Business entity types come in a dizzying array of flavors. Business owners must choose correctly. But questions abound: what is an LLC? Do I need a corporation? What is a sole proprietorship? What about a partnership?
We get it. Because we get these questions all the time, this article breaks down the central business entity types. If you read this, you will understand the main options and start to develop a sense for which would serve your business best.
Towards the end of this article, we outline the main things you ought to think about when choosing between the main business entity types. We hope it makes setting up your business much more straightforward.
Read on and learn!
Business Entity Types: The Most Powerful Ones
As small business lawyers, clients ask us: what type of company should I create? They want to know if they should do a corporation or an LLC or something else? Our answer depends on their needs and goals. We get into more of that later on in this article.
First, let’s discuss the main business entity types.
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A sole proprietorship means just you. Typically, that means you as the owner. There is no separate business entity. That means that you usually do not need to take any action to form a sole proprietorship. You start doing business.
Many companies start this way. However, we don’t recommend a sole proprietorship as a long-term strategy. As your business grows, risks and opportunities flourish. Once this happens, consider other business entity types.
Lack of limited liability protection makes running a sole proprietorship risky, indeed! That means that for a sole proprietor, any debts or liabilities of the business become personal liabilities. That means your house and personal bank account could be at risk. Most other business entity types shield you from this liability.
Limited Liability Company (LLC)
The limited liability company (commonly called an “LLC”) provides entrepreneurs with a convenient and easy choice. Out of all of the business entity types we discuss, the LLC takes a clear lead in popularity. The popularity comes from the limited liability protection.
Limited liability protection confers a key benefit to small business owners. Unlike a sole proprietorship, an LLC’s debts or legal obligations do not typically put the owners’ assets at risk. That means that if something goes wrong in business (we hope it doesn’t), the owners’ assets stay safe.
Also, setting up and maintaining an LLC is relatively painless. While it is essential to make sure that you have an excellent LLC operating agreement and making sure you maintain your LLC, there are fewer formalities than there are with corporations (see below).
An LLC allows one or more members, so this presents the right way for a group to work together.
Although not as common as an LLC, a general partnership offers flexibility to those who need it. Oddly enough, general partnerships can form without the members of the partnership even realizing it. In some cases, simply working together on a joint project forms a partnership. When that happens, members of a partnership have specific legal obligations to one another (for instance, giving a truthful accounting to one another). While we won’t get into this here, it’s essential to know.
That’s because we want you to form a partnership explicitly, rather than on accident. A partnership can be useful where one or more business entities desire to do a project together. For instance, two people or two companies might enter into a partnership to do some joint venture together.
The critical thing to know is that by default, members of a partnership are responsible for a pro-rata share of debts and liabilities. Because of this, we recommend that any partnership have a partnership agreement. This partnership agreement provides a tool to alter defaults and work out potential misunderstandings well before. Remember: be proactive and avoid pain!
Now we enter the world of corporations. A C corporation means a corporation taxed under Subchapter C of the Internal Revenue Code. That means that a C Corporation pays taxes at the corporate level and the owners of the corporation pay taxes on distributions.
C Corporations provide a popular choice because they offer extreme flexibility, along with limited liability protection. Many of the world’s most successful companies use the C Corporation for that reason. C Corporations allow owners to issue different classes of shares. So you might have one type for employee stock options, another for early investors, another for founders and so on.
Understand that while a C Corporation offers flexibility, it also requires more setup investment and additional administrative overhead.
An S Corporation means a corporation taxed under Subchapter S of the Internal Revenue Code. This means that S Corporations do not pay taxes at the corporate level. However, members of an S Corporation still must pay taxes on distributions.
Not every corporation qualifies to be an S Corporation. S Corporations impose requirements for this type of tax treatment. For instance, S Corporations have one kind of share. And they have a limit on the number of shareholders.
Anyone considering this business entity type should consult with an attorney to make sure it is the right choice.
Limited Liability Partnerships and Professional Corporations
These business entity types may not be a good option for most businesses. However, if you are a member of a licensed profession, it makes sense to consider them. The law often requires that professionals form these types. Each profession has different requirements for their formation, so definitely get legal advice before proceeding down this path.
How Do You Choose The Right Business Entity Type?
After seeing the different types of business entities, you may have a common question: which business entity type do I choose?
The answer varies depending upon the business and how the founders wish to structure their venture. In making this choice, business owners want to think carefully about administrative ease, taxes, and possible investment. Business setup represents an important choice, so consult with professionals to make the right moves.
Setting Up Your Business Entity
Now that you know a little bit about the business entity types available, it’s time to think about how and when to set one up. Successful businesses consult with an attorney to help understand which provides the right fit for their business.
The main thing to avoid here is to pick a legal entity and use a cheap online service to set it up. While you might save a few hundred dollars immediately, the consequences can add up to a ton more. Talking to an attorney is more comfortable (and cheaper) than you think.