Choosing the best business Entity Type?

 

With a better understanding of how the common business entity types work and their respective pros and cons, you can now determine which type works best for your small business. The best course of action, if you can afford it, is to consult a business lawyer and tax professional on which structure is optimal for you, given where your business is currently and where you hope to take it.

As a starting point, however, there are three general factors to consider when choosing among business entity types: legal protection, tax treatment and paperwork requirements. In the section below, you can see how the entities stack up with regard to each of these factors.

Business entity summary

Sole Proprietorship

Limited Liability Protections? No. Tax Treatment: Taxed at personal tax rate. Level of Government Requirements: Low.

 

General Partnership

Limited Liability Protections? No. Tax Treatment: Taxed at personal tax rate. Level of Government Requirements: Low.

 

Limited Partnership

Limited Liability Protections? For limited partners only. Tax Treatment: General partners taxed at personal tax rate. Level of Government Requirements: Medium.

 

S-Corporation

Limited Liability Protections? Yes. Tax Treatment: Taxed at personal tax rate. Level of Government Requirements: High.

 

C-Corporation

Limited Liability Protections? Yes. Tax Treatment: Must pay corporate taxes (but beware of double taxation on dividends). Level of Government Requirements: High.

 

Limited liability Company

Limited Liability Protections? Yes. Tax Treatment: Can choose how you want to be taxed. Level of Government Requirements: Medium.

As you can see, sole proprietorships and GPs are light on liability protections, so they expose you to greater legal risk if someone sues your business. But, taxation is simple when you have a sole proprietorships or GP, and you don’t have nearly as many government regulations to comply with. That means more time to do what you love — running your business.

The simplicity of a sole proprietorship or a partnership makes either of these business entity structures a good starting point for freelancers and consultants, particularly if the industry they're in brings little legal risk with it.

Along these lines, fashion and beauty influencer Joanna Faith Williams said: "Being a sole proprietor now seems most appropriate as there is not much that I am liable for at this time. I keep well-written contracts to protect myself, but as I begin to dive more into creating content such as ebooks… or things that my audience will have to pay for, I will definitely consider registering as an LLC."

If your business is in a more litigious industry, on the other hand, such as food service, child care or professional services, that’s a strong reason to create an LLC or corporation right off the bat. And regardless of industry, as your business grows and more dollars are at stake, that can be the ideal time to “graduate” to an LLC or corporation. What works for a freelancer or hobbyist likely won’t work for someone who is trying to hire employees, bring on additional owners, or expand.

Although it’s certainly possible to change business structures at any point in your business’s journey, some changes are easier to make than others. For instance, it’s relatively simple to convert from a sole prop or partnership to an LLC by filing the right paperwork with your state.

Converting to a corporation, however, is more difficult, particularly if you plan to issue stock. Additionally, converting from a C corp to an S corp can bring unexpected taxes. Therefore, before changing your business structure, you'll want to think through the possible advantages and potential problems associated with doing so and consult a business attorney for professional advice.

Moreover, you'll want to keep in mind that the IRS places certain limits and deadlines on how often you can change your business’s entity type. Plus, it's also worth remembering that different government tax plans can change how business entity types are taxed, and this may contribute to how taxes factor into your ultimate decision.

The bottom line
 

Your choice of business entity is a very important one. The entity you choose can affect how people perceive your business, and more importantly, it has a big impact on your legal exposure and finances.

All in all, you'll want to keep the following in mind when deciding among the different types of business entities:

  • Sole proprietorships and general partnerships are good “starter” entities.

  • As your business grows and generates more income, you might consider registering as an LLC or corporation.

  • Think through the pros and cons of each business entity type in terms of legal protection, tax treatment and government requirements.

  • Work with a business lawyer and accountant to get specific help for your business.

 

Ultimately, although there’s not a single best business entity choice for all small businesses, by referring to this guide and consulting legal or financial professionals, you'll be able to determine which type is right for your business.