Congratulations! You did it! You’ve pulled the trigger and decided to make your Side Hustle your Full-Time Hustle! But wait. Now you need to make an entity choice for your business?!
The entity choices available in the United States can feel overwhelming, especially when you’re just getting started with a new business. A few questions to consider as your journey begins:
- How many owners are there?
- Do you need a layer of protection between the business and your personal assets if someone were to take legal action against you?
- Are you interested in investment capital or foreign partners?
- Do you have an end game in mind? Are you building something to ultimately sell, or are you in it for the long haul?
- What do others in your industry tend to do? Is there a legal requirement?
As you can see, there are a few variables that led to the CPA’s favorite answer to all questions. “It depends.” There is no one size fits all solution, and the entity you chose is dependent on your facts and circumstances. It’s important to note, seeking professional advice is always a good idea.
So let’s dive in! In this article, we’ll walk through a high-level overview of some of the legal and tax pros and cons of each entity type. You’ll be armed with basic knowledge to help you decide which entity type may fit the needs of your shiny new business.
DBAs, LLCs, and Corps, Oh My!
Generally, businesses fall into three entity types for taxation: sole proprietors (sole prop), passthrough, and corporations. The tax status depends on if you’ve decided to create a separate legal entity and what box you’ve checked when you received your EIN paperwork from the IRS. In the chart below, we have the basic entity types.
Let’s walk through it.
Sole Proprietors (sole prop) Entity
First things, first. Are you going it alone or with some friends? If you are starting a new business as a one-person show, you have the option of running your business, as well, you.
The Small Business Administration (SBA) defines a sole proprietorship as an unincorporated business owned and run by one individual with no distinction between the company and you, the owner. Since there is no distinction between you and the company, this is the easiest and most common way to start a business. There’s no formal action to take except to ensure you have any necessary licenses or permits regulated by your industry and the government.
Many sole proprietors choose to do business using a name other than their own. This might be the only “official” paperwork needed to get started. Conducting business in a name other than your own is known as a fictitious name. Many states require that you submit a request to use this unique name to ensure it’s not already in use by someone else. This is also referred to as an assumed name, trade name, or doing business as (DBA).
Sole Prop Pros & Cons
- Legally, super easy to set up with minimal expense.
- Taxation: There is no separate tax return. Taxes are filed on your personal tax return.
- Complete control over all business decisions – freedom to enact change whenever the fancy hit’s ya.
- Unlimited personal liability for any debt and obligation of the business or its employees.
- It can be harder to raise money because banks may see it as a higher risk, and there’s no stock to sell to investors.
- Complete control over all business decisions – this can be quite stressful. All the pressure to succeed and all the failures are yours.
Solo-prenuers often find operating as a sole proprietor beneficial. But may find additional benefits within an LLC – Limited Liability Company, in which they have further tax options and legal protections. We’ll cover LLCs a little later.
Partnership Business Entity
Partnerships are particularly popular within professions like medical and legal practices. In order to become a partnership, you need at least one partner. Meaning partnerships are available to two or more individuals who want to do business together. These entities offer a little more flexibility than corporations and LLCs due to the lack of formal requirements to form the entity. To become a partnership, the individuals can set terms with an oral or written agreement. Although it is highly recommended that you formalize your arrangement with a formal partnership agreement to help the organization run smoothly and prevent disagreements later on.
There are two types of partnerships, general and limited. General partnerships are the most common, and the general partners have unlimited liability for the partnership’s obligations and debts. Limited partnerships (also called Limited Liability Partnerships) usually are formed with 3 or more partners. Typically, at least one partner is designated as a general partner on the hook for all liabilities. The remaining partners are limited partners. Their liability is limited to the capital they’ve invested in the business.
In both types of partnerships, income and deductions flow through from the partnership to the partner’s personal tax return based on the partnership percentages.
Partnership Pros & Cons
- Typically, partnerships are simple to set up, with the primary cost relating to having a lawyer draft a sound partnership agreement for the safety and benefit of all partners.
- You can enact a lean business model with each partner able to act as the business for the purpose of contracts and lending agreements.
- Management flexibility – like a sole prop, you are not ruled by legal requirements to hold meetings or to exclude a class of investors as partners.
- Taxation: if you’re holding property expected to go up in value (i.e., a building), taxes are only assessed at one level.
- General partners have unlimited liability, which means creditors could seize business AND personal assets if things go south.
- Limited partners run the risk of becoming general partners if they are viewed as active participants in management and not just passive investors.
- Taxation: income and deductions flow through to the partner’s individual return. This may result in self-employment tax obligations for each partner.
