When starting a business, one of the first things you have to do is choose your business entity type. This decision sets the legal structure of a business.
There are multiple things you need to consider when making this important decision. It all begins with understanding why it’s so essential and what options you have.
Why Choosing a Legal Business Entity is Important
The Small Business Association explains your business entity decision will influence all the basic points of your business.
The entity hugely impacts liability because the formation of your business can either make you personally liable or give that liability to the company. This is incredibly essential to understand because if your business fails and you choose the wrong entity, you could face personal financial ruin.
Your decision will also impact your tax burden and how you can raise money to finance your business. It affects paperwork requirements as well.
The state will require you to have your choice made before registering your business, and lenders may not work with you until you declare your business entity.
In short, choosing your business entity allows you to start your business officially and is an essential step in planning for your business. Failing to do so will hold you back.
The Different Types of Business Entities to Choose From
Now that you know the importance of choosing an entity, you need to know what type of business entity to choose. Before covering that, take a minute to think about what is a business structure because the entity is the structural foundation of your business.
Keep that in mind as you read about each option.
A sole proprietorship is the basic business entity assumption. If you fail to set your entity, this is the default. However, this only works if you are the business’ sole owner because it requires only one owner.
You have complete control over your business and total liability. Anything your business does reflects on your personal finances. When lenders consider your request, such as a business line of credit, they’ll look at your personal credit. If you have any financial troubles in your business, it will also impact you personally.
A sole proprietorship is nice when you first start. It offers a good situation to test out a business idea before you change to a more formal entity.
A general partnership involves two or more people starting a business together. For many, this is the simplest option.
There are two main types of partnerships.
A limited partnership is where one of the owners has unlimited liability for the business and the majority control over operations and the other partners have limited liability and limited control.
This is often a choice when you are the primary business owner with partners who only offer financial help. It allows you to control and run the business as you want but still recognizes the partners’ contributions to the company. It also gives them some buy-in on the business.
With a limited partnership, you’ll pay business taxes on your personal taxes. If you are the partner with unlimited liability, you will also have to pay self-employment taxes.
The other option is a limited liability partnership. In this situation, every owner has limited liability. You can decide the details on running the business together and assign duties as you see fit. None of you are responsible for the decisions or actions of other partners.
Limited Liability Company (LLC)
An LLC protects you from personal liability. However, the taxation passes through to your personal taxes. You can start an LLC on your own or with partners.
Some states put limits on LLCs, giving you a deadline for choosing a different entity type. Your state may also require you to end an LLC if a partner leaves or if you want to make any other significant changes. It may be challenging to start an LLC in some states due to limitations.
This type of entity protects your personal assets.
A corporation is a formal business entity. It makes the business entirely separate from the owners.
A c-corporation provides you the strongest protection personally as an owner. It operates completely separately. You will file taxes just for the business, and any liability falls on the business. You can sell stocks to fund the company.
There are strict record-keeping requirements and you must abide by many additional laws and regulations for this type of business.
The biggest distinguishing aspect of a c-corp is double taxation. The business pays taxes on profits, but shareholders also have to pay taxes on dividends.
An s-corporation is much like a c-corp, but there is no double taxation. Additionally, there are limits on the number of shareholders allowed. Taxation passes through to the owners as well instead of the business paying its own taxes. However, liability is the same.
Hiring a Professional to Determine The Best Entity For You
If you struggle with how to choose the right business entity, you’re not alone. This isn’t an easy choice to make, and the consequences are pretty big. You should work with someone who understands the importance of knowing which business entity to choose.
There is a range of professionals who can assist with your business entity search. Make sure who you choose understands this topic. They should be able to offer you business entity example scenarios to help you best choose the right one.
Some options Entrepreneur recommends include working with a business attorney, the SBA, or another business owner with experience in the field.
How to Choose Your Legal Business Entity
Even consulting with someone else, you need to have a good idea of what will work for you. To do this, you should consider a few critical points that should help narrow down the best option for you.
Think about the liability. As you know, several entity options leave you personally liable for anything that happens with your business. Do you want to take on this risk?
You also want to think about taxes. Do you want to hold the personal tax liability, or would you rather the business be separate for taxation?
It’s important to consider the admin needs. For example, a sole proprietorship has basic needs, whereas a corporation has complex needs. What will work best for you?
Lastly, think about funding. Will you be able to secure financing independently, or will you need help? Do you want to go through a traditional lender, or would you prefer to have stockholders?
The Bottom Line
Choosing a business entity is something you cannot take lightly. You need to go into the process well aware of your options and your needs.
In the end, the choice you make will have a severe impact on your business and how well you can run it.
About the Author, James Webster
James Webster, founder and CEO of ROK Financial has almost two decades of experience within the financial services industry. His passion for helping small business owners and his innovative way of thinking, has allowed him to run multiple successful businesses including National Business Capital & Services. Under the National name, the team was able to help secure over $1 Billion in financing for small businesses nationwide.