How to Choose the Right Type of Entity for Your Business

So you've heard people talk about different types of businesses and everyone has an opinion on what kind you should form to get your business off the ground. But what is each type really, and what fits your business best?

This post gives you a quick rundown of each of the most frequently chosen options for structuring a business so you can decide for yourself what works best for your business. 

How to Choose the Right Entity for Your Business

Sole Proprietorship

Most solopreneurs start out as a sole proprietorship. This is the default when you don't do anything else and you don't have a partner. It's the lowest cost to create, and the least work to maintain. Your business income is taxed on part of your regular tax form (no separate filing required).

But it also doesn't give you any protection from liability. If your business gets in trouble, you are personally responsible for any debts of your business. That means everything is up for grabs (including your house!). 

Limited Liability Company

A limited liability company (LLC) is probably the second most common for solopreneurs and small businesses. It is still fairly easy to set up and maintain but offers more liability protection than a sole proprietorship. When an LLC has a debt or enters a contract, the owner of the LLC (you) isn't personally responsible for the debt or contract.

You can form an LLC with one person or with multiple people. Each state has default laws for how an LLC is operated, but these rules can be modified with an operating agreement, a document that explains the rights and responsibilities of each person in the LLC.

LLCs can be taxed like a partnership or like a corporation. In practical terms, this means that you don't have to file separate taxes for your LLC, you just attach a schedule to your regular taxes. It also means you are only taxed once on your business income (unlike a corporation).

To set up an LLC, you fill out a couple of forms and send them in with a registration fee to your state's Secretary of State. You need to get a separate tax identification number (TIN, also called employer identification number (EIN)).

Partnership

A partnership, sometimes called a joint venture, is created automatically when two or more people start a business venture together. Each state has a set of default rules for how partnerships are run. If you want to change any of those defaults, you need a partnership agreement.

You still have to register the name of a partnership with your state's Secretary of State, just like a sole proprietorship.

When multiple people operate a business together without an LLC or corporation, the law says that this is a partnership by default. The partnership is formed as soon as the partners agree to start the business. There are default laws (that vary slightly by state) that control how a partnership runs and the legal rights of the partners.

In a partnership, when there is no partnership agreement, the partners all share equally in all profits and all losses of the business.

If you have a partner or a few partners, you may have contributed different assets or skills to the business. Maybe you don’t want to split everything 50/50 because one person invested less time or money in the business than another.

If your partner goes out and gets a loan for the business without your knowledge, you are personally responsible for that debt as well. Meaning the bank can take your savings if the business can’t pay back the loan.

Partnerships are used most often by companies working on a project together. I wouldn't recommend starting a partnership for your small business unless you have a specific reason to.

Corporation

A corporation is the most formal of these types of business entities. To set it up, you have to pay a fee and file paperwork with the Secretary of State just like with an LLC. But a corporation requires more formality than an LLC.

Corporations have a board of directors and officers, making the management of a corporation more complex. The rules of the organization are set out in the Bylaws of a corporation. The liability protections you get by forming a corporation can go away if these formalities are ignored.

Income for corporations is also taxed twice. The income is taxed to the corporation in a separate tax return. Then any distributions made to shareholders (owners) are taxed on the shareholders' individual income tax returns. A corporation can be taxed only once like an LLC and a partnership, but it has to meet certain requirements first.

The biggest reason for a small business or startup to form a corporation is so they can give investors an interest in the company in the form of stock. Owners of LLCs have a say in most major decisions for the company. It's much easier to have a hands-off investor own part of a company through stock in a corporation than an ownership interest in an LLC.

Phew, that was a lot of words...

So now you know about the kinds of business entities...

...but realistically, how do you choose?

Choose a Sole Proprietorship if...

  • you're just starting out;
  • you don't have a partner;
  • you won't be taking on much debt; AND
  • your business doesn't have extra risk involved.

Choose an LLC if...

  • you have a partner;
  • you will be taking on debt in the business;
  • the business has more risk than the average business;
  • you have personal assets you want to protect; OR
  • you will be hiring employees.

Don't choose a partnership

Partnerships just don't have any advantages that you can't get with another type of entity. 

Choose a Corporation if...

  • you have partners or investors who don't want to be involved in the daily operations of the business

 

Now you know how to choose the right business entity for your small business or entrepreneurial adventure.

You have no more excuses for procrastinating on building your dream life.

Looking for more tips on how to start your business the right way? Download the 9-Step Checklist to Legally Protect Your Business.

9 Step Checklist to legally Protect Your Business



Older Post Newer Post


Leave a comment

Please note, comments must be approved before they are published