As a small business owner, there are several reasons why you might decide to create a business entity. For example, if you’re a freelancer, you might form a limited liability company (or LLC) to offer some protection in case there are some liabilities incurred by your business. To do this, you’d file papers with the state and pay a required fee.
There are numerous types of business entities, which we’ve detailed below. But which is the best type for your business? That depends on the nature of your business, as well as other factors such as the number of owners of your business. It’s one of the biggest decisions you will make as a business owner, so you should definitely consult a lawyer and / or tax professional to help determine which choice is right for you.
What Is a Business Entity?
A business entity, also known as a business structure, is not defined by what a business does, but rather how it’s structured. The type of business entity will affect how it’s taxed and how any liabilities are handled. Business entities are created at the state level (you’ve probably heard of small businesses creating LLC in Delaware and so on), and must comply with certain state laws.
You create a new business entity by filing papers with your state. The U.S. Small Business Administration may have local offices that can help you with the process of setting up your business entity. You can also often get free or low-cost advice on getting your business started, and direct you to other resources.
Types of Business Entities
These are the most common types of business entity, many of which you may already have heard of:
A sole proprietorship is basically just what it sounds like — you are the sole owner of the business, the company is in your name, and all expenses come from you personally. This is the simplest type of business entity, and one of the easier ones to manage.
But there are some drawbacks, such as being directly financially responsible for any expenses incurred, including lawsuits and taxes. One type of sole proprietorship is the DBA, short for “doing business as,” which is a way for freelancers to create a business name as an alias, to give off a more professional image.
This business entity is a formal partnership agreement signed by yourself and one or more partners. Much like an LLC, this is a fairly simple structure for a business, and has some advantages beyond the partnership itself, such as being able to sell partnership interests in order to raise money. Where a partnership might get complicated is in determining the different responsibilities (and liabilities) of each partner — and, also like an LLC, it may involve some blurriness between personal and business finances.
This is similar to a general business partnership, in that there are still partners who operate the business, but investors can buy a “limited partner interests” in the business. These investors aren’t the same as general partners, and are not generally involved with the day-to-day operations of the business. The general partners still maintain authority over their business, while the investors stand to gain (or lose) financially, depending on how the business performs.
Limited Liability Company (LLC)
The major thing that sets an LLC apart from the previous items on this list is the definitive separation of personal and business finances. With an LLC, you have more protection from legal liability. Having an LLC is ideal for business owners who are looking to attract investors, but not venture capital. An LLC is also more flexible in terms of the number of members who can belong to the company. There are some differences between an LLC vs. INC — read on for more.
For those businesses who are looking for venture capital, a C-Corp may be the ideal business structure. As with an LLC, your personal assets are clearly separated from any taxes and debts incurred by the business itself. However, with a C-Corp, you are getting closer to the “big leagues” and will need to start holding annual meetings. One advantage of C-Corps early on is that the company is taxed on its profits (but you probably won’t have any for the first year or more).
An S-corporation is so called because it takes advantage of Subchapter S of the federal IRS code, which allows them to avoid taxes on their corporate income. This won’t be for everyone when it comes to small business owners. It’s a good choice if you are okay with a limited number of shareholders and not looking for venture capital.
Factors to Consider When Choosing a Business Entity
When you’re deciding on the right business entity for you, consider these questions:
- Do you plan to keep the business small and be the sole owner or expand and take on one or more partners?
- Are you aiming to list the company in the stock market?
- How much liability do you want to take on in your individual capacity?
- What will be the tax implications of starting a business entity? (This is where professional legal and tax advice comes in handy.)