Choosing Your Business Entity
In addition to the thousands of other decisions you make when you start a business, choosing the type of legal entity for your new company is an important one. The entity structure determines how you run your business, your tax liability, your ability to raise money, and your personal risk exposure to your company’s debts and lawsuits.
Below are the common types of entities to help you understand what works for your business.
Sole Proprietor
Single owner
No registration to start or formalities to follow
Unlimited liability for owner
Pass-through taxation
If you run your company by yourself or as a married couple and do nothing to create an entity for your company, you are considered a “sole proprietor.” This means you and the business are one in the same. It also means you are personally responsible for your business’s liabilities and debts. Someone who sues your business and wins could take your personal property (your car, personal bank accounts, sometimes your house) to satisfy the obligation.
Because most people do not want that additional risk when they start a business, legal entities provide certain protections for the business owners by separating the business’s liabilities and debts from the owner’s own finances and debts. Because of how easy it is to start a business as a sole proprietor, some people may start their business that way and eventually form an LLC or corporation.
Limited Liability Company (LLC)
State registration required
Limited liability for owner
Pass-through taxation
Less formal than corporation
New business owners often choose to form an LLC because it provides a lot of the benefits of forming a corporation without as much of the formality. An LLC can be formed by one person or many. It must be registered with the state and renewed annually, but there are few required formalities beyond that.
An LLC’s owners are called “members,” and ownership units in the LLC are called “interests.” An LLC offers limited liability to the members, which means the owner’s personal property is protected from the company’s debts and liabilities.
Tax liability is passed through to the members to report on their individual income tax forms. However, the members may elect to be taxed as an S-corp to reduce the tax burden in certain circumstances.
Partnership
Two or more owners
May have unlimited liability or limited liability in certain circumstances, including for the debts and negligence of other partners
May be informal or formal
Pass-through taxation
A partnership is an association of two or more people or companies who agree to carry on a business venture for profit. A partnership may be formed informally, or even unintentionally, by people or companies engaging in this behavior together, even if they do not have a written partnership agreement or register with the state. However, there are more formal types of partnerships that require registration and a partnership agreement and offer limited liability or other benefits.
Partnerships pass through tax liability to the partners. Subject to tax rules, partners may disproportionately allocate tax liability amongst themselves.
Limited liability partnerships (LLPs) may be formed by certain groups of licensed professionals subject to state law, such as doctors, lawyers, or accountants, for limited liability protection from the debts and liabilities of the entity. State registration is required for this type of partnership.
Corporation
Most formal and complicated
Taxed at corporate level and shareholder level (unless S-corp) but other tax benefits available
No personal liability
Corporations are more formal than LLCs and partnerships because they must follow specific state requirements regarding formation, governance, records, and meetings. Ownership is in the form of shares, with owners called “shareholders.” The corporation is run by a board made up of directors, officers, shareholders, and employees.
The corporation exists as a separate entity from the owners, so the owners are not personally liable for the debts and obligations of the corporation. Corporations also have more tax benefits than other types of entities.
In addition to being more formal, a C-corp type of corporation is subject to double taxation. The corporation pays taxes on its profits, and then the shareholders pay income taxes on the distributions they receive from those profits. For small businesses where the owner and the owner’s family are the shareholders, this can be a big burden because they are paying taxes twice on the same income. For this reason, smaller businesses may elect to be taxed as an S-corp and pass through the income and taxes to the shareholders so that the corporation does not pay a tax as well.
S-corps must meet the following requirements to qualify:
Domestic (U.S.) corporation
Shareholders are individuals, certain trusts, and estates but may not be partnerships, corporations, or non-resident alien shareholders
Only 100 shareholders
Only one class of stock
B-Corps and Nonprofits
A company can also take the form of a benefit company (B-corp) or nonprofit.
A B-corp may be a corporation or LLC, but differs in its purpose, accountability, and transparency by considering its impact on society and the environment in the business decision-making process, in addition to earning a profit. For those reasons, a B-corp has additional formation and governance requirements.
A nonprofit is different from the other entities described above because it is organized for the purposes of some public or social benefit rather than generating profit. Nonprofits may qualify for tax exemption and fundraising benefits, and they have different organizational and governing requirements.
The right type of entity for your business will depend on your individual circumstances and the type of business you plan to start. Pawlick Law, LLC can help you make an informed decision, take care of the registration process, and set you up for successful management of your new company so that you can focus on all your other important decisions.