Forming a business entity may seem straightforward, with most States offering a quick online process. Commercial services like LegalZoom and RocketLawyer also provide assistance for a fee (and tend to upcharge in ways that can exponentially increase the expense). But how do you decide what business entity type is the best for your particular business?
The process involves more than just these mechanical steps. It requires informed decisions regarding the type of business entity and structuring ownership and control provisions to reflect the parties’ understandings. Seeking guidance from an attorney during this process is highly valuable and extremely beneficial.
What are the different types of business entities?
The most common forms of business entities are sole proprietorship, general partnership, limited partnership, limited liability partnership, limited liability company, corporation with S-election (S-Corp), and corporation with C-election (C-Corp). Sole proprietorships and partnership do not require formal government filings (in most states) while other entities do. The filing process involves providing basic business information and paying an annual fee. The real challenge lies in constructing ownership and control documents like partnership agreements, operating agreements, bylaws, and shareholder agreements. An experienced attorney’s help is crucial in drafting these documents.
The majority of the business entities we see are one of four types: Sole proprietor, Partnership, LLC, or Corporation. Each structure has its unique role, spotlighting different strengths and considerations. Read on for a quick breakdown to help you choose the perfect pathway for your entrepreneurial journey.
1. SOLE PROPRIETORSHIP – A type of non-business entity
Pros:
- Simplicity: Operating as a sole proprietor is straightforward with minimal paperwork. In many states, you might not even have to file anything at all.
- Full Control: You make all the decisions and keep all the profits.
Cons:
- It’s all on you- meaning Personal Liability: Your personal assets are on the line for business debts, judgments against the business, or expenses incurred on behalf of the business. Other business entity types will help shield you from personal liability.
- Limited Growth: It might be challenging to scale your business as opposed to other business entity types, which come with build in “klout” from their extensions.
- If you go, it goes. If something happens to you, the business goes kaput. No legacy there.
2. PARTNERSHIP
Pros:
- Shared Responsibility: Partnerships allow for shared decision-making and workload.
- More Resources: Pooling resources with a partner can bring more money, skills, and connections to the table.
- Built In Brain Trust: Having someone to share all the stress can be a GAMECHANGER.
Cons:
- Conflict Potential: Differences in opinion or decision-making can lead to conflicts between the partners. In fact, a 50/50 partnership is the riskiest of all, due to the high chance of “deadlock”— where the partners can’t agree on something critical and the company gets “frozen” because it can’t act!
- Shared Profits: You split the profits with your partner(s).
- Shared Liability. Unless documented otherwise, the partners will split the liabilities of the company– even if that partner did not incur that liability individually. (this may be different in limited partnerships).
3. LLC (LIMITED LIABILITY COMPANY): THE VERSATILE DELIGHT
Pros:
- Limited Liability: The Owners’ personal assets are generally protected from business debts, judgements, expenses, or anything incurred by the business (but remember to follow the formalities of keeping finances separated!).
- Flexibility: Many options for management structure, taxation structure, and ownership structure (equity). The most “flexible” of the business entity types.
- Pass-Through Taxation: Profits and losses can be passed through to owners’ personal tax returns, making your taxes slightly more complicated. LLCs with more than one owner will need to file their Schedule Ks— unless they elect to be taxed like an S-corporation, which is more complex but can provide lots of tax benefits!
Cons:
- Complexity: More paperwork and formalities compared to sole proprietorships or partnerships.
- State Requirements: Regulations vary by state, adding an additional layer of compliance.
- “Piercing the Veil” — both LLCs and Corporations can lose their limited liability protection if the owners are “comingling funds”— e.g. mixing personal and business finances.
4. CORPORATIONS: STRUCTURED FOR SCALE
Pros:
- Limited Liability: Owners’ personal assets are typically protected.
- Investor Attraction: Easier access to capital through the sale of stock.
- Perpetual Existence: The corporation and the LLC both continue to exist even if ownership changes.
- Flexibility: While less flexible than the LLC, a corporation is also super easy to customize.
Cons:
- Complexity: Extensive record-keeping and regulatory compliance.
- Double Taxation: Corporations are taxed on profits, and shareholders are taxed on dividends.
NOTE: For more on LLCs vs. Corporations, try this article.
CHOOSING YOUR STRUCTURE: CONSIDER YOUR BUSINESS NEEDS
- If you’re a new solo business owner seeking simplicity and control, a Sole Proprietorship might be your entity choice.
- For quick-start with shared responsibilities and liabilities, Partnerships provide a collaborative platform to grow.
- If you need limited liability, versatility, and pass-through taxation– or if you want to file your taxes as an S-Corp– the LLC may be your perfect fit (in fact, this is where I direct most of my clients).
- For with investors as part of your business plan, or who need unique shareholder/ equity structure, the Corporation might be your best choice.
Business Entity Types: Which to choose?
In the business world, the right structure sets the tone for success. Carefully consider your business goals, risk tolerance, and growth plans to choose the structure that aligns best with your entrepreneurial vision when starting your business.
Contact Us to discuss the best type of business entity for your specific situation.
