Small Business

4 Types of Business Entities Explained

Choosing a business structure in the midst of hiring staff and developing your market strategy, might seem to be the least of your worries. However, this choice brings some very tangible financial and legal repercussions. It may facilitate or hinder your efforts to obtain a small business loan. It also determines the amount of taxes you’ll be required to pay, as well as what assets other entity can collect on if it comes to a lawsuit you’ll lose.

It’s Not Universal

Choosing the most suitable business entity can be quite perplexing. You will often come across claims that one particular legal form is the best choice no matter the pertaining business of the company, but the truth is – there’s no universal right or wrong. Not only do you need to know what your priorities are, but also how your business will develop over time. It’s easy to make a mistake in this modern maze of bureaucracy, so it’s recommendable to have a trusted and experienced lawyer for small business by your side who will make your decision easy, quick, and, above everything – safe. Now let’s take a look at choices at hand.

1. A Sole Proprietor

A sole proprietorship is the simplest structure of incorporation, making it the most popular one. It is extremely easy to establish – if you launch your small business as a sole proprietor you’re automatically a sole proprietorship under the law and there’s no need to register with the state, although you might need local licenses or permits depending on your industry. There will be no distinction between you and your business, meaning that you’ll be entitled to all the profits, but you’ll also be responsible for all the losses, and debts. This overlap between your business and personal finances enables you to report all your business revenue on your personal income tax return. But it may be more difficult to raise money or get a business loan, and the fact that there’s no registration will make it harder to build business credit. This lack of separation also puts your personal assets at risk in case of a lawsuit.

2. Partnering Up

The partnership is a lot similar, only there are two or more owners. There are two types of this entity – a general and a limited one. In the first one, all partners actively manage the business, sharing equal responsibility for management decisions, profits, and losses. This means you’ll avoid absorbing all the losses, but, at the same time, each one of you may be personally responsible for all liabilities (in some states there are also joint and several liabilities, meaning that each one of you may be personally liable for the negligent behavior or actions of others). You also don’t need to register within the state (creating the same obstacles with loans and business credit). The company doesn’t file income tax itself – the annual information return of profits and losses is shown on personal income tax returns of every partner, meaning you can deduct most business losses this way.

On the other hand, a limited partnership is a registered entity and has two kinds of partners – general partners who own and operate the business, assuming all liability, and limited (silent) partners who act only as investors. The second ones have fewer liabilities and pay fewer taxes, but don’t have control over business operations

3. Declaration of Independence

Corporations are an independent legal entity which is separate from its owners, meaning no personal liability in case of bankruptcy or lawsuit, but they’re more expensive to constitute with fees ranging from 100 to 500 dollars. Corporations must pay income taxes on their profits and shareholders who are also employees must pay income tax on their wages, meaning double taxation. There are also two types.

If you own a C-corporation you can fulfill the roles of the board of directors and shareholders, being in charge of everything. Your biggest benefit will be a limited liability, meaning you don’t risk your personal assets. You won’t be able to deduct business losses on your personal tax return, but you’ll still have more tax deduction options than any other type of entity and the burden of double taxation will be additionally increased with lower self-employment taxes.

If you want a corporate structure but also a tax flexibility, S-corporation might be a better option. This entity preserves the limited liability but it’s also a pass-through entity, which means that profits and losses will pass through to your personal tax returns without corporate-level taxation.

4. The Hybrid

The Limited Liability Company (LCC) is an entity that takes positive features of all others, acting like an upgraded hybrid. It is a combination of simpler tax returns and the liability protection of a corporation, including an option of multiple owners. It can have one single member of multiple ones, even other LLCs. Your personal assets are at no risk, and when it comes to your taxes, you can choose to be treated as a corporation or a partnership. Nevertheless, it requires a costly registration with the state.

There you have it – all the pros and cons, black on white. Although you may rush towards the hybrid, it’s important to think things through carefully and make sure you equip yourself with atheright legal advice. Structure of your business is its foundation and making the wrong choice can make all your efforts collapse in the blink of an eye.

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Daniel Brown is a law graduate and a passionate blogger from Sydney. His areas of interest are alternative dispute resolution and its applicability in different fields of law, IP law and resolution of disputes arising from intellectual property infringement and commerce law.

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