How to Choose & Use the Correct Business Entity
How to Choose and Use the Correct Business Entity
Being a small business owner certainly has its benefits. Yet, there's one aspect that often leaves would-be entrepreneurs scratching their heads: what type of business entity should I choose?
There's a lot to choose from, and for a small business owner with limited time, choosing the right business entity can be a stressful task. However, the right business entity is critical for minimizing risk, maximizing tax savings, and gaining control over your business.
But how do you choose the proper legal structure for your business? Fortunately, you have many options in today's marketplace: sole proprietorship, S corporation, C corporation, limited liability company (LLC), and partnership.
The legal structure you choose for your business will impact your taxes, reporting requirements, and liability exposure. To help you through this decision-making process, here is a basic explanation of each entity type commonly used for small businesses.
What Is a Business Entity?
A business entity is a legal structure that helps you register and organize your small business. The type of business entity you choose determines how your business is taxed and what taxes apply. There are different types of business entities available to entrepreneurs.
The right entity type for your business depends on you and your business structure. The rules and regulations for creating each business entity differ state by state. Furthermore, there are legal fees involved with the creation and maintenance.
What Are the Different Types of Business Entities?
The S-corporation is one of the most widely used types of entities in the United States. An S-corporation is a popular structure for small businesses. However, you may need to consult an accountant or attorney because of issues unique to small business operations.
Your company must meet the following requirements to be considered as an S Corporation:
- It must have 100 or fewer shareholders
- Shareholders can only include individuals, not other entities such as corporations or partnerships
- Shareholders must be U.S. Citizens or permanent residents
- All shareholders must consent to the election of S corporation status
- The business must have only one class of stock
An S-corporation is a type of corporation with shareholders who have limited liability, similar to a regular corporation. However, unlike a C-corporation, which pays corporate income taxes, S-corporations are pass-through entities, and their profits and losses "pass through" to the shareholders.
A C-corp is a corporation with stockholders and owners. C-corporations pay income tax through their corporate entity (as opposed to through the owners). The income earned by all the shareholders of a C-corp is subject to business income tax unless the corporation makes an S election.
The following are things to know about the creation of a C-corporation:
- File articles of incorporation
- Unlimited number of shareholders
- No limit on stock classes
- There is no personal liability associated with the corporation
When you create a C corporation, you transfer ownership of your company to the corporation, so the company itself owns all assets and incurs legal liabilities. Because it is a separate entity from its owners, a C corporation reports its own income, gains, and losses on IRS Form 1120.
It provides complete separation between your assets and business assets. It also allows more than 100 shareholders to invest in the company and pays taxes on its net income at separate corporate tax rates.
Choosing and using the correct business entity type is important for any small business. Limited liability companies or LLCs can provide a formal, recognized structure that allows you to conduct your business in the most tax-efficient way. It also offers flexibility for your business as it grows and expands.
There are only a few requirements for creating an LLC. They are
- Choosing an LLC name
- Getting a registered agent
- File Articles of Organization
There must be at least one member in each LLC. Members can manage the LLC, or a board of directors can do so. There are no taxes on LLC earnings. An LLC may be the right choice for businesses that need flexibility but want limited liability protection.
4. Sole proprietorship
One person owns and operates a sole proprietorship. From both a legal and an accounting perspective, it is the simplest type of business structure. It is the most common form of business organization. A sole proprietorship is very easy to set up and only requires one or two simple steps:
- you file for an assumed name (if doing business under one)
- then register your trade name
The assets of a sole proprietorship belong entirely to the owner, who may use them solely at their discretion. The sole proprietor can decide what taxes apply to his business and how he pays them—or whether he pays at all. However, in many states, all profits along with any debts incurred from operating it go to the person who created it.
The most basic and flexible company structure is a partnership. It consists of two or more people who join forces to pursue a trade or company. It is the most popular multi-person business structure, in which partners split profits and control of the organization.
To run a partnership, the requirements are:
- Two or more partners
- Register a Fictitious Business Name. In some cases, you may need to file a Certificate of Limited Partnership form with the state
- Sign a partnership agreement
A partnership does not exist as a separate legal entity, and its owners are subject to personal liability for all of their acts and omissions. Partnerships are generally not taxed but must file an informational tax return with the IRS on form 1065.
Factors to Consider When Choosing Your Ideal Business Entity
1. Startup Costs
Setting up a business entity means different costs. First, consider the startup capital you'll need to make it work. Then, take into consideration legal fees, administrative fees, and other fees that vary from company to company.
Also, think about the current status of the economy and the industry in which you want to start your business. Then, once you've chosen a business entity, plan for how much personal money you'll need to contribute to funding your startup. If the startup cost is a factor and you want a low-risk business, a sole proprietorship is ideal for you.
2. Limited Liability Protection
Ultimately, you'll want to select the business structure that best suits your current and future needs. While operating as a sole proprietorship may sound simple (and in some ways, it is), this type of entity doesn't provide you with many benefits.
By contrast, an LLC offers some important protections against lawsuits, and a C-corp offers tax benefits that are ideal for a growing business.
If you're not sure which entity will work best for your situation, it's a good idea to consult a Certified Public Assistant (CPA). They can help you determine the right business type to get started on the right foot.
3. Ownership or Transfer of Ownership
Ownership is very important when choosing the right business entity to form. First, ownership is important for tax purposes, and second, for liability purposes. In terms of taxes, you will want to choose an entity that will be treated in the same manner as the owners.
This is generally referred to as a "pass-through" entity. Partnerships and S-Corporations are the two most commonly used pass-through entities.
4. Flexibility and Future Needs
If you plan to scale your business fast, go with a form that offers some flexibility. Overall, the LLC is a good choice for a small business that may grow into multiple lines of work or have a variety of individual investors.
The corporation also has its benefits and may be a good choice if you have employees or are looking to grow your company in the future.
5. Tax consequences
While the tax consequences of a business entity are important, they should not be your sole reason for choosing a particular entity. At the end of the day, your business type decision will be heavily influenced by your preference and need for liability protection.
If you work well with LLCs, then an LLC is probably the best business entity for you. But if LLCs aren't very common in your state and you know that others are uncomfortable working with them, then a C-corp or S-corp may make more sense.
One of the most important financial decisions you'll make as a business owner is deciding which business entity to form. And while the type of business entity you choose may not seem to be relevant at first, it can affect your bottom line in both positive and negative ways.
Before making an unintentional choice, research your options for business entities and understand how they affect your taxes and accounting practices. We hope this article has been helpful to you and that you now have a better grasp of these different types of business entities.
Final Thoughts from the Hall Accounting Team
If any of the information provided above made you feel confused, don’t stress because you are not alone. There are many other businesses that have faced similar problems in the past. However, with time, they have fared well with just a little help.
If you are struggling or just don't have the time to keep up with it, it may be time to have Hall Accounting take over and invest with accurate accounting records and financial reports. The Hall Accounting team will manage your records from start to finish and make sure all adjustments are timely recorded. This option is also feasible for small businesses because it is cheap and hassle-free, at a fixed monthly rate. If you are interested, please feel free to email us at firstname.lastname@example.org and we will get you a free quote!
Estimated tax payment for 2nd quarter of 2022 (Form 1040-ES)