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hen starting a new business, the type of legal structure you file is almost as essential as your business name. Doing business as a sole proprietor will carry different requirements and risks than doing business as an LLC, for example.

Understanding the differences between legal entities will help you make an informed decision on a structure type. Your business structure affects not only how much you pay in taxes — it can also impact your ability to raise capital and the personal liability you face. You’ll need to carefully weigh this decision, ideally after seeking the assistance of a professional such as a CPA. 

Remember: regardless of the business structure you choose, it’s a good idea to open a bank account for your business’s expenses. Novo offers a free checking account to small businesses and startups, no matter which entity you decide to pursue.

Types of Business Entities

The form of business you choose will ultimately depend on what kind of record-keeping, taxation, and liability you’re willing and able to do. Think about the exact nature of your business when considering which entity type you’ll choose. Read on to learn about four types of business entities:

Sole Proprietorship

A popular business organization, a sole proprietorship is when you’re the only person who owns an unincorporated business. 

The main benefit of a sole proprietorship is that it’s easy to form — in many cases, you may not need to file official paperwork — and you maintain complete control of your business as the sole owner. On the downside, you’ll be personally liable for all aspects of the business, and your personal assets may be at stake if someone decides to sue your company. 

Partnership

This type of business entity requires a minimum of two people to agree to share in the profits or losses in a business. If you’re in a general partnership, you’ll need to file what’s called an annual information return to report your income, deductions, gains, and losses from the business itself. You will also create a partnership agreement outlining the structure and responsibilities of each owner. Profits or losses count as part of each partner’s share of their income on their personal tax return.

The main benefit of a partnership is you’ll have someone else with whom to share the responsibilities of the business, a general partner, including any losses or gains that you’ll need to report in your tax returns. However, each partner is personally liable for the company, and a partnership will involve more paperwork than a sole proprietorship.

Corporation

A corporation is a type of business entity where the founders are responsible for the day-to-day operations, but their personal income is separate from the business itself. That means the corporation itself is taxed and held legally liable for its actions, whereas with a sole proprietorship, you would be personally held responsible. 

There are a few different types of corporations, including the C-Corporation (or C-Corp) and the S-Corporation (or S-Corp). Of the two corporate structure designations, the S-Corp is more popular for small businesses given that it requires less paperwork, while still shielding owners from personal liability. However, the main drawback is the increased amount of paperwork when compared with other entity types. Corporations require more record-keeping than other business entities, and as a result, filing corporate taxes may be more cumbersome. 

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Limited Liability Company (LLC)

A Limited Liability Company (LLC) is similar to a corporation. Like a corporation, an LLC gives personal liability protection to business owners who are referred to as ‘members’. Unlike a corporation, an LLC is more flexible in terms of managing and tax. The business income and losses can be shared among the members of the company.

An LLC may have its own bank account and assets. On behalf of your LLC, you can file a lawsuit, be sued by someone else, sign leases and other types of contracts, and put together loan documents. Limited Liability Company members are not personally responsible for business debts and obligations because an LLC is a lawfully separate entity with an Operating Agreement and/or Articles of Organization. 

Choosing the Right Business Entity For Your Business

There’s no one-size-fits-all answer to choosing the right type of business entity. You’ll need to evaluate each business entity according to your company’s needs and goals. Consider these factors: 

Tax Implications

Think about your goals for you and your business. Are you looking to simplify the tax process, or are you looking for any and every opportunity you can find to minimize the taxes you pay to the IRS?

In general, opting for a corporation or LLC offers more opportunities to minimize your personal taxes compared to a partnership or sole proprietorship. The latter two types may be subject to double taxation, where you end up paying taxes both as an employee (the self-employment tax) and as a business owner. Before picking any business entity based on income tax or tax-exempt implications, it’s best to consult a tax professional to see what is best for your situation. 

Legal Liability

Nobody would choose to be sued or face potential losses from their business, but it’s crucial to think about how much you need your personal assets to bear liability protection. If this need is essential, a corporation may be the better route compared to a partnership, for example. 

Remember to consider the nature of your business. Are you likely to be at risk of liability? If not, and if you’re not interested in filing more paperwork to shield your personal assets, a partnership or sole proprietorship may be a better choice. 

Ongoing Administration and Costs

Think about how much you wish to do in terms of record-keeping and paperwork. If all you’re hoping for is to run a simple business, then filing a bunch of paperwork may not be worth it. On the other hand, if you prefer to scale your business and hire multiple employees, the extra paperwork involved with a corporation may be worth it. 

Remember, with more paperwork and record-keeping come higher costs. In most cases, you may be able to get away with filing your own taxes as a sole proprietor, but other business entities tend to get more complex. You may need to hire an accountant or other types of tax professionals to help you with administrative tasks legally required of your business. 

Future Needs and Goals

Thinking beyond your first year in business is essential, as your business entity will ultimately decide what you can and can’t do with your business. For instance, are you looking to scale and hire multiple employees? Or, what if you choose to sell your business in the next few years?

Think carefully about what will happen when you can no longer run your business. An active corporation is usually distributed to beneficiaries, whereas a partnership or sole proprietorship dissolves upon the owner’s death. 

Of course, you can evolve into a different business structure down the line — plenty of sole proprietorships end up forming LLCs or partnerships. Even if you can change your structure later, choosing the correct business entity now will help you get off on the right foot and prevent costly mistakes and additional paperwork down the line. 

The Takeaway

When choosing an incorporation, a sole proprietorship, an LLC, or a partnership, be sure to take into consideration factors like taxes, liability, costs, and future goals. Each option has its benefits and its drawbacks, so it’s up to you to determine what will be best for your business. When in doubt, contacting a CPA or other business expert can help you decide.

Updated 
March 23, 2022
 in 
Business Building
 category