How To Choose A Business Entity
Should you create an LLC or a sole proprietorship? What is a corporation? When you are planning on starting a business, one of the first things you must determine is the type of business entity you must establish. The way you categorize your business determines what income tax return form you have to follow. In the United States, types of business structures include sole proprietorship, partnership, corporation, LLC, and S corporation. So, you are probably wondering how to choose a business entity for your business.
What Is A Business Legal Structure?
The business legal structure is also known as a business entity. This is a government classification of your business. It regulates certain aspects of your business. On a federal level, a business’ legal structure will determine your tax burden. On the state level, it can determine liability ramifications.
Choosing your business’s legal structure is one of the most important decisions you make when starting your business. This decision will impact how much your business will pay in taxes, and it will affect the amount of paperwork your business is required to do. It will also impact the personal liability you face and your ability to raise money.
The Importance Of A Business Legal Structure
We cannot stress enough the importance of understanding the business’s legal structure and how it will impact your business. Here are just a few things to consider when deciding what business entity type to choose:
Business Owners
When starting your business, it is important to consider how many owners your business will have. More specifically – active business owners. If you are the only owner of your business, it wouldn’t make sense to choose a partnership structure for your business. There are business entities that are designed to be operated by a single individual, while others support more than one owner.
Taxes
Every business has to pay taxes. Choosing the wrong type of business entity can lead to paying more taxes or double taxes. Double taxation is a tax principle that refers to income taxes being paid twice on the same source of income. Some businesses may be subjected to double taxation, which can occur when income is taxed both at the corporate or personal level and even international trade.
Sole proprietors, partnership owners and S corporation owners categorize their business income as personal income. C corporation income is business income separate from an owner’s personal income. Given the different tax rates for business and personal incomes, your structure choice can significantly impact your tax burden.
Regulations
There are regulations on every business. These regulations range from federal, state and even down to the local level.
Financing
Your business’s entity type will impact the way that lenders will consider and process business loan applications. An example of this would be if you are planning on selling shares of your business, it would be more viable for your business to be a corporation.
Legal Risks and Liability Protections
The different types of legal entities will limit your personal liability from business debts and lawsuits. Additionally, this will help protect your personal assets. If your business is expected to face legal liabilities, different types of business entities will offer different liability protections. For instance, if you are a sole proprietor as a freelance graphic designer, your legal exposure is low. However, if you are operating a landscaping business, you might be facing the legal liability of an employee getting injured increases. Also, if you have large financial obligations, corporate legal protections can be helpful.
How To Choose A Business Entity or Pass-Through Entities
Pass-through entities (or flow-through entities) are business types that treat business income as the owners’ personal income. Many small businesses (around 85%) will choose a pass-through entity structure that will reduce tax-obligations and for the easy setup.
So, how should you categorize your business structure? The type of entity you choose will depend on: liability, taxation, and record-keeping. Learn more about how you should choose the right business entity.
Sole Proprietorship
A sole proprietorship is the most basic and common form of business entity. It’s easy to form and offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business.
Fun fact: when you or your business partner start a new business, it will automatically be classified as a sole proprietorship for legal reasons. You can change your business entity later down the road.
Partnership
The partnership entity is when two or more people who agree to share in the profits or losses of a business. A primary advantage is that the partnership does not bear the tax burden of profits or the benefit of losses-profits or losses are “passed through” to partners to report on their individual income tax returns. A primary disadvantage is liability-each partner is personally liable for the financial obligations of the business.
Corporation
A corporation is considered a separate legal entity, with structures governed by the state laws where the owners incorporated the business. The corporation becomes an entity-separate from those who founded it-that handles the responsibilities of the organization. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit.
One of the main benefits of a corporate status is to avoid personal liability. The primary disadvantage is the cost to form a corporation and the extensive record-keeping that’s required. A corporation often has many roles, with one person in charge of all these individuals. They also have a few tax advantages as well.
Limited Liability Company (LLC)
The Limited Liability Company (LLC) combines the benefits of a partnership and corporate structure. LLCs allow owners to manage profits and losses with limited legal liabilities. They also offer a flexible approach to tax designation. With an LLC, the Internal Revenue Service will enable owners to choose whether they want to be taxed as a “pass through” or separate entity. Unfortunately, LLCs may have issues attracting venture capital and this requires them to convert to a corporate structure.
The Bottom Line
As you can tell, there are multiple types of business entities to choose from, and there is not a perfect choice either. This is why it is important to weigh the advantages and disadvantages of each type of entity in order to find the right fit for your business.
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