One of the most critical parts of choosing your business is choosing a business entity. So, what is the best business entity for small businesses? When you select a business entity type, you’ll have to follow its requirements. However, there are tricks and things to know that can ease the process.
What is a Business Entity?
A business entity is an organization formed to operate a business. You’ll also hear business entities referred to as business structures.
If you are forming a business, you can choose from the following business entities:
- Limited Liability Company (LLCs)
- Sole proprietorship
How Do You Choose a Business Entity?
Each business entity has its advantages and disadvantages. The business entity that you choose can affect essential aspects of your business, such as:
- Liability– Specific business structures like a limited liability company or LLC can protect your assets from lawsuits. However, LLC structures exist on a state level only and are not recognized by the federal government. C Corporations are federally recognized business structures that have the liability protection of limited liability companies.
- Record-keeping – Each business legal structure has a different tax form.
- Taxation – Tax structures like sole proprietorship and partnerships categorize their business income as personal income, while a C-Corporation’s income is considered separate from the owner’s. Since tax rates are different for personal and business incomes, their tax burden is greatly affected.
- Company hierarchy – Corporations must have a board of directors. Business hierarchies also make dissolving a business a complicated matter.
- Registration – Your legal structure is a requirement for registering your business in your state.
- Fundraising – Your structure can block you from raising funds. For example, a sole proprietor cannot offer stocks; only corporations can.
What is the Best Business Entity for Small Businesses?
The business entity that you choose can have a significant effect on several aspects of your small business. Each person’s business is unique. Therefore it’s crucial to carefully select the one that’s the right fit.
Limited Liability Company
Limited liability companies, or LLCs, are the first business entities you can choose. There are different LLCs available: a single-member LLC and LLCs with multiple members.
An advantage of LLCs is that owners enjoy pass-through taxation. This means that members can pass profits and even losses through to their owners.
The second advantage of LLCs is flexibility. For tax purposes, LLCs can be either single-member or with multiple members. Also, LLCs can file and pay taxes either as a:
- Corporation (applies to LLCs with multiple members)
- Disregarded entity (applies to single-member LLCs)
- Partnership (applies to LLCs with multiple members)
A disregarded entity is considered separate from its owner. If you’re the owner of a single-member LLC, you’ll report your earnings on:
- Form 1040 or 1040-SR Schedule C: Profit or Loss from Business (Sole Proprietorship)
- Form 1040 or 1040-SR Schedule E: Supplemental Income or Loss
- Form 1040 or 1040-SR Schedule F: Profit or Loss from Farming
The following are other possible scenarios for single-member LLCs:
- Form 1120 or 1120S: Individual LLC members that operate their business as a corporation will use one of these forms.
- Form 8832: A single-member LLC that conducts its business as an LLC but would like to file as a single-member corporation can submit its documents with this form.
LLCs with multiple members also have options for filing and paying taxes.
- Form 1065: LLCs with multiple people can file taxes as a partnership by submitting this form.
- Form 8832: Members of LLCs with multiple members can file as a corporation by submitting this form. LLCs with multiple members don’t need to submit Form 8832 if they file taxes as a partnership.
Even though LLCs offer flexibility, LLCs have disadvantages. All members of an LLC will have to pay their individual taxes on the company’s earnings. The cost of starting an LLC is also higher compared to other business entities.
- Be a domestic corporation
- Have no more than 100 members
- Have only allowable shareholders, including individuals, certain trusts, and estates
- Have only one class of stock
- Not be an ineligible corporation, such as domestic, international sales corporations, certain financial institutions, and insurance companies.
S-Corps allow shareholders to avoid double taxation (federal tax and individual tax payments) found in other business entities. This is due to their structure as a pass-through entity. Profits and losses are passed through to shareholders, who then pay taxes on their personal tax returns.
Another advantage of S-Corps is the liability protection they offer to business owners and shareholders. S-Corp owners receive personal asset protection. This allows business assets to remain separate from personal assets. Finally, S-Corps that don’t have inventory can use the cash method of accounting instead of the accrual method.
Even though S-Corps have several advantages, there are also disadvantages. First, your company must already be a C-Corp or an LLC to become an S-Corp. Shareholders will do this through a shareholder election, which requires you to complete Form 1120-S.
Second, there are several processes that S-Corps must follow to keep S-Corp status. Articles of Incorporation and corporate minute documents must remain updated. Third, shareholders must pay taxes on their S-Corps’ income even if they didn’t receive a portion of their income.
A final con to S-Corps is the salary requirement. Officers and owners of S-Corp must make a reasonable salary even if the corporation isn’t profitable.
