A Beginner's Guide to the Different Types of Business Entities
When you start a business, you have all kinds of decisions to make. Determining your name, brand colors, and aesthetic can be a fun part of the process. Only slightly less fun is the task of examining the different types of business entities as you choose how to set up your company. Ok, maybe it’s a whole lot less fun. But, it’s a crucial step.
If you already don’t want to think about this anymore and would like some help figuring it out, let’s connect. At Angie Avard Turner Law, LLC, I help entrepreneurs protect what they’ve created by getting the legal things set up correctly. Schedule a time to go over your needs today.
What Is a Business Entity and Why Does It Matter?
In short, a business entity exists when an individual or group of individuals engage in trade or otherwise conduct business. But which type fits your company? What kind of business are you establishing?
These questions don’t revolve around the industry or niche you serve. Instead, they refer to the legal entity your company will be. This decision is important for several reasons as it dictates your business structure and how the tax code applies to you.
It also determines how much protection you have from legal action against your company. The type of business setup you choose matters.
A Quick Look at the Different Types of Business Entities
If you did a deep dive into all the federal and state statutes, you’d find more than a dozen different types of business entities. But the good news is that most small companies fall under one of six legal designations.
1. Sole Proprietorship
A sole proprietor, also called a sole prop, is a single individual who runs a business. Most small businesses start as sole proprietors because it is the default choice. You don’t need to do anything special to operate as a sole prop.
If you are one person and start a business, congratulations! You’re a sole proprietor.
This type of business is common in the so-called gig economy. Contractors, consultants, and freelancers often take advantage of the sole prop’s simplicity. You don’t need to fill out paperwork, and taxes go through your personal return. All in all, for business beginners, it doesn’t get much simpler.
There are some downsides to a sole proprietorship, however. If someone decides to sue you, all of your personal property becomes fair game if they win a judgment.
There is no legal separation of your personal and business property when you operate as a sole proprietor. This fact means that there is no protection for your personal assets. If something goes wrong, and there is a successful lawsuit against you, the court can come after your bank accounts, car, or home. All assets are fair game.
It is also difficult to secure funding or credit as a sole prop. Most lenders and investors will require that you incorporate before they will hand over any cash or extend credit.
2. General Partnership (GP)
A general partnership is very similar to a sole proprietorship. The key difference, as the name indicates, is that there is more than one owner. Two or more owners who share the risks and rewards of running the company are, by default, a general partnership.
As with a sole prop, there is no official filing with the state and no requirement for things such as bylaws. Hopefully, there are contracts and agreements among the members, but to be a legal business entity, you don't have to do much.
From a tax perspective, partnerships work like sole proprietorships. Each partner includes their share of the business earnings with their personal return.
Similar to the liability attached to a sole proprietorship, the partners’ personal assets are at risk if someone takes legal action against the business. And depending on which state you are in, one partner may be held liable for the negligent actions of another.
Credit and funding are also challenging to come by for general partnerships.
3. Limited Partnership (LP)
A limited partnership is when things get more serious because it is a registered business entity. That is, you must file paperwork with the state when you own an LP.
In this arrangement, there is a distinction between general partners, who do most of the work and assume most of the risk, and limited partners. Limited, or silent, partners are generally investors who pay fewer taxes, do little or no work in the business, and assume less risk and liability.
A limited partnership can be an excellent option for entrepreneurs who need cash for operations but want to maintain majority ownership.
4. C Corporation
C corporations are legal entities separate from their owners. They require a filing with the state and other formalities such as board meetings, minutes, and bylaws.
This type of business entity provides significant protection for the owners. Their assets are legally separate from those of the corporation, protecting them from financial judgments against the company.
One significant drawback to a C corp is that it may face double taxation. The corporation pays taxes on its profit, and the shareholders pay taxes on any dividends they receive. If the owner or owners do not distribute dividends, then this double tax doesn’t apply.
C corps are also the most expensive entity to set up, so be sure to weigh all your options as you decide which entity to pursue.
5. Limited Liability Company (LLC)
For many business owners, creating an LLC is a perfect choice. It’s sort of the unicorn of the different types of business entities because it gives you personal liability protection AND flexible tax options. And if you incorporate as an LLC, you won’t have to worry about things like bylaws and board meetings.
A limited liability company is a popular choice among new small businesses. It combines legal protections with financial flexibility. Establishing an LLC can also make you eligible for grants and other forms of outside funding.
The filing fee to register an LLC varies greatly from state to state. But many business owners find the cost to be well worth the benefits an LLC provides.
6. S Corporation
This type of business filing is different from the others in that it doesn’t specifically apply to the structure of your business. Rather, it is an election you make when filing your taxes. You can choose this once you are an LLC or a C corp.
When you file as an S corporation, you maintain the personal liability protection you already have with your LLC or C corp. However, you avoid the C corporation’s potential double taxation, making it an attractive option.
Instead, taxes work similarly to a sole prop or a partnership. That is, the company’s profits pass through to the owner’s personal tax return.
Many companies start as an LLC and then file as an S corporation when their revenue hits a certain threshold.
How Do You Choose the Right One?
One important thing to keep in mind as you determine the best structure for your business is that you can change your mind later. Although these are legal designations, you aren’t locked into one form for the rest of your company’s life.
Most businesses begin as sole proprietorships or general partnerships since that happens by default. As your company grows or changes, you may decide to become an LLC, C corp, or S corp.
As you decide, be sure to work closely with your legal and financial advisors. They will help you consider facts such as:
Number of owners
Need for funding or credit
Ready to Start?
Choosing and establishing the most appropriate business structure for your company can feel confusing. If you’re ready to have expert legal help with this process, reach out to me at Angie Avard Turner, LLC. I love working with creative entrepreneurs to help them protect their hard work. Reserve your time today to get started.