Business Entity Formation Lawyer

Types of Business Entities

In the simplest terms, a business entity is an organization that has been formed by an individual or a group of individuals in order to conduct business, engage in trade or partake in other activities. The type of entity your business chooses to register as will have implications on how you are legally protected against any action taken against your business, how the business is taxed and how the organization must be structured. There are six common types of business entities, and most businesses will choose to register as one of these entities.

Sole Proprietorship

A sole proprietorship is one of the simplest types of business entities, and as the name implies, it must be owned by either an individual or a married couple at the helm. If you are opening a new business and are the sole owner, the business will automatically be classified as a sole proprietorship under the law. Typically, there will be no need to register the business as a sole proprietorship with the state due to the automatic classification, although it is possible you may need local business licenses or permits depending on your location. It is common for freelancers and consultants to operate as sole proprietors, but it can also be a good option for other businesses with a sole owner.

There are some benefits of registering as a sole proprietor that are useful to be aware of if you are considering choosing this as your business entity. Sole proprietorships are one of the easiest entities to start, considering it is not required to register your business with the state if you are the sole owner. There are no requirements for sole proprietors such as formalities and paperwork requirements that corporations must abide by. Since owners of a sole proprietorship are treated as a pass-through entity, it is not necessary to file additional tax returns for your business, instead you only have to add Schedule C – Profit or Loss from Business to your personal tax return each year. Additionally, you can deduct most business losses from your personal tax return.

Although there are significant pros to registering as a sole proprietorship, there are also cons that you should be aware of as a business owner. As the sole owner of this business entity, you alone are responsible for any debt or liabilities the business faces. If someone files a lawsuit against your business, they are able to take your personal assets in the winning of the lawsuit, including your money in your personal bank accounts. Due to the lack of separation from you and your business, it is more difficult for owners of a sole proprietorship to be granted a business loan and raise money. Lenders prefer LLCs as business entities when granting loans. Without a registered business entity, it is more difficult for your business to build credit.

The ease of setting up a sole proprietorship cannot be ignored when researching what entity to register your business as. The lack of separation between personal finances and business finances can be a great benefit for some, but can also have negative effects in the face of business liability and debt. Even if you are the sole owner of your business, there are other options to consider if the legal risks of a sole proprietorship are deemed too much for you to take on as a new business owner.

C Corporation

A C Corporation is a business entity which legally exists separately from the owners of the company. Shareholders, a board of directors and officers have control over the corporation, although it is possible to fulfill all of these roles as an individual and own the corporation independently. C Corporations must follow many more regulations and tax laws than a sole proprietorship, and forms for registering as a C Corporation vary by state and city.

Although there are more regulations a business must follow if it is registered as a C Corporation, there are also some positives to choosing this type of entity. As a C Corporation, owners are protected from any personal liability or debt the business is facing. C Corporations are also eligible for more tax deductions than any other type of business entity, which can be beneficial in the long run as you optimize savings for your business. As an owner of a C Corporation, you pay lower self-employment taxes than other business entity owners are required to pay, and owners have the ability to offer stock options, which can also help optimize savings and business funding in the future.

In addition to more regulations than other business entities, there are other cons to consider before deciding on a C Corporation as your business’ entity type. Registering as a C Corporation is more expensive than registering as a sole proprietorship or partnership. The filing fees range depending on the state in which your business will be registered, but they are generally anywhere from $100 to $500. C corporations also face double taxation: while the company pays taxes on the corporate tax return, shareholders are also required to pay taxes on their dividends earned on their personal tax return. Unlike a sole proprietorship, owners of a C corporation are unable to deduct any business losses from their personal tax return.

While many new business owners decide against registering as a C corporation due to the expensive registration costs and the stricter regulations, it can be a beneficial entity classification as a business begins to grow and owners recognize the need for more legal protection from business liabilities.

S Corporation

An S corporation is similar to a C corporation in that it protects owners from liability that the business is facing, but it is taxed as a pass-through entity. This means it follows a similar tax structure to a sole proprietorship, and business gains or losses pass through the business owner’s personal tax returns, and there is no corporate-level taxation for this type of entity.

While the S corporation has the same benefit of protection from business liability for the business owner or owners, it also has benefits for taxation purposes. There is no corporate taxation, which means owners are able to deduct business losses from their personal tax return. Owners of S corporations also avoid double taxation, since they will not be paying taxes on corporate income and dividends.

