A business entity is the legal form of your business. It determines how you operate and how the law will treat you. Learn more here.
As a small business, you have to register your business at the State and Federal levels to gain authenticity and permission to run your business legally. As such, you are required to select among the common business entities for your business to become legal.
To choose the best type of business entity for your business, you must consider factors like the number of business partners, the personal liability, and the type of income tax return your business can handle.
Your choice has financial and legal implications for your business. So, what is a business entity?
When you decide to start your business, one initial step is choosing your business structure. Your structure is your business entity, the legal, organizational structure formed by people aiming to start and run a business successfully.
Here are the different types of business entities.
A sole proprietorship is the most common business entity because it's the easiest to form and is mainly fit for small businesses. Since it involves one business owner, it can operate under its name or a trading name.
If you start your business as a sole proprietor, all you need to do is get the permit or license from your local government, and you are ready to start your business since it requires minimal documentation. You also get the advantage of managing the business as you'd like since you are a single-member entity. This also means that you have complete control of the business.
However, the risk of starting a sole proprietorship is significant since it has no limited liability protection. If you take a loan to start the business, for example, and you default, maybe because you have yet to profit, your lender can take your assets to reimburse the loan.
Additionally, a sole proprietorship is subject to local, state, federal, and self-employment tax based on your net profits, meaning you can end up paying a significant amount of tax for a small business.
Sole Proprietorship Example
An excellent sole proprietorship business example is starting a painting service business. Other examples of sole proprietors include freelance writers, consultants, local shop owners, house cleaners, and a computer repair service provider.
This agreement is made between partners to start, manage, and run a business. It is the most common business entity for companies with more than one member. In a general partnership, the owners share ownership of the business.
Among the different business partnerships, like limited liability and limited partnerships, general partnerships are the easiest to form, the least expensive, and the most straightforward. All partners share responsibility, profits, losses, and unlimited liability status for the business debts.
Every partner should contribute to the business. This can be in the form of labor, skill, funds, property, or any other asset the business needs. As a result, the capital in a general partnership is easy to raise.
It provides the likelihood for the company to start with a variety of skills and substantial experience. The network from each partner also offers benefits like increasing its number of potential investors and customers.
Another advantage of being in a general partnership is that tax is subject to individual tax returns instead of the usual federal income tax on profits. As such, the overall tax paid is lower in comparison.
General Partnership Example
Any business can be a general partnership since it doesn’t require a complex formation. For example, if you decide to start a painting business with two of your best friends, it becomes a general partnership as long as every member is involved in the business in one way or another.
One can be in charge of marketing, the other finance, and you can see the business's overall operations.
In this business entity, there is one general partner and limited partners who contribute to the business but have no part in the management or running of the company.
In a limited partnership, the general partner has unlimited liability, while the limited partners have limited liability totaling the amount of their investment.
This means the general partner can lose their assets if the business is in debt, but the limited partners only lose their investment share. Also, these entities are pass-through entities, meaning the company is only taxed once. The limited partners are not required to pay self-employment tax as well.
In most states, the government conducts the formation of limited partnerships. Also, you should register the company with the Secretary of State. Changing management roles or transferring ownership is challenging in a limited partnership business entity.
Limited Partnership Example
Real estate investors and hedge funds are excellent examples of limited partnerships. If you register your business as a limited partnership in the painting business example above, you will be the general partner. Your two best friends would be the limited partners.
Individuals form a business by creating and sharing business shares in this business entity. The primary determinant of a C Corp is that the business owners are taxed separately from the C Corp, but the business is subject to double taxation.
Every shareholder's legal and financial obligations might be limited, but the limited liability protection protects their profits. Another advantage of a C Corp is expanding its assets, like its own business properties. It's also attractive to venture capitalists, angel investors, and other investors.
Usually, the shareholders choose a board of directors responsible for managing the business policies and making business decisions. However, C Corp follows strict rules like having a consistent director and shareholder meeting yearly and having a board of directors.
Nonetheless, it offers significant flexibility in transferring ownership, raising capital, and giving or selling individual shares.
C Corporation Example
With the painting business example, the partners can register under a C Corp. But, each member would have a share of ownership in the business. The number of partners is not limited to a few people.
An S Corp is much like a C Corp, except it only allows a maximum of 100 members or shareholders with certain eligibility, like individuals or specific estates, and it can only have one class of stock.
Like a C Corp, members in an S Corp must have shareholder meetings, keep the minutes and records, and observe practices like having a board of directors and writing corporate bylaws.
However, the S Corp isn't liable to double taxation since it is subject to pass-through taxation. The entity also offers liability protection to its owners.
S Corporation Example
You can register your business as an S Corp if it has less than 100 members and follows the S Corp requirements.
For instance, in your painting business, when you register as an S Corp with your two friends, you can share ownership equally, or you can own 40% while the rest share 30% of the business shares. This means your initial capital contribution and, as a result, your profits will be greater than that of your shareholders.
