Types of Business Entities
Starting a business offers great possibilities, including a list of essential decisions. As an owner, one of the most important decisions is which business entity would best serve the business and protect its owner(s).
The business structure selected ultimately impacts the business’s daily operations, the way taxes are filed, and the personal assets that remain at risk, among other impacts. This business decision must balance legal protections against tax considerations. Those unfamiliar with the available business entities will find it incredibly helpful to consult with a knowledgeable business law firm to determine which entity would best serve the owner’s interests.
The most common business entities include a sole proprietorship, a corporation, a partnership, and an S corporation. Note that a Limited Liability Company (LLC) offers another type of business entity under state statutes.
Sole Proprietorships
A sole proprietorship offers the easiest entity to create. It provides an owner with complete control of the business. If a company engages in business activities without registering as any other business entity, the business is automatically considered a sole proprietorship.
However, sole proprietorships are not recognized as separate entities from the owner. A sole proprietor can potentially be held liable for obligations & debts incurred by the business. A sole proprietor has the option to select a trade name; however, it is challenging to raise money because a stock sale is not available, and lenders remain concerned when lending to a sole proprietor.
A sole proprietorship is an intelligent choice if the business is low-risk, or the business owners want an opportunity to test their business initiatives before committing to a complex and costly formal business entity.
Partnerships
A partnership offers the simplest type of business entity for businesses with more than one owner. There are two primary types of partnerships. These are discussed below.
Limited Partnerships (LP)
A Limited Partnership is an entity with one general partner (who operates with unlimited liability), plus other partners with limited liability. Profits generated are passed through personal returns, with the general partner required to pay self-employment tax. But note, the limited partners also have limited control concerning business decisions, with the partnership’s specifics outlined in the agreement.
Limited Liability Partnerships (LLP)
An LLP is similar to an LP, with each owner granted limited liability. A Limited Liability Partnership protects each partner from debts against the business and the actions of partners.
Ian from LLCGuys.com “Notes that a Limited Liability Company (LLC) offers another type of business entity under state statutes.
Corporations
A corporation (aka – a C Corp.) is an entity that legally separates the business from its owners. As a business entity, a corporation can be taxed on its profits and be held legally liable for its actions. In specific scenarios, corporate profits are taxed twice. The first tax is applied to the company profit, with the second tax paid by shareholders when filing their returns.
A corporate entity offers owners the most robust protection from personal liability, but the additional protection comes with a cost – a corporate entity requires more comprehensive record-keeping and reporting. A corporation operates independently from its shareholders but often raises money through a stock sale.
Establishing a corporate entity is a good choice for businesses that operate with a medium to high risk or if a company plans to go public or is looking for a viable buyer.
S Corporations
An S corporation (aka – an S Corp.) is a special corporation developed to avoid the C Corp.’s potential double taxation. S Corporations permit certain profits & losses to be directly passed through the owners’ income without corporate tax liabilities. S Corporations must file with the Internal Revenue Service to obtain status, which differs from simple state registration requirements.
The taxation of S Corporations varies among states, with most jurisdictions recognizing the federal government’s taxation approach. Some states do not tax S Corps., while other limit taxes to profits above specific limits.
The IRS has developed special limits for S Corporations which is why it is wise to check the website for the S Corporation’s eligibility requirements. An S Corp. is a smart choice for those businesses that meet the S Corp. criteria.
A Limited Liability Company (LLC)
An LLC is a business entity that allows owners to reap the benefits of a partnership and a corporation. A profit or loss is passed to the owner’s income with no corporate tax; however, the members of LLC are considered self-employed by the IRS and must contribute toward self-employment taxes.
Limited Liabilities Companies offer, in most instances, protection from personal liability. In other words, personal assets are not at risk if the LLC is involved in a lawsuit or bankruptcy.
LLC’s have limitations in states but are often the right choice for business owners who want to protect personal assets while simultaneously taking advantage of lower tax rates than those assessed on a corporation.
The Take-Away
It is important to understand that business entities offer protection in terms of their tax status. For example, an LLC can be taxed as a nonprofit or corporation. However, these are complex situations that require the guidance of a knowledgeable business law firm.