Similar to C corporations, S corporations have corporate regulations they must follow, which make business operations more complicated. These regulations include the implementation of company bylaws and holding board and shareholder meetings. S corporations have limitations on the issuance of stocks, which is another negative to the S corporation classification. They are also more expensive to file than sole proprietorships, although the costs vary by state, similar to that of the C corporation registration costs.

S corporations are a good choice for business owners that would like the liability protection and corporate structure for their business, but would also want to receive the tax benefits of operating as a pass-through entity. Organizing as an S corporation, or changing your business entity to an S corporation after the business is already registered, can be done through the filing of Form 2553.

Limited Liability Company (LLC)

A limited liability company (LLC) is a popular type of business entity because it takes many of the desirable features of other business types into one entity. Similar to corporations, LLCs offer limited liability protection for the business owners. However, since they are not a corporation, they have less paperwork and corporate regulations, in a similar way to the limited regulations of a sole proprietorship.

The LLC has the aforementioned benefits for business owners, as well as additional benefits that are important to consider when making the decision to file as an LLC. The main tax benefit is that owners of an LLC can choose how they are taxed on their business earnings. Owners can choose to be taxed as a corporation, and follow a similar tax system to the C corporation, where taxes are filed independently of the personal tax return. Owners can also choose to be taxed as a pass-through entity, and put business earnings and expenses on their personal income tax return. The option to choose allows LLC owners to optimize their tax savings, when they choose the best option for their situation.

Similar to the cons of a C or S corporation, LLCs are more expensive to register than a sole proprietorship. The cost depends on the state in which the LLC is being registered.

LLCs are often referred to as the best option for small business owners and freelancers, because they offer the flexibility to choose how they are taxed, along with the liability protection of a corporation without the regulations that corporations must abide by.

Partnership

A partnership is similar to a sole proprietorship, except like the name implies, it must be started by two or more business owners as opposed to one. There are two kinds of partnerships: General Partnerships and Limited Partnerships.

General Partnership

In a general partnership, all partners are actively managing the business and they share in the profits and losses the business faces. Like a sole proprietorship, a general partnership is the default business entity, and there is no need to register as a general partnership with the state. Your business will automatically become a general partnership if it is owned by two or more members.

The pros of owning a general partnership include the ease of the entity formation which, as mentioned above, is an automatic classification for your business entity. There are no corporate formalities that a general partnership must follow. The benefits of the partnership allow the partners to equally split all the losses, so as an individual you will not need to absorb any loss on your own. All partners are also able to divide business expenses and deduct them on their personal income tax return.

Similar to a sole proprietorship, the cons of a general partnership are related to personal liability. All partners are personally liable for any liabilities or lawsuits the business is facing. In some states, partners are also liable if another member of the organization is negligent, this is referred to as severe and joint liability. It is also more difficult to get a loan or obtain business funding without being registered as a business entity. Another thing to consider when entering into a partnership is potential difficulties with your business partner. A general partnership can fall apart under the strain of a failed business relationship, leading to business and personal losses for all parties.

Many people choose to enter into business with a partner or multiple partners to lower the risk of personal loss, however it is important to choose the right partner, and ensure the general partnership route is the right option for your business.

Limited Partnership

Although they are both partnerships, limited and general partnerships have key differences that business owners must be aware of. Unlike a general partnership, a limited partnership is a registered business entity. Paperwork must be filed with the state the business operates in to form the limited partnership. There are two types of partners involved in a limited partnership: general partners, who own, operate and assume liability for the business and limited partners, who act as investors. Limited partners are sometimes referred to as silent partners. Limited partners assume less liability and play less of a role in the day to day operations of the business.

A limited partnership is a good option to consider for business owners who have investors interested in their company. Including limited partners in your business will allow you to raise money, and limited partners can reap the benefits of ownership without the personal liability a general partner will face. General partners are able to reap the benefits of having control over their business, while still having the financial backing from limited partners. Limited partners have the freedom to leave the partnership at any time without dissolving the business entity, making this less of a legal commitment for the investors.

Similar to the general partnership, general partners in a limited partnership can still face personal responsibility for the business’ debts and liabilities. The limited partnership is also more expensive to create than the general partnership, and involves filing forms with the state. Limited partners need to be aware of their role in the business, for they too can face personal liability if they take too active a role in the business dealings.

For multi-owner businesses that want to raise money from investors and still operate as a partnership, the limited partnership is a good option to consider.