Have you been dreaming about starting your own business? That’s wonderful! Becoming an entrepreneur can be an exciting and fulfilling journey. But where do you start? There is a lot to think about when establishing your new business.
One of the first steps for many business owners is setting up their business entity. What is the legal business structure of your company going to be?
Whether you’re a rideshare driver, a real estate professional, or a graphic designer, setting up your business entity is a critical decision. It will shape the way you make decisions about your business, and it will shape your personal and professional liability and your tax liability more generally.
What is a Business Entity?
A business entity is an organization created by one or more people to be a business to engage in a service or trade. It describes the legal status that the business has as an entity for purposes of taxes and regulation. When various levels of government look at your business, what will they see, and how will they interact with your company?
Business entities are formed at the state level, usually by filing documents with a state agency, such as the Secretary of State, and picking a registered agent to handle communication with the state. They’re often subject to taxation, so the business owners must plan on bookkeeping and filing a tax return for their businesses.
The type of business entity determines a lot about your tax status and other financial liabilities. There are five main types of entities that your new business could be:
- Sole proprietorship
- S corporation
- C corporation
- Limited liability company (LLC)
What Are Your Options When It Comes to Entity Formation?
A sole proprietorship is one of the simplest business entities an entrepreneur can start. In fact, if you make any money as a self-employed individual, you have technically already started a sole proprietorship — maybe without even realizing it!
This entity type requires few forms for set-up, and only one owner exists. That means all decision-making about the business is quick and easy to manage because everything is up to you. You get to decide what happens to the business. It also means that all of the profits go to one person – you!
There are also downsides to a sole proprietorship. If you suffer losses, all of those are yours to bear. You can’t escape business debts because your business liabilities are personal liabilities. The business has no legal entity apart from you yourself, so sole proprietorships are taxed on your personal tax return. If your business goes bankrupt, your personal assets could be sold to pay off those bankruptcy debts.
Partnerships are also reasonably simple to set up, as very little paperwork is required. A partnership is a business entity owned and operated by two or more people who have contributed money or effort to start and run the business.
Your profits are split between you and your partners, depending on each person’s capital contribution ratio or on a predetermined ratio based on qualitative contributions.
As with sole proprietorships, if your business goes bankrupt, all of the partner’s personal assets are at risk of being sold to pay off creditors and debts. You form a partnership by filing paperwork with your state.
Limited and General Partnerships
Some partnerships split everything down the middle, sharing profits and decisions evenly, which is known as a general partnership. A limited partnership, however, will have duties and liabilities that vary between the partners.
Perhaps you don’t have a lot of money, but you’re willing to manage your new restaurant day in and day out for a percentage of profits. In that case, your limited partner may provide most of the funding while leaving the work to you and avoiding liability for business losses beyond their original investment.
Corporations are unique business entities that are owned by shareholders. The shareholders elect a board of directors who oversee the operations of the business and are accountable to the shareholders.
Starting a corporation requires a lot of paperwork and is significantly more expensive to start than sole proprietorships and partnerships. You can take your unincorporated business and start the process to becoming a corporation by filing articles of incorporation with your state.
Corporations operate as completely separate legal entities from the owners. This means that the owners have limited liability for business losses, which is one of the most attractive things about corporations. Corporations can own property, raise capital through stock shares, acquire other businesses, and sue or be sued.
Corporations are often very highly regulated business entities; You will need to file annual reports and comply with other regulations to keep your business in good standing with the state.
C-Corps and S-Corps
There are two types of corporations, S-corporations and C-corporations, and the biggest difference between the two relates to taxation. C Corps are taxed separately from their owner; in an S Corp, the business passes profits to the shareholders. They then pay taxes on the business income directly on their personal income tax returns.
With a C Corp, you are effectively subject to double taxation. The corporation pays taxes on income, then it pays wages, and then everyone who receives those wages has to pay taxes on that income a second time.
S Corps avoid that issue, but generally, only small corporations are eligible for S Corp status. To qualify to file as an S Corp, a corporation must have only one class of stock and no more than 100 shareholders.
Last but not least, we have Limited Liability Companies (LLCs). This entity type operates as a combination of partnerships and corporations, giving you the best of both worlds.
LLCs provide liability protection to the LLC owners, otherwise known as members of the LLC. This protects their assets, similar to how a corporation would. As with LLCs and partnerships, the profit share and operating agreement are determined by the members. If the parties agree, they can modify these as needed.
Forming an LLC requires paying for the status and filing your articles of organization. Many states may also require submitting your operating agreement, which outlines the bylaws and governance structures of your LLC.
As a member of an LLC, you will also need to pay self-employment taxes. This is the same as if you were operating a sole proprietorship or partnership.
Making the Right Choice for Your Company
There are a lot of different directions you can go when establishing your business entity. It will affect you personally and professionally, and it will definitely shape your tax liability now and in the future. Take the time to contemplate what exactly you want from your business and your goals.
Contact our experts if you’re feeling overwhelmed and unsure which entity is best for you. We’ve helped thousands of entrepreneurs like yourself with entity formation, and we’d be happy to discuss your options and help you get the ball rolling with your new business.
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.