Many businesses prefer the limited liability company entity because of its limited liability protection benefits. Also, the entity is subject to pass-through tax, and it has the properties of a partnership and a corporation. As long as you are not an insurance company or a bank, you can start an LLC if you fulfill the requirements like filing the articles of organization and paying the registration fee in your state.
Well-known companies like Johnson & Johnson and Alphabet, the Google parent company, are LLCs.
Each business entity offers different benefits and requirements to follow from the examples above. So, after determining, "what is a business entity?" how do you choose one for your business? By making the following considerations:
The capital you need to start your business can come from several sources. But depending on the business entity you settle on, the terms of raising and gathering the capital will differ. As such, some terms might be unfavorable for you as the primary business owner.
For instance, if you plan to start a business as the only owner, you become liable to yourself whether you use your savings or take a business loan to finance your business. If you choose a C Corp, you might have the flexibility to gather enough capital, but the partnership terms will be subject to rules like sharing in profits.
Different business entities hold differing expectations considering management and ownership. Here's how:
Starting a sole proprietorship or a partnership is more manageable than starting a corporation or a limited liability company (LLC). The former only requires you to register the business with the relevant agency. In contrast, the latter requires registration through the local Secretary of State and the adherence to a set of rules and regulations to maintain the LLC protection.
Regarding business ownership, a sole proprietor is the business's sole owner. But with partnerships and corporations, the ownership is divided based on the number of business partners, investors, shares, and shareholders.
The ease of transferring the ownership also changes based on your business entity. For instance, transferring ownership in a C Corp or an S Corp is relatively easy since it only requires a transfer of shares by selling. But with business entities like partnerships, the business needs to be terminated or sold so that a transfer of ownership can occur.
Your business entity also determines the separation you have with the business management. LLC's, limited partnerships, and corporations offer you, the business owner, separation from the business management. That way, if any management issues arise, you are not held liable or responsible for the decisions of your management team. But the same protection is not offered to general partnerships or sole proprietorship businesses.
Every business owner who is branching out has one thing to worry about: Business tax. Double tax means paying personal income tax and the required state and federal government business tax, making it a non-pleasant experience for many businesses.
However, depending on the type of business entity you choose, you can escape double taxation. For instance, LLCs and S Corps are subject to pass-through taxation, exempting them from double taxation.
Pass through tax means the entire tax payment is passed to the business owners and your investors or shareholders based on the share of profits and salary earned from the business.
Nonetheless, every LLC and S Corp business owner and shareholder should consider the self-employment tax liability for these types of entities.
Some business entities, mainly LLCs, C Corps, and S Corps, offer limited liability protection to owners, shareholders, and investors. This means that you are protected against any lawsuits or debts your business incurs. A sole proprietorship and a general partnership entity don't extend the same protection.
In a nutshell, determine whether you need limited liability protection, investors, and a simple or complex business structure based on the four factors in the list. This will help you narrow down your choice of business entities.
Business entities determine the tax form you file for your business. It also determines what happens to the company and your assets if you are sued or in debt. Business entities are formed to categorize you under the double taxation laws or the limited liability protection laws.
Your business will pay a business tax and an income tax for double taxation. Your assets are protected from possession for limited liability protection if your business is in debt or a lawsuit.
Nonetheless, choosing the best business entity depends on the type of business and the number of owners or shareholders you have. Once you determine the type of business entity to choose for your business, you're required to file the paperwork with your state at a fee if necessary.
Disregarded business entities are separate from the business owner. This means that the internal revenue service (IRS) and the state will ignore your business tax. As such, business taxes, in this case, are passed through to you to pay them as self-employment tax.
Typically, business entities with one business owner fall under the disregarded business entity category. If your business has more than one owner or member, it doesn't qualify to be a disregarded business entity. Spouses make a partnership, not a disregarded business entity.
The most common disregarded business entity is the single-member LLC (SMLLC). However, it is considered a corporation if you file your SMLLC under the Entity Classification Election.
What is a business entity? It is a decision bound to affect your taxes, potential to earn, and personal liability. For instance, sole proprietorships and partnerships pay tax based on individual tax rates, meaning your tax amount will keep increasing as your business grows, which, in turn, might reduce your percentage income.
And if you get sued? Because you don't have limited liability protection, you can lose your home, cars, and savings. This risk is more significant in a partnership because you become liable for your partner's actions. Therefore, your business structure is essential in accounting because it affects your revenue flow and sustainability.
Go over your business idea and determine where to be in the future based on your goals. Expect that your business needs will vary with time, meaning you need to be flexible regarding changing your business entity in time.
Also, consider getting the right partner to help you successfully work on the sustainability of your business plan. For instance, Hoist is an intuitive business building platform designed to start, grow, and run painting businesses effectively.
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