Corporations are another type of business entity. Members of corporations are shareholders, and shareholders are separate from the corporation.
There are four requirements for corporations. A C-Corporation:
- Has a board of directors and shareholders
- Has a more complex business structure than a limited liability company
- Is legally independent of its owners
- Is not a personal tax liability for its owners
The structure of a C-Corp gives it several advantages. If you form a C-Corp as an owner or a shareholder, you’ll have limited liability protection. Also, C-Corps are separate entities from shareholders, giving shareholders peace of mind about their assets.
There’s no limit to the number of shareholders that can join a C-Corporation. The existence of the company doesn’t end if an owner leaves. Instead, the board of directors continues the corporation’s operation.
C-Corps also offers tax benefits to owners and shareholders. You may pay taxes at a lower tax rate if your business income falls into a lower tax bracket. Another advantage of C-Corps is their tax deductions. Corporations can receive tax deductions for the following:
- Bad debts
- Charity donations
- Compensation of officers
- Employee benefit plans such as insurance and pensions
- Repairs and maintenance
Although C-Corporations offer benefits to owners and shareholders, there are a few cons. C-Corps aren’t as easy to set up compared to other business structures. C-Corps are also subject to double taxation. Double taxation occurs when the corporation pays a federal tax, and shareholders pay an individual tax for the corporation’s profits.
- General partnerships
- Limited partnerships (LPs)
- Limited liability partnerships (LLPs)
General partnerships are the most common partnerships.
An advantage of general partnerships is that all partners can manage the business and share their profits. Another advantage to a general partnership is that you are more likely to get a business loan if there is more than one business owner. This is helpful if you have a low credit score. A disadvantage of general partnerships for you to consider is the liability that partners can face. Personal assets can be sought for all members in a general partnership.
Depending on your business needs, a limited partnership may be best for you. Limited partnerships (LPs) are a second partnership option. They differ from general partnerships in essential ways.
In a limited partnership, there is a single partner and a general partner with unlimited liability. The general partner acts as a manager for the partnership and is also responsible for any business liabilities. A limited partner, therefore, cannot lose more money than they contributed.
Other partners have limited liability. These partners aren’t responsible for managing the business, but they’re allowed to invest in the business.
The final choice for a partnership is a limited liability partnership (LLP). Limited liability partnerships (LLPs) are the third option in partnerships. You may consider this option if you want your partners to share personal liability. All partners in limited liability partnerships share personal liability.
Sole proprietorships are the most uncomplicated business entities to form. It is also the most common, allowing you to create a business and operate it as an owner. Many famous multi-million dollar businesses like Marriott Hotels and Walmart started as sole proprietorships. Sole proprietorships offer several advantages compared to other business entities:
- For tax purposes, sole proprietorships require you to use your individual income tax return (Form 1040) and information about your business’s loss or profits (Schedule C).
- Sole proprietorships don’t require you to have a separate bank account to conduct your business, though it is recommended.
- The cost of starting your sole proprietorship is lower because there are fewer requirements. You won’t need a board of directors or track any meetings.
- Finally, ending a sole proprietorship is as easy as starting one. As the sole proprietor or small business owner, you can dissolve your business at any time without formal paperwork.
Even though sole proprietorships offer significant advantages, there are disadvantages that you should know. Some cons of sole proprietorships include a lack of training, liability, and taxes:
- Sole proprietors aren’t required to have formal training to start their business. This can create organizational problems due to not knowing what bookkeeping needs you should track. You don’t have to track company minutes, financial transactions, or take note of business decisions.
- Sole proprietors are personally liable for company debts, as there’s no separation between the owner and their business. Sole proprietors have no protection because sole proprietorships don’t offer liability protection.
- Finally, as a sole proprietor, you’re responsible for several taxes that other business entities can avoid. You’ll pay income taxes, sales taxes, and self-employment taxes. You’ll also need to set aside money for estimated taxes to avoid paying a lump sum in self-employment taxes.
Nonprofit corporations are the most specific business entity. Corporations may operate as a nonprofit for the following purposes:
The business structure of nonprofit corporations allows them to have an exemption from taxes. This is for both federal and state income. A nonprofits profit organization can operate similarly to C-Corps regarding their organization.
Nonprofit corporations can only use their earnings for the above industries. Income from nonprofits can’t use their earnings for any campaign. Nonprofits can’t use their profits as a form of income for their employees.
Work with the Pros
Choosing the best entity for your small business can have a significant impact on your business requirements. Work with an accountant today to make sure that you select the right business entity for your needs.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.