Starting a Business: Type of Business Entity
Deciding to become an entrepreneur is a great step towards creating a sustainable income as well as having control over your future career growth.
One of the biggest steps you will make is deciding your type of business. This may sound confusing as you have established the type of business based on your services and/or products, however, this is about the legal structure of your business and how your company will appear on tax forms.
There are several different types of business entities you may consider before deciding on which one works best for your business. These types include:
1. Sole Proprietorship
2. Partnership
3. Limited Liability Company (LLC)
4. Corporation
5. Cooperative (Co-op)
While there are several types of entities to choose from it doesn’t have to be difficult to decide which is the right choice for your business. Some questions you may want to ask yourself are:
Debt and Liability: are you willing to accept personal liability for your venture?
Taxes: will you be filing business expenses as well as profits and losses on your personal tax returns?
Partners or Investors: are you working with partners and/or investors? Which entity protects you and them from personal liability?
Employees: will you be hiring employees now or down the road?
Is your business for profit or is it to help a cause?
Will your company be owned and operated by its members?
Once you have answered these questions you will have a better idea of the type of business structure that best suits you.
1. Sole Proprietorship
If you are expecting to work alone or prefer this approach then a Sole Proprietorship may be the fit for you. This is an unincorporated business owned by one person, you, and requires no registration. However based on services, products, or location you may need to register for location business permits. This type of business tends to be one of the simplest where you are responsible for all company profits and debts. You may find this type of business appealing because any income or expenses will be included with your income tax record. What happens, in this case, is that your profits and losses are recorded on the Schedule C tax form which is then transferred to your tax return
Remember that with a sole proprietorship you are personally responsible, or liable, for your company. This means that you are using your assets as collateral which can be used to satisfy any possible business debts or legal claim against you. Some advantages of this structure are:
Easy Setup: With no executives boards or partners to answer to there is little paperwork since the business will be owned by you.
Low Cost: The cost for opening and running your business will vary based on several factors including the city and state you will be operating. Generally, the most common expenses are license fees and business taxes
Tax Deduction: The most important part of any business is making sure your tax information is up to date and correct. With this type of entity, you and your business are a single entity. This means you may be eligible for certain business tax deductions, including health insurance.
Exit Strategy: You may not want to think of a point where you may need to exit your business but it is important to have a plan to be safe in the case of illness or death. If you decide to cease the operation of your business this entity makes it very simple as you can dissolve the business with no formal paperwork. Simply put, by discontinuing operations and advertising your business can be dissolved in the eyes of the government.
Some companies you know started as a sole proprietorship are:
eBay
Walmart
Marriott Hotels
2. Partnerships
This type of entity is when a single business is owned by two or more people. In this instance, each partner will contribute money, property, labor, or skills. While owners in partnerships are responsible for any liabilities of the business the partnership must file an annual information return. Filing this particular return reports information such as income, deductions, gains, and losses but does not pay income taxes. Instead any profits or losses “passes through” to the partners which are included on their tax return as their share of the partnership’s income or loss.
There are options to take into consideration such as the different types of partnerships. Such as:
General Partnership: This is the easiest partnership to form and every partner is taken into account in the operations of the business. This also means that the personal assets of each partner can be used to repay any liabilities. Each partner will share responsibility for the other's actions meaning that if one partner is sued, the other partners' assets may also be listed in the lawsuit.
Limited Partnership: This type of partnership has at least one general partner. The general partner manages the operations of the business as well as takes on the responsibility of unlimited liability. In this entity, there are limited partners, which has them take on only as much as their financial stake in the business. However, they are not involved in the management and do not have direct control over the company.
Limited Liability Partnerships (LLP): While LLPs are similar to partnerships this business is not possible for all businesses and is often restricted to professions such as lawyers or accountants. Multiple partners can be responsible for the operations of the business and are not personally responsible for the debts of the business as well as the actions of others involved in the partnership.
