How to Select Your Business Entity Type

Selecting your type of business entity is one of the most crucial early decisions for all small business owners.

The business entity is the legal structure of your business. This decision determines, among other things, (1) how the government taxes your business, (2) how your assets are protected (or not protected) in a lawsuit, and (3) what types of investments you can accept for your business.

Many of the previous sections have been building up to this decision. We talked about defining your “who,” defining your “where,” and planning your funding… all of those earlier decisions now come to fruition with selecting your type of entity.

“Selecting your type of business entity is one of the most crucial early decisions for all small business owners.” 

Here are the basic entity types that are generally available in most states:

• Sole Proprietorship
• Corporation
  • C Corp
  • S Corp
• Limited Liability Company (LLC)
• Partnership
  • General Partnership
  • Limited Liability Partnership (LLP)
  • Limited Partnership (LP)
  • Limited Liability Limited Partnership (LLLP)

Let’s walk through each one to help you decide which is best for your business.

SOLE PROPRIETORSHIP

A sole proprietorship is the most basic type of business entity.

In a sole proprietorship, you are the only person in charge of your business and you have no liability protection. That means that if you get sued, your personal assets are on the line and there’s really nothing protecting you.

One of the benefits of a sole proprietorship is that there is no double taxation. In other words, you don’t get taxed at the business level and at the individual level. Another benefit is that it is very easy to set up.

Sole proprietorships are a very basic way to set up a business. Legally speaking, this is the equivalent of not setting up your business at all. It’s really an old fashioned way to do business. If you’re serious about the future of your startup, you will more than likely want to consider another option.

CORPORATION

The second common type of business entity is a corporation. In many ways, this is the polar opposite of a sole proprietorship. With a corporation you have liability protection, meaning that if you are sued for negligence or breach of contract, you generally have a level of protection of your own personal assets.

One of the downsides of corporations is that there are all sorts of corporate formalities and extra paperwork. Plus, traditional corporations are typically double-taxed. That means you are taxed at the corporate level and at the individual level. That particular type of corporation is called a subchapter C corporation, commonly known as a C corp.

There is a more recent development called a subchapter S corporation, which is like a C corp except that it has pass-through taxation, meaning you are generally taxed at the individual level and the IRS does not tax you at the corporate level. So that’s a little bit of the best of both worlds.

On the other hand, a C corporation has greater flexibility in the number and type of investors it can use for funding the business. So, if you are planning on seeking venture capital or even hope to be publicly traded someday, you might consider a C corporation. As with so many other decisions, it all depends on your end goal.

LIMITED LIABILITY COMPANY (LLC)

Speaking of the best of both worlds, there is also something called a limited liability company (LLC) This is a state law concept available in many, if not all, states.

LLCs provide liability protection and pass-through taxation. LLCs are becoming a more and more common way to organize your business. They are not as complicated as corporations, and they do not have the double taxation that you see with a C corp. And they also won’t leave you completely vulnerable as a sole proprietorship would.

If you do not intend to take on a large number of investors or seek investments from companies or foreign nationals, an LLC is frequently the way to go. Again, keep your end goal in mind as you make this decision.

PARTNERSHIP

There are also partnerships. The first two types of partnerships that we’ll talk about are designed for equal partners, meaning that everything (responsibilities, liabilities, benefits, etc.) is split equally.

First is the oldest traditional way of doing a partnership, called a general partnership. This is the partnership equivalent of having a sole proprietorship. That means that both partners are completely in charge of liabilities.

There is also something called a limited liability partnership (LLP). It is like a general partnership in that both partners are in it together and there is no differentiation between the levels of responsibility and benefits. The benefit of a limited liability partnership over a general partnership is limited liability, of course.

You may want to set up a partnership where the partners have differentiated levels of responsibility and benefit. Those are called limited partnerships. In a limited partnership, you have a general partner who is in front, doing the work, taking on the responsibility; and you have a limited partner, sometimes these are just investors backing the business but don’t want to be involved in the day-to-day operations

A limited partnership (LP), is the basic way to separate the roles of the partners. What it’s lacking is liability protection.

There’s a new type of partnership called a Limited Liability Limited Partnership (LLLP). An LLLP is a limited partnership in the sense that you can differentiate between the partners. But it’s limited liability, so if the business gets sued, your personal assets (or your partner’s personal assets) will not be on the line.

It is important to note that just because you’re going into business with a partner or a group of partners does not mean you need to choose one of these types of partnerships. You can also be an LLC or a corporation. There are both single-member and multi-member LLCs. The choice between a partnership and a multi-member LLC often comes down to taxes. If you have narrowed down your choices to these two options, consult a tax professional.

HERE’S A QUICK RUNDOWN OF THE DIFFERENT BUSINESS ENTITY TYPES:

• Sole proprietorship – Just you. No liability protection, no double taxation.
• Corporation –  More complicated than a sole proprietorship. Has liability protection. C corps are often better for large businesses but do have double taxation. S corps do not have double taxation.
• Limited Liability Company (LLC) –  Single-member or multi-member. Offers liability protection without double taxation.
• Partnerships – Can be broken down into two categories: equal level of responsibilities or differing levels of responsibilities. From there, you can choose to have liability protection or forgo liability protection.

Choosing your business entity type is a very crucial decision for your business and something that will require a lot of thought. As always, do your homework and consult a licensed professional in your state.