Embarking on an entrepreneurial journey can be an exciting endeavor. However, it requires important decisions early on. One of the first crucial decisions a business owner must make is how to legally structure their business. The choice, also known as business entity type or legal entity type, has significant implications for a business. It can impact one’s legal liability, taxes owed, and how business profits are divided among owners. In this article, we outline different business entity types. Further, we provide some tips to help you choose the right business structure for your business.
Legal entities are established by each state’s statutes and common law and thus vary by state. To complicate things further, the tax code provides additional legal entity variations. Fortunately, there are a few entity types that are uniformly available and commonly selected. These include sole proprietorship, general partnership, limited partnership, limited liability company (LLC), and corporation.
Approximately 70-80% of businesses in the United States start out as sole proprietorships. This is because it generally requires no formal state registration and is the default classification for single-owner businesses. The owner of a sole proprietorship has complete control over his or her business. However, this has a significant drawback: the owner is personally liable for the business’s debts and obligations. Therefore, the owner’s personal assets may be at risk in business-related legal issues or financial troubles. For tax purposes, the profits and losses of a sole proprietorship “pass through” and are reported directly on the owner’s personal tax return on Schedule C.
Partnerships are formed when two or more individuals come together to start a business. When no other type is selected, the default entity type of a partnership is a general partnership. The partners of a general partnership share unlimited personal liability for the obligations of the business and also share in the management and decision-making of the business, as well as its profits and losses. Like sole proprietorships, general partnerships do not require any formal state registration. For tax purposes, the profits and losses of a partnership “pass through” and are taxed on the partners’ personal tax returns.
Two or more business partners may form a limited partnership by registering with their state. A limited partnership consists of at least one general partner and at least one limited partner. Similar to a general partnership, general partners are subject to unlimited personal liability for the obligations of the business and are responsible for managing the business. Limited partners, on the other hand, are shielded from personal liability and have limited say in business operations. This structure works well when certain investors want to remain passive and not engage in daily management. New businesses seeking to raise capital from investors may find this structure attractive.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) combines the “pass through” tax benefits of a sole proprietorship or partnership with the personal liability protection of a corporation. An LLC is a distinct legal entity formed by registering with one’s state. This distinct legal entity can help to safeguard personal assets from business-related liabilities.
By default, single-member LLCs are classified as disregarded entities for tax purposes. The profits and losses of a single-member LLC are reported directly on the owner’s personal tax return on Schedule C. A single-member LLC can also elect to be taxed as a C or S corporation (discussed later). By default, multi-member LLCs are classified as partnerships for tax purposes. However, they can elect to be instead taxed as a C or S corporation.
A corporation is the most complex and formal business entity type, often chosen by larger businesses and start-ups seeking substantial growth. A corporation is a separate legal entity that shields its owners from personal liability. It requires state registration, adherence to corporate formalities, and the issuance of stock. The tax code allows corporations to further select from one of a few varieties, the most common of which are C corporation and S corporation.
C corporations are subject to double taxation, meaning the company’s profits are taxed at the corporate level and then again at the shareholder level when such profits are paid out as dividends.
On the other hand, S corporations receive pass through taxation so profits and losses are only taxed at the shareholder level. The IRS has established stricter rules for S corporation, however. These rules include:
- No more than 100 shareholders.
- Only one class of stock.
- Must be a domestic corporation.
- Shareholders can only be individuals (with a few narrow exceptions) and must be US citizens or
For these reasons, most large companies and publicly traded companies cannot elect to be taxed as an S corporation.
Selecting the best business entity type for your situation is a critical decision that should not be taken lightly. Careful consideration should be given to your desired management structure and the tax and legal implications for your business. There are additional complexities not covered here, such as the impact of entity selection on self-employment taxes. While a business may later change its legal structure, doing so after the initial selection can be very challenging with many legal and regulatory hurdles to overcome and potentially negative tax implications. Contact us for assistance in making a well-informed choice the first time to help ensure the success of your business venture.