What business entity means is important to know before starting a business or deciding to restructure your business. Most people think of the words “business,” “company,” or “corporation” as essentially interchangeable, but differences do exist. Depending on what type of business you operate, how many people you employ, if any, and your plans for future growth, knowing these differences can help or hurt your bottom line when it comes to tax season, running payroll, and operating your business in general. Establishing the right business entity can also help simplify regular operations, cutting red tape that need not exist. With that introduction out of the way, let’s get into the different types of business entities and
What is a Business Entity?
A business entity is a legal structure that permits ownership and operation of a business by one or more individuals. Sometimes entities are also referred to as business structures. There are many different types of business entities, each with its own set of benefits and drawbacks. More than five types of entity exist, the IRS breaks down the options in to five types.
What are the Different Types of Business Entity?
Sole Proprietorship
A sole proprietorship is a business structure in which one individual owns and operates the business. The IRS does not tax this entity as a corporation, partnership, or LLC. The owner is responsible for all the business’ income and expenses. There are no partners to share in the profits or losses.
Sole proprietorships are popular because they are easy to start and manage. There are no formalities or legal requirements, other than filing a simple tax return. If you have the financial resources to start and run the business, a sole proprietorship fits perfectly for you. There are many benefits to owning and running a sole proprietorship.
With sole proprietorships the IRS taxes the business as an individual. This means that the sole proprietor pays self employment taxes. These taxes include social security and Medicare taxes, as well as income taxes on their profits.
To get some perspective on what this means, consider how payroll taxes work. Most W2 employees or business owners who employee W2 workers, the employer and employee split the cost of payroll tax. Sole proprietors are both employee and employer, so they’re responsible for covering both halves of what they would pay as a payroll tax.
The upsides of a sole proprietorship the simplicity with which you can establish and operate them. The downsides are that the owner-operator can end up exposed to liability or extra taxation.
Partnership
A partnership is a business entity where two or more people form an agreement to share profits and losses. The business can operate as a sole proprietorship, a partnership, or a corporation. When two or more people form a partnership, they become called partners. When two or more people form a corporation, they become shareholders.
The advantages of a partnership are similar to that of a sole proprietorship, they’re easily to establish. Having had a partnership myself (me, the person writing this. I just broke the fourth wall), the simplicity of establishing the partnership was shocking. The agreement can be incredibly simple. “Person A and person B agree to split all profits and losses of business X 50/50.” The agreement can be as as specific or as broad as you like. If you want to detail specific responsibilities or break down profits in a specific manner you can also do that.
The downsides to a partnership are similar to that of sole proprietorships as well, few tax benefits exist. A common issueis the possibility that partners wish to take take the business in different directions. One (or more) partner wants to focus on expanding while the other wants to sure up the business’ current position. That’s just one example, but the number of ways that partners can disagree knows no limit. The dissolution of partnerships must happen when differences in opinion become irreconcilable.
Dissolving a partnership can come with complications. It’s similar to a divorce, but instead of a marriage it’s a business, which is harder to extricate.
Another issue with partnerships is that one partner can unilaterally take actions. The other partner is then fiscally and legally responsible for these actions whether they knew about them or not.
51/49 Partnerships
With a partnership, the agreement or split can be whatever the different parties agree upon. There is no rules or requirements that the ownership of the business be equal, and in many cases, it’s not. Often, partners operate under what’s called a 51-49 partnership. As the name suggests, one partner owns 51% percent of the business while the other owns 49%.
People often establish a partnership when someone doesn’t have all the money needed to open the business. It’s also common for people to form a 51-49 partnership with someone they trust. This allows them to run their business without having to worry about day-to-day operations.
Limited Partnerships
Limited partnerships are a sub category within partnerships. They exist to help avoid some of the issues that can occur with general partnerships. The responsibilities and capabilities of each partner more specifically detailed as to limit discord and disorganization.
