How to Select an Entity Type For A Business

There are many factors when selecting an entity type for a business. Entrepreneurs should consider control, investors or shareholders, taxation, growth, and future needs.

Brad Nakase, Attorney

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After years of cooking delicious meals for her family from the comfort of her home kitchen, Mary is ready to open her own restaurant. But before she can begin serving comfort food to her community, she needs to select a structure for her business. Mary is a cook; she is not familiar with different entity types. Mary consults Joan, a friend of hers who owns her own business. Joan tells Mary about the advantages and disadvantages of different entity types, and how they can impact a company. Joan explains that she once owned a sole proprietorship, but she later changed to a limited liability company because of the liability protection offered. She therefore encourages Mary to do her research before picking a structure, to ensure that it suits both Mary and her business.

Which Business Entity Type Should a Business Owner Choose?

When an entrepreneur makes the decision to start a business, it is critical they he or she understand the options for picking an entity type. This is because identifying a business’ structure can seriously impact a company’s future chances of success. It forms a key part of how a business will operate, and therefore a business owner should take the time to research different entity types’ advantages and disadvantages. By determining which entity type best serves a business, an entrepreneur can increase the chances of his or her business surviving long term and finding success.

This article will review the common type of entity structures, including sole proprietorships, general partnerships, and limited liability companies. This post will help an aspiring business owner better understand the entity types and know which might serve their new business best.

To figure out which entity type is best suited for a business, an entrepreneur should first understand the major differences between the types. After all, each entity type is designed to serve different purposes; they are not interchangeable.

What Is a Sole Proprietorship?

Sole proprietorships make up the easiest and simplest business entity type. Selecting this entity type allows a business owner to have total control over his or her company’s operation. Also, there is luckily little paperwork. A business owner does not have to file very many forms with state agencies, so legal fees will generally be lower.

When paying taxes on a sole proprietorship, an entrepreneur can do this through his or her personal tax return. While this is a great advantage, there is a significant disadvantage in the form of personal liability.

A sole proprietor will be personally liable for his or her business’ activities, liabilities, and debts. If the business is sued, then the owners’ personal assets and reputation will be at risk. For instance, if the company loses a lawsuit, then the business owner may lose his home, car, or personal savings to cover a judgment.

Another disadvantage of running a sole proprietorship is that an entrepreneur may not issue equity, such as stocks. Therefore, a sole proprietor does not have access to this financing option, limiting the business’ ability to raise funds.

What Is a Partnership?

If an entrepreneur would like to do business with someone else, such as an associate, he or she may choose to set up a partnership. There are two main types of partnerships to consider: a general partnership and a limited partnership.

Both of these partnership types form a legal entity that allows interest to be transferrable to other parties. A general partnership is typically easier to set up because it demands less paperwork to be filed. Similar to sole proprietors, partners are liable for the business’ activities and debts. Again, this means that if the company faces a lawsuit, both partners are at risk of losing their personal assets, such as homes, cars, and personal savings.

By contrast limited partnerships include both general partners and limited partners. Limited partners enjoy limited liability proportional to their investment in the business. This means that due to their defined role in the company, they have less responsibility. If there is a lawsuit, they stand to lose less.

Also, limited partners tend to be more “hands-off” when it comes to the company’s regular, day-to-day activities. In a limited partnership, all parties need to sign written agreements detailing specific relationships and roles. In addition, certificates must be filed with the necessary authorities.

Before creating a business partnership, it is important that a business owner completely understands and is happy with the partnership agreement. This is because the agreement will protect an owner in the future, making sure that the partnership is fair to all involved.

If, at some point, an owner determines that a partnership is not working out, then he or she may need to buy out their partner.

What Is a Corporation?

A corporation is a legal entity that is entirely separate from its owners. The business owner will own shares in the business, which will allow them to both transfer ownership and raise funds through the issuing of stock. One major advantage of owning a corporation is having liability protection, unlike sole proprietorships and partnerships. In the event of a lawsuit, the owner’s personal assets and reputation are safe from judgment.

One negative aspect of running a corporation is being subject to double taxation. Not only will the business’ profits be taxed, but also the dividends paid on shares or earnings one takes from the company.

What Is an S-Corporation?

An S-Corporation is a slightly different form of a corporation. The National Small Business Association (NSBA) reports that 33% of all small business structures qualify as S-corporations. The main benefit associated with running an S-corporation is that the company will not be subject to double taxation. Having this type of entity means that a business owner will only have to report profit and loss on his or her personal tax returns.

This entity structure requires the same formalities as any standard corporation, such as annual meetings and minute-taking. Also, an S-corporation is limited in how many shareholders it can have, as well as their type. There are limits on who can own shares, which negatively impacts the business’ ability to raise funds.

What Are Limited Liability Companies (LLC)?

Known as a hybrid business structure, limited liability companies (LLCs) operate as a combination of a partnership and a corporation. As a separate legal entity, the business will offer liability protection to its owners. In the event of a lawsuit, their personal assets will be safe from judgment. Taxes may also be paid in a manner similar to a general partnership, via the business owner’s personal tax returns. Also, there is no limit to the number of owners. Another great advantage is the lack of formality. An LLC is not required to hold annual meetings or maintain other corporate formalities.

Unfortunately, it can be difficult and complicated to form a limited liability company. The process can involve steep legal fees and a lot of paperwork that must be drafted and signed. The complexity involved in forming a limited liability company can make it difficult for a business owner to attract investors. This, in turn, can make it difficult to raise funds. In addition, it can be difficult to grant share options, also affecting the raising of capital.

Summary

According to the National Small Business Association (NSBA), the following is a breakdown of entity types across the country:

  • Sole proprietorships: 14%
  • Partnerships: 3%
  • Corporations: 18%
  • S-corporations: 33%
  • Limited liability companies: 33%

Picking a business entity type is a critical step for entrepreneurs, though a structure can be changed later if necessary. That said, changing an entity type can have legal and tax costs, and it may disrupt one’s business. It is therefore important to review the pros and cons of each entity type at the beginning, so that it is more likely an entrepreneur makes the correct decision from the get go.

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