the business can come after the individual owner’s personal assets.
Business owners certainly have a compelling interest in separating themselves from their entities to preserve a liability shield. This is where the LLC comes into play.
#2. The Limited Liability Company (LLC)
An LLC is considered a hybrid entity because it has features of both a partnership and a corporation. LLCs are owned by one or more people or entities, known as “members.”
Like a corporation (and unlike a sole proprietorship), LLCs offer personal liability protection for its members. The business is a formal legal structure with a separate identity from that of its members, so with a few exceptions, creditors of the business cannot attach a judgment to the owner’s personal assets. LLCs also provide flexibility when it comes to taxes, as members can choose whether they are taxed as a corporation or as individuals. As with any entity, taxes can get complicated with an LLC, so it is best to consult a small business attorney when forming one and selecting your tax treatment.
#3: The Partnership
A partnership is a slightly rarer entity – the majority of small businesses are run as sole proprietorships or LLCs. A partnership consists of two or more individuals who own and control a business. It is similar to a sole proprietorship, except that profits, debts, and liabilities are shared among partners instead of borne by the sole proprietor alone. Each partner files his own taxes for their share of the profits and separately report their losses.
There are two types of partnerships: general and limited. In a general partnership, partners share all profits and liabilities equally. Conversely, in a limited partnership, some partners have a limited share of the profits and a limited share of the liability, depending on how ownership is allocated among the partners.
#4: The C Corporation
A C corporation is a common entity form for larger businesses with employees. Like an LLC, it is considered a separate legal “person” from its owners. A C corporation (often just called a corporation) is owned by its shareholders and run by a board of directors and management.
Because a C corporation is a separate legal entity, the entity, not the owners, is responsible for the business’s debts and liabilities. Likewise, a C corporation is taxed separately from its owners. Additionally, C corporations are subject to “double taxation,” meaning that revenue is taxed both when it is earned and when it is distributed to shareholders. This is why many smaller businesses form as LLCs, which have the option of single taxation (at the revenue level only).
#5: The S Corporation
The second type of corporation is called an S corporation. To become an S corporation, an entity must always form as a C corporation and then apply to become an S corporation. S corporations also provide limited liability protection to shareholders and are run by a board of directors and management.
The main difference between the two types of corporations is that S corporations pass their income, losses, deductions, and credits on to their shareholders, who then file this information on their personal income taxes. The corporation, therefore, does not pay its own federal income taxes.
Important Questions to Ask Before Selecting an Entity Type
Every business entity is unique, but there are some key questions to ask yourself (or your attorney) when deciding on your business entity. These include:
Will you run the business alone or with someone else?
If you are starting a business alone, you can choose any of the above entities except a partnership, which requires two or more partners to form. If you are starting the business with at least one other person, you can choose any of the entities except the sole proprietorship. Do you want to limit your personal liability?
Depending on which entity structure you choose, if your business cannot pay its debts, your personal assets as the owner could be at risk. You may want to consider forming an entity with limited liability protection, such as an LLC or C corporation. Sole proprietorships and general partnerships do not offer limited liability protection.
Can you keep up with the administrative requirements?
When you own a business, you are obligated to make various filings with your state’s Secretary of State’s office, depending on your entity type. If you are looking for simplicity, a sole proprietorship tends to be the most manageable entity to form and run. However, your business needs might be better suited for a more formal legal structure, such as a C corporation, which requires appointing directors and officers and filing documents with the state. Consult your attorney to determine the filing and administrative requirements that accompany each entity type before making your final decision.
Which Entity Should You Choose?
Every small business is different, and each entity type offers pros and cons. At Wilson Ratledge, we help people every day to determine how to best set up their new venture, and hope this article has helped you feel well-equipped to discuss these options with an attorney and be well on your way to establishing your small business entity.