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Few things are more exciting than deciding to open a new business. Every day hair stylists, freelance writers, aspiring chefs, accountants, graphic designers and other entrepreneurs put together business plans, line up funding and hang out their shingles with a goal of making a profit.
Small business owners are the bread and butter of the US economy, representing 30.2 million businesses and employing nearly 59 million people.
First-time business owners have countless decisions to make, and one of the first and most important is understanding the different kinds of legal structures available to them. In this blog, we’ll highlight the four types of business entities and cover the pros and cons of each.
There are four main types of organizations: sole proprietorships, partnerships, limited liability companies and corporations. As you evaluate which option is best for you, you should carefully consider the following questions:
- What are the legal or administrative requirements for registering the business?
- How will you and/or the business be taxed?
- Can you be held personally liable for the business?
- Who has decision-making authority over the business?
- What are the ongoing regulatory responsibilities and costs?
- Does the legal structure have flexibility for the long-term?
Let’s dig a little deeper into each.
What It Is: An unincorporated business that is owned and operated by an individual.
Common Examples: Hairstylists, marketing consultants, graphic designers, home repair workers, landscapers, home healthcare workers, computer repair experts, music teachers
A sole proprietorship is the simplest business entity available. As the name implies, the business has just one owner who is personally responsible for all its debts and liabilities. The owner may use his or her own name for the business or create a “doing business as” (DBA) name.
This legal structure is often the most popular for small businesses because it doesn’t require much start-up capital. Setting up the entity generally requires just a social security number and any necessary permits or licenses.
There is no distinction between the individual and the business itself. This is a double-edged sword. On the one hand, it means that income is taxed just once rather than twice (i.e., once as a company and once as a personal source of income).
On the flip side, should the business incur debt, the individual is responsible for covering those losses with personal assets. Likewise, if the business owner experiences divorce or other personal or financial difficulty, the business may be at risk.
- Easy to set-up with minimal expense or legal requirements
- Simple structure that gives the owner complete control
- No separation between personal and business taxes, making taxes easier to file
- Owner has complete authority in decision making
- Easy to dissolve the business entity
- Owner pays incomes taxes on profits
- Owner is personally liable for the entire business
- Can be difficult to raise capital; cannot sell equity in the company
- Creditors can seize personal assets
- Some expenses, such as health insurance payments, can’t be deducted from business income
Next, we’ll review partnerships.
What It Is: A business that is owned and operated by two or more people.
There are different types of partnerships, including general partnerships, in which partners participate in the day-to-day operations and share in the profits and losses of the partnership.
There are also limited liability partnerships in which the main partners manage the business and share fully in profits and losses, whereas limited partners share in the profits but their losses are limited to the extent of their investments. Limited partners are not generally involved in daily operations.
Common Examples: Law firms, medical practices, family enterprises, venture capital investment groups, accounting practices, real estate groups
A partnership involves two or more people who agree to share in the profits or losses of a business.
No legal documentation is required to set up this kind of entity, however, it is highly recommended that the partners create a partnership agreement. That agreement should carefully detail agreed upon principles such as the overall business plan, expected partnership contributions – both financial and time, management structure, profit, and loss distribution formulas, disagreement resolution tactics, and an exit strategy.
The chief advantage of a partnership is that profits or losses are passed directly to partners to report on their personal income tax returns. The other is that the burdens of the business are shared, such as raising capital, setting strategic objectives, and managing operations.
The downside of having shared responsibilities in a general partnership is that each partner is responsible for the losses of the other(s).
- Simple and inexpensive to establish
- State and federal filing requirements are low, relative to a corporation
- Pass-through taxation, meaning the partners record partnership income or losses on their individual tax returns
- More flexible business structure
- Shared pool of resources
- Profits must be shared
- Each partner is liable for the debts and obligations of the business
- High potential for disagreements between partners due to actions of the other(s)
- Each partner can legally commit other partners to a business contract
- Some employee benefits may not be tax deductible
- Can be challenging to raise capital for a general partnership
Next, we take a looks at LLCs.
Limited Liability Company (LLC)
What It Is: A hybrid form of a partnership that passes profit and loss taxation through to owners but insulates them from personal liability.
Common Examples: Retail stores, rental property owners, accounting firms, consumer goods manufacturers, gyms, family businesses
Limited liability companies are popular because they provide the tax advantages of partnership-forms of business, yet protect owners from risking their personal assets should liability problems arise. For example, if the owner of a boat touring company is sued by a passenger that flips over a boat rail, the individual sues the LLC, not the individual owner of the LLC.
In some cases, partnerships will transition to form an LLC or a corporation. This allows the partners to reduce their personal risk without significantly impacting their day-to-day operations. Forming an LLC requires more paperwork, including articles of incorporation, filing fees, operating agreements, and other licenses and permits, though guidelines vary from state to state.
- Liability is reduced for owners
- Pass-through taxation to the owners
- Relatively easy to establish and reasonable filing costs
- Any member or owner can be involved with operations
- Fewer filing and administrative requirements than a corporation
- More regulatory and filing requirements than a sole proprietorship or partnership
- Some states require an LLC to dissolve under certain circumstances (e.g., after 30 years, if a partner dies)
- Some states enforce franchise/capital taxes on LLCs
The final type of business entity is a corporation.
What It Is: A business entity that is separate and distinct from its owners, who are called shareholders. Like partnerships, there are different types of corporations, including C Corps and S Corps, which define different taxation and shareholder parameters.
Common Examples: Computer manufacturers, oil companies, retail chains, telecom services, software providers, banks, insurance companies
Corporations are a popular form of business structure because they shield owners, called shareholders, from liability. A shareholder can’t lose more than the amount of his or her investment and is not responsible for paying back any debts of the corporation, which is an independent legal entity. Owners are therefore protected from personal legal action should the company be sued.
Compared to other business structures, corporations are highly regulated, making them more expensive to operate.
Shareholders elect a board of directors who oversee the management of the corporation. The board must hold regular meetings and publish the minutes of those meetings. Ownership of the corporation can be transferred through the sale of stock or transfer of controlling interest.
The primary drawback of this form of business entity is that it is subject to double taxation: the corporation pays income taxes, and the shareholders pay income taxes on that same income if they receive a payout. Some corporations will mitigate double taxation by paying major shareholders a salary, which can be deducted as a business expense. These tactics are closely monitored by the IRs and can result in fines if done improperly.
- Liability protection for owners (i.e., personal assets of owners are not at risk)
- Corporations can retain profits without owners paying tax
- Improved ability to raise capital, in part through stock offers
- Can operate indefinitely (i.e., are not required to dissolve)
- Clear leadership roles and responsibilities
- Filing and administrative requirements are significant
- Higher overall tax rates
- Double taxation: both the corporation and owners are taxed
- Varying regulatory requirements across local, state and federal jurisdictions
- More significant administrative and compliance costs
With these basics in-hand, new business owners should have a pretty good idea of which business type will be best for them.
Deciding on a business structure is just the first step. New business owners have many other important decisions to make, including what type of business management software will best help them manage their multiple needs.
That’s where we come in. If you’d like help defining your marketing, accounting, customer relationship management or other needs, give us a shout. We’d love to help you get off to a strong start!