How to Choose a Business Type: 3 Main Options
Starting a business is a big decision, and many entrepreneurs wait years to take the plunge. One reason for this delay tends to be the confusion around selecting a business entity. What is a business entity? Often referred to as a business type, a business entity is a legal structure for your business whose main purpose is to determine how you are taxed and what protections you have for your personal assets.
There are nearly a dozen business structures to choose from, and each has benefits and drawbacks that fit different businesses and situations. Below we provide clarity on three of the most common business types you can select—whether you’re a budding entrepreneur who’s just getting started or an established business owner who’s looking to formalize operations.
Limited Liability Company (LLC)
A limited liability company (LLC) provides you with protection from personal liability— including your personal assets like your car or home—for lawsuits and bankruptcies your LLC may face during the course of business. State statutes govern LLCs, so regulations vary nationwide and heavily impact forming and operating this business structure.
You can establish an LLC as either domestic or foreign. But don’t let the latter designation throw you off—foreign LLCs are generally just companies that were formed and conduct business outside of their state of origin. For example, if you started a restaurant in Arizona, you’d form a domestic LLC in that state. Eventually, if you wanted to open restaurants in Oklahoma and Texas, you’d then form foreign LLCs in each of those states, paying applicable state taxes and obtaining any necessary business licenses.
An LLC may also be owned by a number of different parties (called members), including individuals, corporations, other LLCs, and foreign entities. Specific LLC regulations may impact aspects such as the type and number of members an LLC can have. Formation and yearly fees may also differ by state, and there are special LLCs (such as the series LLC) that can only be formed in certain states.
- As a corporation, an LLC is treated as a standard corporation, and owners must file a special form electing to be treated as such.
- As a partnership, an LLC is treated proportionately as part of each owner’s tax return, with each owner addressing their pro-rata share of partnership income, credits, and deductions, as well as paying the self-employment tax on their share of partnership earnings.
- As a disregarded entity, an LLC is treated as part of the sole owner’s tax return, and the owner is subjected to the self-employment tax.
It’s important to note that some types of businesses generally aren’t allowed to form LLCs, such as banks, insurance agencies, and several other financial institutions. Additionally, some states prevent other types of businesses—such as architecture and accounting firms—from forming LLCs.
LLCs are appropriate for most small business owners for a few reasons:
- They provide a relatively simple method of formation while also ensuring legal protections for an owner’s personal assets.
- They help keep paperwork and administrative upkeep light with regard to taxation.
- They provide a taxation method that avoids the corporate tax since they can be treated as a disregarded entity.
Corporation (C corp)
Unlike an LLC, a corporation (C corp) is always considered a separate entity from its owners with regard to profit, taxation, and legal liability. This complete independence from its shareholders, which often includes (or may be exclusively) the original owners, makes the structure more flexible as business needs shift over time. In addition, separating the business entity from its owners offers the strongest protection from personal liability.
In contrast, however, C corps are more expensive to form and are more of an administrative and operational burden, requiring extensive record-keeping, operational processes, and reporting. They also pay income tax on their profits and are taxed twice (called a double tax)—once from making a profit and once when paying out dividends to shareholders on their personal tax returns. To be clear, the C corp doesn’t get a tax deduction when distributing dividends, nor can shareholders deduct any loss of the corporation. Lastly, just like LLCs, you must pay an estimated tax as a C corp.
Forming a C corp might be right for you if:
- You anticipate your business being a medium or high risk and want to have the best chance at avoiding personal liability.
- You want to raise funds through different methods, such as the sale of stock.
- You plan to sell the business at some point and want an easier legal transition to new owners or the remaining shareholders.
Nonprofit, or not-for-profit, corporations are sometimes referred to as 501(c)(3) organizations because that is the section of the IRS code most commonly used to grant the tax-exempt status, avoiding state or federal income taxes on surplus funds. While they follow organizational guidelines similar to C corps, nonprofits do differ from most other business types in a few ways.
For one, nonprofits have special requirements for how they use their profits—namely they aren’t allowed to distribute their profits to political campaigns, organizational members, or other parties. Instead, nonprofits use their surplus funds to further their mission, which generally benefits the public in some way and is often focused on a social, religious, literary, scientific, or educational cause. This is why nonprofits are able to claim tax-exempt status.
For an idea of what types of businesses may be ideal for establishing as a nonprofit corporation, consider these examples from the IRS:
- Charitable organizations
- Churches and religious organizations
- Private foundations
- Political organizations
- Other organizations that meet requirements specified in subsections other than 501(c)(3), such as social clubs, civic leagues, and labor organizations.
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