More people are pursuing their entrepreneurship dreams and starting their own businesses than ever before – and that’s great! But you need to know some key concepts if you hope for your business to succeed. Specifically, you need to understand business entities and how they may affect your entrepreneurial endeavors in the future. This article will break down what a business entity is, plus go over the different types of business entities in detail.
What is a Business Entity?
In a nutshell, a business entity is the structure of a company. Business entities are important since an organization’s structure can affect its tax liabilities, how much it needs to pay in taxes overall, ownership and control, and more. Note that business entities don’t refer to what a business does or provides (i.e., the products it makes). A business entity only refers to a company’s organizational structure.
Furthermore, business entities are typically created at the state level. When you start a business, you usually have to file documents for your business’s chosen entity with the Secretary of State’s office or a similar organization. You’ll choose your business entity as one of the first steps you take when starting your company.
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What Are The Types of Business Entities?
Depending on the size of your business and other factors, you may choose from between four major business entity types. There are also a couple of exceptions from these varieties. Let’s break down each type of business entity in detail.
Limited Liability Companies
A limited liability company is an effective business entity that offers its owner(s) liability protection. Depending on your needs, they’re relatively simple to set up and can be treated as corporations or pass-through entities for tax purposes. Furthermore, LLCs can have one or many owners, making them excellent for even the smallest businesses whose owners don’t want to classify their organizations as sole proprietorships.
Advantages of Limited Liability Companies
A limited liability company offers several strategic advantages for companies, such as the ability to choose how you want your company to be taxed, plus less paperwork overall compared to larger corporations.
Pros:
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No personal liability for business debts
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Choose whether your LLC is taxed as a corporation or partnership
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Relatively easy to set up with low fees
Disadvantages of Limited Liability Companies
LLCs also come with several drawbacks you should be aware of, including a handful of fees and less flexibility compared to a sole proprietorship.
Cons:
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More expensive to set up your LLC compared to a partnership or sole proprietorship
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Not as flexible as “smaller” entities
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Not as many tax breaks compared to corporations
Corporations
Corporations are legally distinct business entities that are counted as individuals to some extent. All corporations have shareholders, boards of directors, and officers, and they may help separate your business and personal assets significantly.
Advantages of Corporations
Should you choose to identify your business as a corporation, you may benefit from several advantages like increased personal control on your end and liability protection for business debts.
Pros:
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Owners may pay lower taxes
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Easier to raise money for business expansions
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No personal liability for business debts
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No double taxation with certain types of corporations
Disadvantages of Corporations
However, the corporation business entity type also has some disadvantages, like higher than average fees and the fact that you may also lose control over your business depending on how many shareholders you have.
Cons:
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Have to share control with shareholders and/or a Board of Directors
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More expensive than other business entity types
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Some corporations face double taxation (C-corporations)
Partnerships
General or limited partnerships are also good business entities to consider. General partnerships are unincorporated businesses with at least two owners, and all partners manage the business and share in any profits. A limited partnership is a registered business entity with two partner types: those who manage and assume liability for the business and its debts and “limited partners” who are basically just investors.
Advantages of Partnerships
Setting your business entity up as a partnership could be a good idea, thanks to several benefits. It is very easy to start and requires only a minimum of corporate paperwork requirements.
Pros:
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Owners can usually deduct business losses on personal tax returns
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Low fees and paperwork requirements
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Easy to raise money if starting a limited partnership
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Owners can maintain control over business operations
Disadvantages of Partnerships h4>
A partnership also carries several potential disadvantages, including liability for business debts and a high reliance on your partners. Thus, partnerships should only be entered into if you trust your partner(s) highly.
Cons:
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You may be responsible for some or all business liabilities
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Partners can dismantle or derail the business
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You might be liable for partners’ actions
Sole Proprietorships
The sole proprietorship business entity is arguably the simplest overall. It’s an unincorporated business with at least one or possibly two owners who are married. Under a sole proprietorship, you file a single tax return, and all business profits and liabilities are accounted for under your name.
Advantages of Sole Proprietorships
The sole proprietorship business entity does have a few distinct benefits, like enjoying total control over the business.
Pros:
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Very easy to start with practically no paperwork
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No paperwork requirements or corporate formalities
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Can deduct business losses from your personal tax returns
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Very easy to file taxes
Disadvantages of Sole Proprietorships
But sole proprietorships also come with several disadvantages, including a lack of liability advantages that other business entities enjoy.
Cons:
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You are responsible for all business liabilities and debts
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No separation between your personal and business finances
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Can be tough to build business credit or get a business loan
What are “Disregarded” Business Entities?
Before choosing your business entity, remember that business entities can become “disregarded” because of tax-related concerns. A “disregarded” entity is not counted as a separate entity by the IRS for tax purposes. For example, a sole proprietorship business is disregarded since the IRS classifies the owner and the business as the same taxable unit. Furthermore, the IRS sometimes allows one-member businesses to be classified as disregarded entities, though this requires the owner to file specific forms with the IRS.
Summary
Ultimately, it’s crucial that you understand how different business entities work, their unique advantages and disadvantages, and which business entity may be right for your company before choosing between them. By educating yourself, you’ll make better business decisions and create a stronger company overall.
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