A business legal structure, also known as a business entity type, is a government classification that regulates certain aspects of your business. Your business entity type has administrative, financial, and legal implications, and is one of the most important first steps in starting your business. When deciding on what business entity type to choose, several factors should be considered carefully. Some of the factors that need to be evaluated include the following:
- The cost of formation and ongoing administration
- To what extent do you, as the owner, need to be protected from legal liability
- Based on your goals as a business owner, what are the opportunities to minimize your tax obligations
- Your expected earnings and deductions
- Your need to maximize the flexibility of ownership
- Whether you will have a partner or investor
- Anticipated future needs of your business
You will need to choose a business entity type before you register your business with the state, obtain a tax ID number, and file for the applicable licenses and permits. Each business entity type has certain advantages and disadvantages compared to the other types, and there is no single one that ideally suits all businesses. Following is a basic overview of the most-common business entity types.
Sole Proprietorship
Most small businesses are owned by a single individual making a sole proprietorship the most-common of all business entity types. Usually, the owner is responsible for the day-to-day management of the business and has complete control over all decisions regarding the business. It is both the simplest and least-expensive business entity type to establish
and maintain.
Other than any state or locally required business licenses or permits, there is no formal action required to set up a sole proprietorship. Since it is an unincorporated business type, there is no distinction between the business and the owner. This means the business assets and liabilities are not separate legally from the owner’s assets and liabilities.
From a tax perspective, this means that all revenue and expenses flow through to the owner’s individual tax return. Income is taxed only once, and the owner may be eligible for specific sole proprietor tax deductions, such as a health insurance deduction. However, the owner also can be held personally liable for the debts and obligations of the business. So, if someone files a lawsuit against the business and it can’t pay the debt, the owner’s personal assets are at risk.
Partnership
A partnership is a single business where two or more parties share ownership. There are two basic types: a general partnership and a limited partnership. In a general partnership, owners share equally in the business’s legal, financial, and management duties. In a limited partnership, there is one general partner who has unlimited liability, while all other partners have limited liability. Those with limited liability also tend to have limited control over all other aspects of the business, and the extent of those limitations typically is based on their percentage of investment in the business.
Creating a partnership is similar to creating a sole proprietorship with the addition of a partnership agreement that details the division of ownership and duties among the partners. As with a sole proprietorship, income and tax obligations of the business pass through to the individual owners.
C Corporation
A C Corporation (Corporation) is a separate legal entity from its owners. Corporations can make a profit, are required to pay federal, state, and local taxes, and are held liable legally for its actions. Because a corporation is its own legal entity, it provides the most protection to its owners from personal liability. However, this means that corporate profits can be taxed twice, first when the corporation files its tax return and again on dividends paid to any shareholders on their personal tax returns.
The cost of forming and maintaining a corporation is the most-expensive and time-consuming of all business entity types. Incorporating a business involves registering your legal business name and filing Articles of Incorporation with your state, creating bylaws, selecting a board of directors, and issuing stock. Once created, a corporation must hold regular board and shareholder meetings, file an annual report with the state, file its own tax returns, and comply with any other federal or state regulations and tax laws.
A subtype of the corporate structure is the S Corporation. Created through an IRS tax election, it allows it allows a C Corporation to elect to be taxed as a partnership. While still considered a separate legal entity from its owners, an S Corporation’s profit and losses pass through to the owner’s/shareholder’s personal tax returns. This avoids the double
taxation of a C Corporation.
Limited Liability Corporation
A Limited Liability Corporation (LLC) is a hybrid business entity type that combines the advantages of a corporation with those of a sole proprietorship or partnership. It can be a single- or multiple-member LLC. An LLC provides business owners with the personal liability protection of a corporation while allowing profits and losses to pass through to the owner’s personal tax returns. Forming an LLC requires less paperwork and fewer compliance requirements to maintain than a corporation. It can be member-managed since there is no board of directors. Because the owners manage the daily operational responsibilities of the business, an LLC has the managerial flexibility allowed by a sole proprietorship or partnership.
If, after comparing the advantages and disadvantages of the various business entity types, you are still trying to decide which type to choose, you will want to seek advice from a professional. A legal or financial counselor can guide you to the business entity type that is best-suited for your business’s needs and goals.
Dana Rogers is the controller for the National Wood Flooring Association (NWFA) in St. Louis. She can be reached at dana.rogers@nwfa.org.