Some advantages to choosing a business partnership are:
Easy to Form: There is little paperwork to file as with a sole proprietorship, however, specifics vary state by state. Some states may require you to operate under a fictitious name (“doing business as” or DBA). If this is the case for your location you will need to file a Certificate of Conducting Business as Partners and draft an Articles of Partnership Agreement, which will be an additional cost.
Growth Potential: If you are looking into securing a loan a bank will look favorable on two credit lines with multiple owners giving you more leverage.
Companies that started as a partnership are:
Warner Brothers
Apple
Microsoft
Ben & Jerry’s
Twitter
3. Limited Liability Company (LLC)
A limited liability company is one of the most flexible types of business by combining elements of partnerships and corporations. This type of business offers the limited liability of corporations while also featuring tax efficiencies and the flexibility of the operation of partnerships. An LLC also exists as its legal entity protecting the owners from being personally liable for debts of the business.
While some LLCs are automatically classified and taxed as a corporation by federal tax law, the federal government does not recognize an LLC as a business entity. In this instance, LLCs are not taxed as a separate entity and all profits and losses are “passed through” the business to the members of the business. This means that members report this information on their returns similar to that of a partnership.
Some example of LLCs are companies such as:
Sony
Nike
Sony
IBM
Pepsi-Cola
4. Corporations
An ideal type of business for companies that are further along in growth than a startup is a corporation. A corporation is a type of business that is a completely separate business made up of multiple shareholders. The law looks at corporations as separate from their owners with their own set of legal rights, which do not affect the owners. Meaning that it can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks. Corporations are more complex than other entities because of the costs for things such as executive-level salaries along with more complex tax and legal requirements making it more common to exist with larger more established companies with several employees.
The profits of a corporation are taxed when earned by the corporation and then are taxed to shareholders when distributing dividends. There is no deduction for the distribution of dividends and shareholders cannot deduct any loss of the corporation.
There also exist different types of corporations based on the needs of your business. Such as:
C-corporations: Usually geared towards larger companies this entity is owned by shareholders while being taxed as separate entities.
S-corporations: Designed with small businesses in mind you can avoid double taxation, much in the same as LLCs and partnerships.
B-Corporations: These are also known as benefits corporations are for-profit types of businesses that are structured to have a positive impact on society.
Closed Corporations: This is not a publicly-traded business and is usually run by several shareholders and secured under limited liability protections. This type of business may also be referred to as a “privately held company” allowing for more flexibility than publicly traded companies.
Open Corporations: When a corporation takes ownership of the company allowing anyone to invest making them available for trade on a public market.
Nonprofit Corporations: These businesses are tax-exempt, existing to help others while focusing on something without an emphasis on turning a profit.
There are multiple advantages to this particular business structure:
Limited Liability: Stockholders are only liable for their investments and not personally liable for claims against the corporations.
Continuity: Business will continue indefinitely even in the event of death or transferring of shares.
Capital: When incorporated it is much easier to secure and raise capital from multiple investors.
Once your business grows to a certain level it is likely best to weigh your options of incorporation. Some examples of corporations are:
General Motors
Exxon Mobil
Domino's Pizza
5. Cooperative (Co-op)
This type of entity exists when a business is owned by members of the organization. This means that whatever earnings are made by the cooperative will be shared among the members without being required to pay external shareholders. In this instance shares of the cooperative can be sold to members who then have a say in the operation of the cooperative. To become a cooperative the organization must create bylaws, have a membership application, and have a board of directors with a charter member meeting.
Benefits of this type of business are:
Lower taxes: A cooperative does not tax the members on their income.
Increased funding: To get started there may be specific grants that can assist in establishing this type of business.
Discounts and better service: The ability to obtain discounts on products and services for members by leveraging the business size.
Some examples of cooperatives are:
Welch’s
REI
Ace Hardware
Navy Federal Credit Union
When deciding on the type of business you wish to open it is important to factor in where you see yourself short-term and long-term. This allows you to look at finances, suppliers, locations, equipment, the flexibility of your business, taxes, and liability and decide what works best for you. If you find yourself overwhelmed we always suggest consulting with a professional to ensure all your questions are answered and to make sure you are on the right path.