Are you about to choose your small business legal entity? Here are the types of business entities available, the pros and cons of each, and which would best suit your goals.
Starting a new business is as exciting as it gets! Every year in the U.S., 627,000 new companies establish their formal company structures and open for business. Before you can do the same, you need to know exactly which business entity will work best for you.
This is an important decision—your choice will impact your taxes, insurance, legal liability, and finances. It’s the first great decision you can make for your company that will help you on your journey to growth and success.
To pick the right legal entity, here are clear definitions of each structure along with the advantages and disadvantages of each. Decide which of these will best suit your small business.
What Is a Legal Entity?
The exact definition of a legal entity is: “An organization or individual that has legal standing in the eyes of the law.”
Business entities with legal standing can create legal documents, enter into agreements, are liable for debts, and are responsible for their actions. These entities can even be sued! This legal framework allows people to be separate from the entity itself. Each type of entity has its obligations and rights as outlined by the law.
All businesses have financial and legal needs that directly relate to their formal structure. Here is what your small business could become, depending on the choice you make.
Types of Business Entities
The small business structure that you choose will come from this list of options. They can be difficult to set up on your own, so it’s always a good idea to find legal services that can help you with the process. The goal is to turn your idea into a legally formed company.
In the meantime, here are your six best options.
#1: Limited Liability Company (LLC)
A limited liability company or LLC is a flexible business structure that extends limited liability—or accountability—to its owner. It’s one of the simplest to form of the six options.
An LLC contains similar tax elements as a corporation but with the legal liability of a partnership or sole proprietorship. As a kind of hybrid structure, it’s not a corporation, but it does have the flexibility under certain circumstances to take advantage of tax laws or nonprofit formations.
- Simplest to form
- Business owner is not personally liable for the company’s actions
- The tax structure is flexible (pass-through entity)
- Any amount of members (persons, corporations, partners)
- More paperwork and formalities
- Difficult to set up—make sure tax advantages are in place
- No stock options for investors
- Self-employment taxes
If you want to start an LLC as a small business, it’s the LLC formation that’s the easy part. Then you will have to file articles of organization, draw up operating agreements, and open accounts. This is best done through legal support to get the maximum benefits of this business structure.
#2: C Corporation
A C corporation is a business entity that allows owners to be taxed separately from the company. This is the structure that is recognized and used by big business and is subject to corporate income taxes. That means profit is taxed on a corporate and personal level for owners.
- Limited liability protection
- Ability to offer employees share options (talent attraction)
- Can leverage shares for funding
- Complex to form and maintain
- Fees and taxes are consistently expensive
- Double taxation (corporate and personal profits)
The real benefit of starting a corporation like this is what attracts tech start-ups—giving employees access to shares and selling stock for venture capital funding. If you are a fast-growth start-up planning to expand using these techniques, then this may be an option for you.
#3: S Corporation
An S corporation is similar to a C corporation except that it’s easier to operate for small business owners. This closely held corporation does not pay any income taxes. Instead, the income and losses are passed to the entity’s owner or shareholders. Typically, there must be 100 shareholders or less.
- Avoid personal liability
- Avoid double taxation
- Report on and pay individual tax returns at regular rates (no corporate tax)
- Complex setup and maintenance
- Lots of paperwork, rules, and fees
- Strict salary requirements
You can get corporation advantages without having to pay corporate taxes with this structure. It’s easier to manage than a C corporation, with simpler taxation. If you get the right help with setup and filing, it can be an asset to have this structure as a growing small business.
#4: Sole Proprietorship
A sole proprietorship is a structure that means you own the business, and you are the business. All of the personal liability falls on you, which means that if your small business ever gets into trouble, it will impact your personal finances. All debt, responsibility, and legal action is yours to manage.
- A simple business structure
- Minimal setup and licensing costs
- Very few formalities to consider
- Little government involvement
- Cash withdrawals and total control
- Not a legal entity
- No capital can be raised using shares or interest in the business
- Personal liability for the owner
- Self-employment tax
As the owner, you will not have to file any special paperwork, online or otherwise. All you have to do is contact a legal service that will help you secure the right state licenses and permits. This structure is popular among small businesses because it’s simple to maintain.
A partnership is a legal arrangement between two or more people to own, manage, and run a business together. They also share the profits, depending on the agreement in place. Many partnerships have silent partners and operating partners.
- Create partnership opportunities to attract new talent
- Partnership agreement clearly outlines relationship
- More skills, resources, and opportunities
- Not a legal entity (partners share income and losses)
- Difficult to sell the business or divide it up for sale
- Conflict can cause business issues
Partnerships are a little more complex to set up than sole proprietorships, but they’re a popular choice for start-ups and skilled people who want to do business together. Like the other business structures, forming one is best achieved with some professional legal assistance.
#6: Nonprofit Corporation
A nonprofit corporation is similar to a corporation but with fewer tax concerns and less profit drive. This legal entity focuses on charitable, social, recreational, and educational purposes instead of sales. It has the same protections as an incorporated structure but for different reasons.
- No taxes to deal with
- Personal liability protection
- The entity is separate from the owners or people managing it
- Mission-focused corporate structure with employee benefits
- Expenses like paperwork, a business license, and administrative costs are still due
- Some restrictions on business processes
- Ongoing funding competition
A nonprofit business structure is unique and rewarding for cause-driven business owners. There are still many considerations during formation, setup, and maintenance that must be made. To correctly create your nonprofit, contact a professional legal services company.
Which legal entity would work best for your small business? Review these core business structures and take note of the pros and cons. From there, you need to sit down with a professional.
While legally forming a business on your own is possible, it’s not always advisable. Some of these structures demand complex paperwork and licensing and getting your setup process wrong can cause tax implications for as long as you trade.
The easiest way to simplify this process is to pick out your structure and chat with a small business service that will take you through each step of starting your business—from creating your business plan to performing these essential legal tasks.
Start your small business right with a legal entity that will make your company structure stronger!