If you’re reading this blog chronologically, then you’ve already looked at your business idea with a critical eye and decided that it is worth pursuing. Now, you’ll need to look through the types of business entities and decide which one you should use for your business.
Why would the type of business entity matter? Mostly, it’s for understanding how you’ll have to pay your taxes and how to deal with your business’s liability in case something goes wrong. You’ll want to figure out the most convenient way for you to minimize both.
To be honest, learning about different types of business entities is kina boring. But this is something you have to know as a business owner. Luckily, you only have to have a general idea. I promise to make this as short and as painless as possible. There won’t even be a quiz at the end.
To start, I’m going to explain the four most popular types of business entities in the business world:
- The sole proprietorship,
- The partnership,
- The LLC, and
- The corporation.
In the next article, I’ll talk strategy and help you pick the best type of business entity for you.
Let’s get started.
Pick the Best Type of Business Entity for You for Now and Change Later if Needed
Before we get into too much detail, you should know that most businesses can go through several types of business entities as they grow. You can start as a sole proprietorship, graduate into an LLC, and end up as a corporation. So, make the best decision you can for now, and change later if you have to.
Why do you need to decide on the type of business entity right now? Because once you have decided, you can file the paperwork to officially form the business entity with the government. After the paperwork is approved, you can use it to open a business bank account. Then, you can then formally do business under your business’s name.
I’m assuming my readers are mostly based in the US, so the information in this article is mostly based on US law. If you live in a different country, you need to know that your country’s laws might treat these business entities somewhat differently. So, before you make any decisions based on this article, you should double check with a lawyer or an accountant.
The Easiest and Fastest Way to Start a Business Is With a Sole Proprietorship
A sole proprietorship is the easiest and the least expensive way to start a business. It is so easy that many people with side gigs or working as contractors don’t even realize that they are, in fact, sole proprietors.
There is no formal paperwork you need to file to start a sole proprietorship. All you have to do is to start selling something or providing a service.
You can run the business under your own name, but you can also run the business under a business name (called trade name). With a trade name, you’ll have to file an assumed name certificate with your county or state. It’s an easy form you can fill out yourself. The filling fee typically costs less than $100.
Legal Liabilities of a Sole Proprietor
As a sole proprietor, you’re fully liable for all your business dealings. This means you can be sued personally and lose everything you own. You can buy business insurance and insulate yourself a little bit from the liability, but, ultimately, you’re still responsible.
Tax Consequences of a Sole Proprietor
As a sole proprietor, you’re taxed as yourself, under your social security number. You don’t need a business tax number (called an Employer Identification Number or EIN) from the IRS, but you can get one if you want. In the US, sole proprietors file business and personal income taxes together using Form 1040. You can use Schedule C to deduct your business expenses.
Once you start to generate revenue, you’ll have to file estimated taxes with the IRS every quarter.
If you’re interested in starting a sole proprietorship, read our more detailed article about sole proprietorships:
If You Have Business Partners, You Might Want to Consider a Partnership
You can set up a partnership if you have investors or co-owners who plan to work with you to build the business. A general partnership doesn’t require you to file much paperwork with your state but a limited partnership does.
While there are default laws in each state that govern how partnerships operate, these laws are not always the most convenient to follow. You can override some of these laws through a partnership agreement. A corporate lawyer can help you tailor one to your needs.
Legal Liabilities of a Partnership
In a general partnership, each partner is individually liable for the entire partnership. This means that, if you have a lot of money and your partner has very little, you might end up paying most of the monetary damages if the partnership is sued.
There are ways to limit this partnership liability. For example, instead of a general partnership, you can form a limited partnership. But it is best to explore these possibilities with a lawyer’s help.
Tax Consequences of a Partnership
Probably the biggest reason to set up a partnership is that the income of a partnership is not taxed. Instead, it’s passed through to each partner, who then pays taxes as themselves at the end of the year. Each partner will also have to pay quarterly estimated taxes, if you’re in the US and the partner is a person instead of another business entity.
If you’re interested in forming a partnership, we have two articles that can tell you more:
An LLC Is a Great Alternative to Sole Proprietorships or Partnerships, but Only If You Do Business Mostly in the US
A limited liability company (LLC) is typically a good compromise for a small business. It balances the tax advantages of a sole proprietorship with the limitation of liability of a corporation.
However, the LLC as a business format is only recognized in the US. If you plan to do business internationally, you might end up with a larger liability than you bargained for.
