As a business owner, you're constantly making countless decisions that affect your business in a myriad of ways. One of the most impactful decisions you can make is choosing the right business entity, as your choice will have direct implications on your taxes, liabilities, and the amount of paperwork you'll be facing, among other considerations.
With these key aspects in mind, let's dive into the four most common types of business structures for business owners to choose from.
1) First is a sole proprietorship, which is among the least complex business entities. A sole proprietorship allows one person - the owner of the business - to possess full managerial control of all business functions. Additionally, this specific type of entity can help minimize potential business losses by offering the ability to include your business's income and expenses onto your personal income tax returns.
However, a drawback to this type of business entity is that all of the financial obligations, liabilities, and risks fall on the owner, meaning that if your business accrues debts or legal claims, your personal assets could be seized because of that. Also, sole proprietorships are the most difficult to raise funding for and typically require that of the owner's personal funds or assets to fuel the business forward.
2) The second type of entity is a partnership, which can be reflected as either a general partnership or a limited partnership. A general partnership allows both parties to have controllership over the business and to take on any obligations of the other partner if necessary. A limited partnership on the other hand, only allows investors to be partners, meaning they should be relatively passive, as their managerial power is basically negligible. Limited partners also have limited liability to business creditors because of this.
An advantage of this business structure is that general and limited partnerships don't actually pay taxes on their income but are considered "pass-through" entities. What this means is that the taxes you pay are eliminated from the entity level and are instead "passed through", meaning that the owners will be taxed on the profits of their partnership entity.
While each business has specific needs and unique requirements, pass-through entities are usually among the most beneficial entity types. Other "pass-through" entities include sole proprietorships, Limited Liability Companies (LLCs), Limited Liability Partnerships (LLPs), and S corporations. But more on that later.
3) S corporation or C corporation is a legal entity that's separate from the owners of the business, meaning that the corporation itself can be taxed, make a profit, or be held liable without any of it being transferred to the owner. The primary benefit of choosing a corporation as a business entity is that it protects the owner from liabilities.
However, corporations are the most expensive option as they require loads of legal and accounting services to ensure that they comply with tax laws and other regulations. Additionally, C corporations face the issue of double taxation, which is when a corporation pays federal taxes on its income and its owners are taxed on their personal income tax returns as well.
The good news is, there are a few ways you can avoid corporate double tax:
- One of the options is to become an S corporation, which is specifically designed to eliminate the federal tax at the corporate level while still maintaining the nature of your business under state laws.
- The other option is to defer the tax on the owner's personal income tax return by suspending profit distributions to corporate owners.
4) Last but not least is the limited liability company or LLC, which provides a hybrid incorporation of both limited liability advantages and the "pass-through" tax treatment. Because of this, choosing an LLC as your business entity can increase your loss deductions, disproportionately distribute tax benefits among owners, and reduce taxes when either a new owner becomes a member of the business or owners receive business liquidation allocations.
Some state laws permit LLCs to have a singular owner, but this varies from state to state. In cases where sole ownership LLCs are not permitted, an S corporation is a good alternative, as it will defer tax when a corporate giant buys out the business. One thing to note is that for professional services, Professional Limited Liability Companies (PLLC), LLC, and LLP business structures should be utilized to protect against limitation of liability, especially malpractice liability.
Now that you know some of the most common business entity types as well as their disadvantages, advantages, and perks, let's discuss how to determine which one is the right choice for your business.
When it comes to choosing the right business entity, it's imperative that you think about your business's specific needs and differentiators.
- As frequently discussed throughout this blog post, legal liability is a large part of many business entity types. Before making a decision on a business structure, you should determine the extent to which your owner(s) or business need to be protected from liabilities, and if you can survive them if they come your way.
- Another crucial aspect to consider are the tax implications of each entity type, and the consequences of making changes to your business structure. Evaluating the different tax implications of each business structure is especially important if you're looking into corporation structures. If you're considering making any changes to your business's organization, you should seek professional advice beforehand.
- With choosing a business entity, you'll want to be present in the moment and think about your business's current concerns, strategies, and conditions. However, it's equally critical to have a future-oriented mindset and look towards the goals and direction that your business is headed towards when it comes to choosing the framework for your business structure.
- Finally, you want a business entity that will extend your business flexibility. Like we've said before, each business is unique in the things it requires, needs, and wants. When choosing a business structure, you want to maximize all that you can around your business's goals.
Ready to get started in the search for the right business entity for you or your business? Get in contact with our expert business consultants at Sorge CPA to discuss your options.