Once you have finally decided to start your journey as a business owner, you will find yourself stuck with dozens of queries, questions, and doubts. There are so many big decisions to be taken, and of course, you want to tread as carefully as possible.
One of the first significant steps to entrepreneurship is to choose the right business entity.
The step is essential because the business structure you decide to start your entrepreneurial journey will impact the future of your startup.
The above choice will have an impact on decisions like – funding options, the size of your business, business operations, the degree of ownership, the share of profits, and your legal liability.
The first step towards selecting the best entity for your startup is to know your options.
To understand each entity type in detail, it is a good idea to consult a tax or legal expert.
Types of Business Entities:
Here are the major types of business entities you should know:
Perhaps the most common type of business entity, a sole proprietorship, is where the business is owned and controlled by one person.
The sole owner of the organization holds the decision making power and control and is singularly responsible for taxes, profits, debts, and everything else. He or she is not answerable to anybody.
As per the Small Business Administration, about 70 percent of businesses in the US are registered as a sole proprietorship. Several famous brands like eBay, Marriott Hotels, and Walmart started as a sole proprietorship.
Registering a startup under this kind of entity is cheap and hassle-free.
Another benefit is an exemption from corporate tax payments.
A major disadvantage is that in this arrangement, the owner is personally responsible and liable for all the financial obligations of the organization.
Things may become difficult during tax time or in case a lawsuit has been filed against your company.
This entity works well for small businesses and medium enterprises.
Here the control, ownership, profits, debts, costs, and losses of a business are shared by two or more people.
Partners file the taxes for their share of profits. Partnerships can be general or limited.
In general partnerships, there is an equal division of profits and responsibilities, whereas, in limited partnerships, one partner has complete control over the business.
The other partner(s) in limited partnerships receives a part of the profits and shares some financial responsibilities but has little or no control.
This business structure works well for entrepreneurs who are willing to share responsibilities and leverage the extra security that comes with having one or more business partners.
If you want to share responsibilities, and still maintain primary control over your business, opt for a limited partnership.
A corporation can be defined as a legal entity, which is formed to conduct business. It is separate from its owners and founders and takes care of various responsibilities of the business.
It can make a profit and has legal rights, right to transfer ownership (via stock sales), freedom to own/sell the property. A corporation can be sued, held liable for its actions, or taxed.
By getting a corporate status, the owner can avoid personal liability. However, setting up this entity as well as record-keeping is not cost-effective.
Apple, Amazon, Microsoft, Google are all corporations.
There are two main types of corporations –
- C corporations
- S corporations
This entity is usually for larger businesses. The business, a separate entity, pays corporate taxes. The taxes, debts, and legal structure of your company will be kept different from your own.
There can be one or more owners. The supervision of the corporation lies in the hands of the board of directors, shareholders, and management.
If you are aiming to attract venture capital investors, a corporation can be a good option. It brings in a new level of legal structure to an organization.
The added structure offers better security, and this is why venture capital investors are often more keen on investing in C corporations.
A-C corp is taxed on corporate profits.
Here the credits, deductions, losses, and income are passed onto the shareholders. S corporations leverage the Subchapter S of the federal internal revenue code.
The Subchapter S enables them to avoid the taxation of corporate income both at the state and the national level.
If you need liability protection and limiting the number of shareholders is not an issue for you, S corporation is a viable choice.
Along with offering some tax benefits, this entity separates the owner’s assets from his/her organization’s debts. S corp may not be a suitable option for you in case you are seeking venture capital.
Limited Liability Corporation, or LLC, is perhaps a hybrid business entity. It enables the owners to enjoy the benefits of partnership as well as corporate business entities.
The business owners are protected from personal liability. They may choose how they are willing to be taxed – as individuals or as a corporation.
Choosing the right business entity
A few questions that you must answer before making the big decision are:
- How large do you expect your startup to grow? Are you willing to run your business for the long haul?
- Do you plan to be the only leader with a few employees working under you, or you are interested in taking on business partners or collaborate with the investors?
- What steps will you take to raise the capital?
- Are you willing to hold full decision-making power, or do you see yourself working in collaborating with the investors, board members, and partners?
- Do you plan to bring in shareholders and issue stock to them now or in the future?
Outside funding can significantly affect the success of a startup. Corporations are often favored by venture capital, bank loans, and investors.
It is not very difficult to attract investors in the case of LLCs. However, sole proprietors and partnerships may have a hard time finding investors outside the business.
If you want primary control over your business, opt for sole proprietorship or LLC.
This is negotiable when forming a partnership agreement. In the case of corporations, you may have a fair amount of control over your business activities in the beginning. However, this tends to change as the business grows.
As a startup, you would want to steer of paying double taxes (corporate tax and personal income) Sole proprietors, partnerships, and LLCs pay tax on personal income.
Corporations are taxed on profits (post expenses). As a business owner, you will be paying corporate tax besides your individual income tax.
The level of operational complexity is varied for each entity. While a sole proprietorship is the simplest option, you may have to face difficulty in getting outside funding, if you choose this entity.
A partnership can solve this problem. However, you will need a signed agreement for defining roles and splitting the profits. Corporations and LLCs have a complicated setup as well as reporting requirements.
In case of a sole proprietorship, you alone will be liable for all the expenses and damages.
If that’s not something you are comfortable with, consider going for a partnership where the liability is shared by the partners.
Liability protection is better for shareholders in the case of an LLC. If you want the best personal liability protection, go for a corporation.
Although it is preferential to choose your business structure at the beginning of your venture and then stick with the decision, it is quite possible to convert your startup to a different entity later on.
Consider your current status, financial projections, and goals while narrowing down your options.
Consult a lawyer in case you require some help and guidance in making a decision.
Each business is unique. It is advisable to put in a lot of research, seek out proper counsel, and weigh your options for choosing the business entity that is most suitable for your business!
Here is a table to help you in choosing the right business entity for your business:
|General Partnership||Limited Partnership||C Corporation||S Corporation||LLC|
Simple, hassle-free and inexpensive. Filing isn’t required
|Simple, hassle-free and inexpensive. Filing isn’t required||More expensive to set-up in comparison to General partnership||The cost of setting up a C Corp is more than sole proprietorship or partnership|| The cost of setting up a C Corp is more than sole proprietorship or partnership|| The cost of setting up a C Corp is more than sole proprietorship or partnership|
|Taxation||Profits and loss reported on the personal tax returns of the owner.||The profit or loss is reported on the personal tax returns of the owners.||The partners are provided a return on their investment. The nature of this return is mentioned in the partnership agreement.||Corporation is a separate taxable entity.||Pass-through taxation. Hence, double taxation can be avoided. ||An LLC is given the opportunity to choose how it wants to be taxed (corporation or partnership).|
|Liability||The owner is personally liable for the liabilities incurred by the business. ||Partners are personally liable for the liabilities incurred by the business. ||As long as they are not involved in the management, the limited partners have limited personal liability in terms of business debts. ||All business debts are the Owner’s personal liability. ||Limited liability for the business debts for owners.||This hybrid business structure is a mix of a corporation’s liability protection and a partnership’s pass through tax structure.|
|Maintenance||Formal corporate maintenance is not needed||Cash can be raised by the partners without roping in outside investors in business management||Cash can be raised by the partners without roping in outside investors in business management||Stocks can be used for raising capital. |
Formality requirements are needed in order to maintain corporate status.
|More formality requirements as compared to LLCs.||Easier to maintain as compared to a corporation.|