Partnerships are excellent for people in professions who want to expand their practice and are limited in scope only by imagination. Some of the largest companies in the accounting profession are limited liability partnerships. For example, PwC (PricewaterhouseCoopers LLP), one of the Big Four accounting firms, is part of a global network with 276,000 employees.
Corporations are the most formal entity type on the list. It is a separate and distinct entity from its owner(s). As such, the owner’s risk is limited to the direct investment in the corporation. The rules associated with corporations are defined by the state in which you incorporate. The state defines corporate governance and guidelines for the company, which often includes a corporate charter, bylaws, having a board of directors, and complying with regulatory reporting requirements. All these formalities can be costly.
Typically, a corporation is owned by shareholders and run by directors and officers of the company. However, legally, the firm is treated as a person and, therefore, can buy and sell property, sue and be sued, enter contracts, etc.
For tax purposes, corporations can elect to be treated as a “C-Corp” or an “S-Corp.” Each has it’s pros and cons and could be an article on its own. It breaks down into a C-Corp pays tax at the corporate level, and shareholders pay taxes on money taken out in the form of dividends. This is part of that double taxation you always hear about in relation to corporations. S-Corps are taxed similarly to partnerships and LLCs. The income and deductions flow through to the shareholders, preventing double taxation. But, this benefit comes with additional restrictions on ownership. Notably, S-Corporations are limited to 100 shareholders, all of which must meet specific qualifications, residency status, and only one type of stock is allowed. C-Corporations do not have any of the same restrictions.
Corporation Pros & Cons
- Corporations are fully separate and distinct legal entities offering some protections from personal liability.
- If your goal is outside investment or to take the company public one day, this is it! Transfer of ownership through stock purchase is legally simple.
- Startups can issue stock as part of a compensation package to retain top talent.
- Taxation: There is flexibility in choosing a tax status (C vs. S status) that is most beneficial to the business owners.
- The cost to incorporate and set up the legal documents and procedures could be cost-prohibitive to new businesses.
- S-Corps limit the number and type of shareholders allowed, notably preventing foreign investors.
- Taxation: The ever-present double taxation issue for C-Corps requires careful analysis to determine if it’s a cost or a benefit based on tax brackets and ever-changing tax law.
A corporation can be quite advantageous for certain industries and end games. This pro/con list is in no way exhaustive. It’s just the tip of the iceberg regarding the possibilities and variations of what’s possible with big dreams and a corporate setup. As always, it’s best to consult with both an advisor familiar with both tax and business law.
Limited Liability Company (LLC) Entity
Last but definitely not least, we get to Limited Liability Companies (LLCs)! We saved this beauty for last because an LLC acts sort of like a sole prop, partnership, and corporation all in one entity. Easily becoming one of the most popular entity types, LLCs have members rather than shareholders or partners. Members are treated similarly to shareholders in that they cannot be held liable for the business’s debts and obligations. As a distinct legal entity, LLCs can also file DBAs to conduct business under a name different from the registered LLC name.
For tax purposes, an LLC can elect to be taxed as a sole prop, partnership, or corporation (C or S). Generally, managing members opt to avoid double taxation, which always sounds good. Consulting with a tax advisor before checking the box is always a good idea.
Limited Liability Company (LLC) Pros & Cons
- Provides the protection of a separate legal entity without the cost and management restrictions of a corporation.
- Provides credibility with potential customers, vendors, partners, and investors.
- Taxation: You can choose the tax strategy that works for you now with the flexibility to work with your tax advisor to adjust as necessary as your business grows.
- Like a sole prop or partnership, the business is dissolved with its members’ death or bankruptcy. (Only corporations live on forever)
- Taxation: Members could be subject to self-employment tax on earnings depending on the tax status selected.
- LLCs are still relatively “new,” which means the laws are still catching up on how to tax and regulate their activity. (Fun fact: LLCs came into existence in 1977 in Wyoming.)
As the new kids on the block, LLCs have a lot to offer with no ownership restrictions for members. A few industries cannot organize as LLCs, such as banks, insurance companies, and nonprofits.
Wrap it Up
We covered A. Lot. We covered some pros and cons of the major entity types. Hopefully, you feel more confident about which entity type might be right for your new business. This isn’t a decision to be made by throwing darts at the wall, though. Take your time. Starting a new business is exciting and scary and then exciting again.
Choosing an entity type should reflect your goals and end game. Where do you want to go with your business? Is your plan to beat Jeff Bezos and build an empire or build something more intimate with a family feel? Are you going it alone or with partners? Are you building a legacy?
As always, we’re here to help. We have experience talking this out and will refer you to an excellent legal counsel if your situation requires it.