When deciding to start a business, you might wonder which kind of business you should form. Your business's structure should be chosen based on your particular needs. When creating your business, you have four basic entity types you can choose to use. Each one has its advantages and disadvantages, based on what you sell, your business's finances, and the number of owners the business will have.
The Questions to ask yourself: What type of business do I run? How many owners do I have? What is my financial situation? There is no one choice that suits every single business: Business owners have to select the structure that best fits their needs. Below we compare the most common business types you can form.
What are the Different Types of Business Entities?
Choosing the right business structure is an important step in setting up a company. Each entity type comes with its own legal, tax, and operational considerations. Understanding the differences can help you make an informed decision that aligns with your goals and protects your interests.
Sole Proprietorship
This is the simplest option of the four. Typically, when a business is starting out, the owner will not do much research into entity types, and this is the default option. Not only is it easy to create a sole proprietorship, but it also simplifies the tax process come April. All the owner has to do is report its profits or losses on their personal tax record, and that is it.
However, this simple structure means it is tied to your personal assets. That means that if the business fails, you could lose your personal property and savings to pay for any lingering debt. You also will likely have to pay a self-employment tax on any profits you make, which could mean having to pay the government a substantial portion of profits earned.
Partnership
A general partnership is a lot like a sole proprietorship; if you are working with someone else, it is the default entity type for your business. But, like the sole proprietorship, a general partnership ties the business and personal assets of the partners together. If you choose, you could make a limited partnership as long as neither of the partners personally manages the affairs of the business.
This lowers personal liability for business debts, but does not eliminate it. A partnership also raises issues of the ownership of ideas, if your business is built around one. The lack of inherent protection with these entities means that if, for whatever reason, one partner chooses to walk away, they may take the idea with them and kill whatever business had been made.
Corporation
This is a very common entity type, though the paperwork and effort involved in the incorporation process may scare some small business owners away. However, by incorporating, you are greatly protecting your personal assets by creating a separate entity from yourself.
This does make accounting a bit more complicated, but you pay taxes based on what you choose to pay yourself from the corporation, which could mean less money being given to Uncle Sam and more to help your business along. Any ideas your business is built around also becomes the property of the corporation, and not the owners.
After you incorporate, you could also choose to elect an S-Corporation status. What this effectively does is tax the shareholders, instead of the income of the corporation. Creating an S-Corporation, however, is complicated and you could actually get similar benefits from another entity that is much easier to create; the Limited Liability Company.
Limited Liability Company (LLC)
LLCs are very popular entity types because they give the owner, or owners, many more choices. Typically, owners can either opt for the tax structure of a corporation, in which the corporation's income is taxed, or the pass-through structure of a partnership or a proprietorship, wherein personal income includes business profits and losses and is taxed accordingly.
Some states have not changed their tax law to reflect the IRS's ruling that this is allowed, so you should try and contact a professional from the state you are trying to form your company in. Whatever tax structure you choose, your personal assets are still afforded some protection if the business fails if you choose to form an LLC.
When choosing the entity type right for you, be sure to consider the future needs and situation of your company, not just its position in the present. As was said before, there are pro's and con's to each type, but if you consider them carefully, the best fitting entity will likely be clear. Before doing anything, it is wise to consult with a lawyer and an accountant to have your options clarified and questions answered.
Final Thoughts on Choosing the Right Business Entity
Selecting the best business entity depends on factors like liability protection, tax implications, and long-term business goals. Whether you prefer the simplicity of a sole proprietorship, the flexibility of an LLC, or the structure of a corporation, understanding your options is key to making the right choice. Consulting with a legal or financial professional can help ensure that your decision aligns with your needs and sets your business up for success.
Frequently Asked Questions
How do I know which business structure is right for me?
Consider liability protection, tax benefits, and business goals. Sole proprietorships are simple, while LLCs and corporations offer more protection. Consulting a professional can help you decide.
Can I change my business structure later?
Yes, you can change your business structure, but it may involve paperwork, tax implications, and legal adjustments. Many businesses start simple and transition as they grow.
Is it necessary to incorporate if I am a small business or freelancer?
No, but incorporation provides liability protection and tax advantages. Many freelancers operate as sole proprietors but later form an LLC or corporation for added benefits.
What is the process for registering my business structure?
The process varies by entity type and location. Generally, it involves choosing a name, filing formation documents, obtaining permits, and meeting tax requirements.
