The entity classification, or legal form for business matters for a couple of reasons.
The entity structure that your venture selects can have important ramifications on the ways in which your business grows and expands, not to mention the amount of personal liability that your founding team could face.
Let’s take a closer look at the entity structure options available to entrepreneurs.
The following summary of legal entity structures should be considered simplified information and not legal advice.
A sole proprietorship is a business where the owner is the business.
It is an unincorporated business with a single owner.
There may be some state or local filing requirements for business licenses and, if applicable, the ability to collect sales tax, but there is no other burden of filing for a sole proprietorship.
Because sole proprietorships are unincorporated, the profits and losses from the business are reported directly on the owner’s personal tax returns.
This may make a sole proprietorship seem like an attractive entity classification; however, there is one big reason why it is very ill-advised for entrepreneurs to start their businesses as sole proprietors: liability protection.
Legally speaking, a sole proprietor is one and the same with his or her business.
There is no legal shield (other than insurances) protecting the assets of someone who elects to use this legal form.
This means that in the event the business is found liable for damages, the sole proprietor’s personal assets can be targeted.
If the business assets do not cover the extent of the claim, the sole proprietor’s bank accounts, home, vehicle, and other assets are all fair game.
Many business owners who find themselves subject to a lawsuit thought it would never happen to them.
A single suit can completely devastate the accounts and assets of a fledgling business, not to mention the personal accounts and assets of a sole proprietor.
Additionally, when it comes time to seek funding, investors are wary of the risk that sole proprietors carry and will pass on these opportunities.
A sole proprietorship consists of a single business owner; partnerships consist of more than one owner.
Partnerships, like sole proprietorships, are pass-through entities (profits and losses are recorded on the personal taxes of the partners), and partnerships offer no legal shield for each partner’s personal assets.
Partnerships are governed by written agreements.
By default, each partner has the right to participate in the management and profits of the business equally, but this can be overridden via contracts.
These partnerships are known as general partnerships or agreements where partners are on equal liability footing.
Groups of two or more individuals can also file to become limited partnerships, those with two classes of the partner.
In a limited partnership, general partners see no change in treatment.
However, some partners may be designated “limited partners,” partners who contribute financially but do not participate in the management of the business.
Limited partners are liable only up to the amount of money they have contributed to the limited partnership.
LLC stands for limited liability company, and LLCs are a common entity classification for small businesses.
LLCs do require filing at the state level, and this application comes with a nominal fee and often a yearly corporate tax.
LLCs are governed by their operating agreements—written rules that serve as bylaws for the business and dictate aspects such as
- profit sharing,
- and the roles and responsibilities of the owner(s).
In a single-member LLC (one owner), a standard operating agreement will often suffice; however, when multiple members are involved, operating agreements must become more complex to reflect the needs, interests, and circumstances of each co-owner.
LLCs are uniquely structured in the sense that while they do provide a large degree of liability protection to business owners, for tax purposes they are considered pass-through entities.
This means that the business itself does not pay taxes, and that profits and losses pass through the business on to the tax filings of the owner(s).
IRS Subchapter S corporations, or S corps as they are commonly called, bridge the gap between an LLC and a fully-fledged corporation (C corp).
They have a higher burden of eligibility than an LLC; while nearly anyone can form an LLC, S corps can only be formed and owned by US citizens or permanent residents.
Additionally, S corps can raise funds through the sale of stock, although they are only permitted one class of stock, distributed to a maximum of 100 shareholders who are US citizens and only natural persons (that is, not other business entities).
- Like LLCs, S corps are taxed as pass-through entities.
- Unlike LLCs, formation is a little more involved and requires the filing of articles of incorporation, which can incur ongoing expenses at the state level.
Additionally, S corps are required to elect a board of directors.
An LLC may have a board of directors but is not legally compelled to as S corps are.
LLCs generally have more flexibility than corporations regarding how the entity is structured.
IRS Subchapter C corps are full corporations, and this status comes with a range of benefits and considerations.
C corps are not limited in the number of shareholders they can have, there are few restrictions on who can purchase shares, and stock can be divided into classes.
C corps as a whole benefit from a number of favorable tax circumstances.
C corporations are not pass-through entities, and this means that revenue is subject to a “double tax.”
It is taxed once at the company level, and then dividends are taxed again as personal income.
If the owner takes a salary, it’s subject to income tax as well.
In addition to being compelled to maintain a board of directors, C corps are subject to more oversight and a slew of other regulations and expenses.