A Guide on How to Choose a Business Entity

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If you're planning to start a small business, there are several structures you can choose from. Here's a quick guide that can help you decide.

There are a few different legal structures you can choose to use when you start a new business, and each has its own unique benefits and drawbacks. In this article, we'll take a look at the five most common business entity types and what new business owners should know about each one.

Overview: What is a business entity?

When you start a business, you'll need to choose a business entity type. In simple terms, your business type is simply the legal organization that conducts business. Your business entity can be rather simple (you and your business are the same entity) or it can be rather complex, like a corporation.

The reason why there are several different types of business entities has to do with legal liabilities, ownership structure, and taxation. Unfortunately, there is no one-size-fits-all answer to which business entity type is the best one, so let's take a look at the most common types of business entities and what you as a business owner should know about each one.

The 5 main types of business entities

When it comes to choosing a business entity type, there are five common choices you can pick from:

  • Sole proprietorship
  • Partnership
  • Limited liability company
  • S-corporation
  • C-corporation

Let's take a closer look at each one, and talk about some of the advantages and disadvantages of each type.

1. Sole proprietorship

This is by far the simplest type of business entity owner structure. In a sole proprietorship, one person functions as the owner and operator of the business. When you (or you and your spouse) start a new business, it is automatically classified as a sole proprietorship for legal purposes, unless you decide to change it.

As a personal example, when I published my first article for The Motley Fool as a freelancer, I immediately became a sole proprietor.

The benefits of being a sole proprietor mostly have to do with the simplicity. You don't have to file any formal incorporation paperwork or separate business tax returns. On the other hand, because of its simple structure, you and your business are effectively the same entity in the eyes of the law and financial institutions.

As a sole proprietor, you are responsible for any legal and financial liabilities of the business. If your business gets sued, your personal assets can be at risk. And if your business is unable to pay its debts, you're on the hook.

2. Partnership

A partnership is almost as simple as a sole proprietorship, with the biggest difference being if your business has more than one owner. In other words, a partnership is the default business entity if you and someone else start a business together. Partnership taxation is very simple -- the business profits are simply divided proportionally among the partners.

There are two main subtypes of partnerships you can form. A general partnership is one where all business owners share equally in the profits, losses, and legal liabilities of the business (to be thorough, this is the default status for a multi-owner business). A limited partnership is where some partners actively operate the business and some are "silent partners" or simply play the role of investors in the business.

While a general partnership is a simple business entity that doesn't require any special registration or paperwork, a limited partnership is a registered business entity and requires filing paperwork.

This can be a smart business structure for people who want to raise capital from outside investors while keeping their business as simple as possible. However, it doesn't provide the same level of legal protections for active owner/operators.

3. Limited liability company (LLC)

Limited liability companies, or LLCs, combine some of the advantages of sole proprietorships and partnerships with the liability protection of corporations. And to be clear, you can use the LLC structure even if it's just you -- this is known as a single-member LLC.

While it's more expensive and complicated to create an LLC than a sole proprietorship or partnership, it's generally easier than creating a corporation. Plus, there are fewer ongoing corporate requirements, such as the requirement to hold shareholder meetings.

On the positive side, LLC owners don't have any personal liabilities for the business' debts, and also are generally protected from legal liability. This is the biggest advantage of choosing an LLC over a sole proprietorship.

So, if you operate an LLC and someone sues your business, your personal assets are generally not in jeopardy. Plus, LLCs are generally treated as pass-through entities for tax purposes, meaning that LLC profits aren't subject to corporate taxes and are treated as personal income of their owners.

4. S-corporation (S-corp)

An S-corporation, or S-corp, is a business entity that combines some of the benefits of an LLC with those of a corporation. Like an LLC, business owners don't have legal or financial liability for the business' activities, and they function as pass-through entities for tax purposes.

And like a corporation, an S-corp has financial flexibility when it comes to paying salaries and dividends to owners, which can help reduce the owner's payroll tax liability.

However, S-corporations have drawbacks. It can be more expensive to form and maintain an S-corp, and there are requirements to have board meetings, create bylaws, and more.

5. C-corporation (C-corp)

A C-corporation (often simply referred to as simply a "corporation") is the most complex type of business entity on this list and offers the greatest level of separation between the business and its owners. For example, most publicly traded companies are structured as C-corporations.

In a C-corporation, owners don't have legal or financial liability for things having to do with the business, and also have the most available tax deductions. There's also a greater degree of flexibility when it comes to compensation with a C-corporation versus an S-corp -- for example, a C-corporation can offer stock options, while an LLC or S-corp cannot.

On the other hand, creating and maintaining a C-corporation is more expensive and more involved than other business entities. For example, corporations are required to have board and shareholder meetings. In addition, C-corporations are subject to double taxation -- the business has corporate tax liability on its profits, and owners pay personal income taxes on distributions (dividends) paid to them.

It's important to note that this isn't an exhaustive list. There are certain other business entity types, but most only apply to a certain type of business. For example, a nonprofit corporation is a business entity that most people reading this won't be able to choose, and the same goes for a municipality, which is a corporate status that is used by a city or town.

How to choose the right business entity for your business

There's no perfect solution for everyone. Some businesses, like freelance journalism and certain professional services, function just fine as sole proprietorships or partnerships, while others benefit greatly from the legal protections of one of the corporate entity types.

With that in mind, here are three things to consider when deciding which business entity type is the best choice for you.

Tip 1: Consider how many owners your business has

The first thing to consider is how many owners your business has and how many are active owners. For example, if you are the only owner of your business, you can eliminate the partnership structure. Additionally, there's generally (but not always) no good reason to have a single-owner C-corp.

Tip 2: Do you need liability protection?

How likely are you to face serious legal liabilities in your business? As a freelance writer, my legal exposure is low, so I choose to function as a sole proprietor. On the other hand, if you're operating a convenience store and someone slips and falls, the legal liability can be quite large. Unless you have minimal legal risk, the protection of one of the three corporate entity types is a big benefit.

The same logic applies if your business will have large financial obligations. If your business regularly owes significant amounts of money to vendors or financial institutions, the corporate legal protections could be very appealing.

Tip 3: Consider tax implications

For most business owners, being able to avoid corporate taxes is a big benefit. But there are also payroll (Social Security and Medicare) taxes to consider. With an LLC, for example, all of your business' profits are treated as income to the owners. On the other hand, with an S-corporation, you can choose to designate some of the profits as salary (which is subject to payroll tax) and the rest as dividends (which is not).

Tax planning strategies are a major consideration for many businesses when choosing an entity type, and good tax software may help you determine the tax implications of each entity structure on your business.

The bottom line on business entities

As you can see, there are several common business entity types, and there's no such thing as one perfect choice for everyone. It's important to weigh the pros and cons of each entity type as they apply to your business in order to find the one that is the best fit.

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