Owners of an LLC are called members. Members can include investors or working co-owners. There are default laws governing the internal workings of an LLC, and they are slightly different for each state.
These default laws can be overridden with an operating agreement. The agreement outlines things like ownership percentage, voting structure, operating/management procedures, etc.
If you have multiple members in your LLC, it would be best to work with a lawyer to tailor the operating agreement to your needs.
Legal liabilities of an LLC
The law treats an LLC as a “person” separate from its owners. This means if an LLC breaks the law or can’t pay a debt, the members of the LLC usually are not responsible for the liability. In this way, an LLC works just like a corporation to limit the liability of its owners.
This limitation of liability can sometimes fail to work, however. One of the easiest ways this can happen is if you don’t keep good records that show you’re treating the LLC and the members of the LLC as separate people.
For example, maybe you put your personal money and the LLC’s money all in one bank account. Then, if the LLC fails to pay a debt, a judge might say that, since you don’t think of the LLC and yourself as separate people, then we’re not going to treat you as separate people either. You would then have to use personal money to pay back the LLC’s debts.
LLCs have fewer record-keeping requirements than corporations, so LLCs are easier to run. But some minimum requirements are still there.
Tax Consequences of an LLC
As an LLC, you can choose how you want to be taxed by the IRS. If you’re a single-member LLC, by default, the IRS treats you as a sole proprietor. You would file your income taxes with your own personal taxes at the end of the year.
If there are multiple members in your LLC, by default, the IRS treats you as a partnership. You can also elect to be treated as an S corporation or a C corporation by filing a form with the IRS.
How you file taxes as an LLC depends on how you choose to be treated. LLCs choosing to be taxed as sole proprietors or partnerships must file quarterly taxes. LLCs choosing to file as corporations must pay taxes under the various corporate tax schedules.
If you’re interested in forming an LLC, we have a series of three articles that go into this business format in more detail:
- What is a Limited Liability Company (LLC) and Why It’s Great for Small Businesses
- How to Set Up an LLC
- How Much Does Starting an LLC Cost?
If You Plan to Grow Very Big, Seriously Consider Starting Out as a Corporation
Corporations can be a little complicated to run, especially for a small business with just one owner. But it is probably the preferred form of business entity used by most businesses around the world.
Owners of corporations are called shareholders. Shares can be transferred relatively easily, so you can add or buy out investors and working co-owners relatively easily. Shares also make selling the business in the future relatively easy.
It will probably cost a few thousand dollars to set up a corporation, so you have a high investment upfront. If you decide to set up a corporation, it’s best if you work with both a lawyer and an accountant to set up and then run the business.
Legal Liabilities of a Corporation
Most laws around the world treat the corporation as its own “person.” This is why, under most circumstances, the shareholders are insulated from the legal liability and debt of a corporation.
To keep this “personhood” construct, you have to at least keep good records on shareholder meetings. You also must not co-mingle any of your personal assets with the corporation’s. Otherwise, the corporation’s creditors might be able to get to the shareholders’ personal assets.
Tax Consequences of a Corporation
Corporate taxes can get very complex. Ordinarily, the corporation pays its own income tax and, when the yearly profits (called dividends) are passed to the shareholders, the shareholders have to pay income taxes on those.
In the US, some corporations can qualify under a special tax category called the S corporation. An S corporation’s profits are passed to the shareholders without being taxed, and the shareholders pay the taxes as their personal income.
Even if you’re the only shareholder of a corporation, if you work for the business, then you’re also an employee of the business. This means, when you’re paid by the corporation, it has to pay the various employee taxes to the IRS.
If you’re interested in starting a corporation, here are our three intro articles to get you started:
There Are Other Types of Business Entities Available, so Talk to a Lawyer to Find Out More
In this blog entry, we’ve covered the four major business entity formats used in the US and all over the world (except for the LLC). There are other types of business entities available, however.
For example, in some states in the US, a professional such as a lawyer cannot form an LLC. Instead, they must form a PLLC (professional limited liability company). In other jurisdictions, you can form something called a limited partnership (LP), where investor-partners who do not run the business can limit their liability. A lawyer or an accountant can tell you if a better format exists for your business.
Still, most small businesses don’t need complicated business structures. Picking from one of the four types of business entities covered in this article should be enough to cover all circumstances and types of industries.
So, which type of business entity should you pick? Read our next blog to find out!
DISCLAIMER: This article does not constitute legal advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer. Only lawyers properly licensed in your state/country are qualified to give you legal advice.
Questions? Comments?