Limited partnerships are also great for owners seeking investors, but don’t want the investors to control the business’ direction. This often works out well for both parties. The primary partner gets the funds they need to start and operate the business. On the other side, the limited partners are simply able to collect the profits from their investment. Limited partners are often referred to as “silent partners” when they wish to keep their involvement in the business unknown.
Corporation
A corporation is a legal entity that is created by a state or country to carry out specific business activities. Corporations are divided into two types: public and private. A public corporation gets registered with the government and sells shares to the public. Private corporations do not register with the government, and they are usually owned by a small group of people.
Put simply, a corporation is a deliberative body that oversees the operations of the business. This means that unlike sole proprietorships and partnerships, there is a separation between the business and the people running it. Think of a corporation like a government structure for the business. A corporate board must exist, specific positions like CEO, CFO, and COO need officers, meetings and reports must occur regularly. Shareholder (owners) must write bylaws for the corproration. Board members must vote taken on actions regarding the corporation’s business decisions and potential responsibility to their shareholders.
Keep in mind, a corporation can consist of a single person. While the word “corporation’ often spurs thoughts of high rises and conference rooms with wall-to-wall glass, that doesn’t have to be the case.
The benefits of a corporation include the ability to offer stock options to raise capital, tax deductions, and personal liability protection from any lawsuits.
The downsides to a corporate business entity are that they are more expensive, time-consuming, and complicated to establish. The number of documents required to filed and submitted throughout the corporation’s existence.
S-Corp
An S-corp is a type of corporation that is taxed similarly to a partnership or sole proprietorship. This means that the corporation’s income and losses get passed through to its partners. As a result, S-corps are not subject to corporate income taxes or double taxation, but they may be subject to personal income taxes on the profits of their partners.
Smaller to mid-sized businesses most frequently choose this business entity to take advantage of what the corporate entity has to offer while benefitting from the pass through taxation simplicity of sole proprietorships and partnerships.
One of the major benefits to choosing an S-Corp as your business entity is that you are not personally liable for financial judgments against your business. The downsides for S-corps are similar to corporations, there are greater expenses in establishing them and more regulation of the business’ operations.
Limited Liability Corporation (LLC)
An LLC is a type of business entity that allows you to operate your own business without having to go through the hassle and expense of setting up a corporation. LLCs are popular for small businesses because they offer many of the same benefits as corporations, such as limited liability and tax advantages, but with some important differences. For example, one person or a group of people jointly managing the business can form a LLC. This means that each member has a vote in decisions made about the business. Additionally, LLCs can be formed in any state, which gives them a wider range of legal options when it comes to running their business.
LLCs have become increasingly popular in recent years. They offer business owners a great amount of flexibility with taxes, how they can expand or change, all while remaining protected from personal liability and without excessive oversight or regulations like what corporations experience
Are Some Business Entities Better Than Others?
In particular situations, yes, but that can only be answered with specific circumstances taken into account. No “right” answer exists for everyone, because each business has different needs. Further, the needs of the present might not be the same needs of the past or future. That’s the nature of commerce, things change!
So How Do I Know Which Business Entity to Choose for My Business?
It’s extremely wise to turn to your accounting specialists to answer this question. As they know your particular circumstances, these people will be able to break down the pros and cons of what each business entity will mean for you. This will make the ultimate decision easier.
The best thing to do before going into this meeting is to make a list of questions for yourself about your business and future plans. This list should inquire about your current finances, access to credit, investors, if you hope to expand to other states or countries, how many people you expect to employ, whether your business is at high risk for litigation, if you intend to sell shares of your business, and so on. By no means should these questions
Can I Change to a Different Type of Business Entity?
Yes, but it’s not always simple. Changing business entities isn’t a single process, and this process will be different depending on what type of entity you were before, and what you want to become. This is another reason why it’s so important to speak with a professional and choose wisely when establishing or altering a business entity. Choosing incorrectly could result in higher taxes, less flexibility, and greater overall frustration.
Closing Out
We’ll discuss more about specific business entities in upcoming articles, as this topic could fill books, and actually does. Hopefully this gives you a good start in knowing the questions to ask yourself, your partners, and your accountant.