So you are starting a business and looking to learn more on business legal structures! Great let’s get you going with the right business entity for you.

To clear things up right away, what does the word “entity” mean? In short, it refers to an organization which has a legal identity separate from its members. Each entity is a legal structure that indicates how the business will operate, be governed, and taxed. Some options are simplistic and inexpensive to set up while others will require additional paperwork and various registration & renewal fees.

In this article we are going to review the four most common types of business entities. If you are either starting your business or looking to grow, one of these entities options will most likely best suite you: 

  1. Sole Proprietor
  2. Partnership
  3. Limited Liability Company (LLC)
  4. Corporation

There is no right or wrong choice as each has their advantages and disadvantages and the best choice is not always the most obvious one either. 

To assist you with picking the right legal structure that meets your business’s needs, we put together this overview guide to the most common legal structure options for your business. 

Starting Notes

While this article is very informative, after reading this you may also decide to speak with a lawyer or accountant for additional guidance. There is no one size fits all so make sure you select the best option for you.

Also please keep in mind your initial choice for your business legal structure does not need to be permanent. You do have the option to change as your business grows and develops. For example a sole proprietor may become an LLC, and an LLC may convert to an S-Corp. 

Additionally, there are alternative business structure options available depending on the special situational need. For example a pair of doctors looking to limit their personal liability may need to set up a professional corporation or professional limited liability company. These alternative options are outlined in: Unique Business Structure Options.

Legal Structure Options For Your Business

Sole-Proprietorship vs LLC vs S-Corp vs C-Corp

Sole Proprietor

For many individuals starting their small business, the typical default legal structure is a Sole Proprietorship. That is because a sole proprietorship is the most simplistic legal structure of them all that is very inexpensive to create and straightforward to operate. That is because it is not really a separate entity compared to to a Corporation or LLC. We will get into that further down.

What is a Sole Proprietorship?

A sole proprietorship is one individual with 100% responsibility with their business. All profits and losses will be reported on the owners individual tax return.

How is a Sole Proprietorship created?

Sole proprietorships do not require any additional paperwork to establish outside of your standard tax documents. Most states do not require registering a sole proprietorship.

Typically startup’s begin with this while the business is in early stage development and later transition to another legal entity as additional debts and liabilities are taken on. If your business does not have any potential exposure to signifiant debts and court judgements, then you can stay as a sole proprietorship.

How am I paid in a Sole Proprietorship?

In a sole proprietorship, the owner of the business will be paid 100% of the profits generated. Since a Sole Proprietorship is not recognized as a separate entity, it cannot retain any form of income.

How is a Sole Proprietorship Taxed?

All income generated is considered pass through and will be taxed as ordinary income on the individuals tax return.

Sole Proprietor Overview

When is a Sole Proprietorship The Best Choice?

A sole proprietorship makes great sense for a small business where personal liability is not a concern. For example if your business is not going to be taking on any significant debts, and will not be exposed to any legal binds (lawsuits, ownership or other disputes, etc..), then a sole proprietor is a great start. 

If you are looking to scale your business further and take on exposure that insurance cannot cover, then you want to consider an LLC, or Corporation.

Are there any drawbacks of a Sole Proprietorship?

While the only primary benefit of a sole proprietorship is simplicity, there are many disadvantages you must be aware of.

No Asset Protection

A sole proprietorship provides absolutely no asset protection. That means under a sole proprietorship you the business owner are 100% liable for actions of the business. This is a massive risk if you are in a business that is exposed to lawsuits as all personal assets owned by the business owner will be threatened. 

The business owner is personally liable for every claim the business incurs and in turn, that business owner could end up losing their home, life savings and end up bankrupt (not a fun situation to be in). This is because the business owner and the legal entity are treated as one and are not separate.

Additionally sole proprietorships do not have any tax advantages that corporations have, thus owning a business structure like this only benefits because of simplicity.

No Tax Advantages

Additionally sole proprietorships do not have any tax advantages that corporations have, thus owning a business structure like this only benefits because of simplicity.

You Cannot Sell A Sole Proprietorship

It is extremely hard to sell a sole proprietorship as the value is based on the owner and not the business. The only items that can be sold are the assets of the business. Nothing else can be transferred and when the business owner dies, the sole proprietorship will terminate.

There can only be one (1) owner

By way of name, a sole proprietorship can only be one owner. If you desire to bring on additional owners, you will need to change entities to either a partnership, LLC, or corporation. 

Partnership

If you are looking to go into business with another individual or group of individuals, then you would look into starting a partnership. 

What is a Partnership?

A partnership is simply going into business with someone else besides yourself. It can either be a simplistic partnership with minimal protections similar to a sole proprietorship, or a full corporation partnership governed by a board of directors and providing limited liability. 

How is a partnership created?

Partnerships must be setup as any of the following business entities:

A general partnership is similar to a sole proprietorship except it now has more than one individual involved. This is also a very simplistic and inexpensive option to start up your business and can be created with a simple handshake.

Under a general partnership all profits and losses generated will be reported on each of the participating individuals personal tax returns. 

This legal structure does start to present some risks as now personal liability is shared between all individuals involved in the partnership.  

In a partnership, each partner is personally liable for the business related activities of the other partner(s) either good or bad.

Limited liability can be in the form of either:

  1. Limited Liability Company
  2. Limited Liability Partnership

Either option will provide more protection limiting the owners’ personal liability for business debts and court judgements against the business. They also both provide a more formal structure outlining the roles and responsibilities involved with each of the partners typically outlined in the Operating Agreement.

Additionally, owners have the ability to elect how they will be taxed (either as a corporation, or as a sole proprietorship) which allows them to take advantage of some favorable tax rates.

For more details on limited liability options, see below.

Forming a corporation is much more complicated and costly but it can be far worth it in the long run. Corporations receive much more favorable tax rates as well as provide the limited liability. 

Although less flexible than a limited liability in how profits are paid out and overall management (corporations require more oversight), they do give you the ease and ability to scale. When seeking funding for your business, most investors look for corporations compared to LLC’s.

 

Partnership Overview

How am I paid in a Partnership?

Getting paid in a partnership is dependent upon how the entity is structured. If is is structured as a general partnership or LLC, 100% of the profits will be distributed as pass through to the owners/members.

If the partnership is structured as a corporation, owners will be able to take a “reasonable” salary as well as be paid a dividend distribution.

How is a partnership taxed?

Partnerships are taxed either two ways:

  • Sole Proprietorship
  • Corporation

If taxed as a sole proprietorship, all income will be passed through as ordinary income.

Under a corporation, the partnership will face double taxation but will have more tax advantages available compared to a sole proprietorship. 

When is a partnership the best choice?

In simple terms, a partnership is the best choice if you are looking to go into business with someone besides yourself.

Are there any drawbacks of a partnership?

Any potential drawbacks are based on the elected partnership option (General, Limited Liability, Corporation) and how the business entity will be utilized. 

If you are considering a General Partnership to keep things simple, similar to a sole proprietorship, there is no asset protection and each partner is 100% liable for the actions and debts of the other.  

Limited Liability Company (LLC)

The next step towards a more formal business legal structure would be a limited liability company (LLC). LLC’s are the most commonly selected as they provide many benefits for small business owners where a sole proprietorship lacks while also being more flexible than a corporation. 

What is an LLC?

The LLC provides the flexibility of a sole proprietorship or partnership with the additional benefit of a corporate shield (called a corporate veil). More importantly, the LLC provides the limited liability where a sole proprietorship does not. 

Under a limited liability business structure, the owner(s) known as “members” of the business are now protected from any business debts and court judgements that may go against the business.

When starting an LLC, it can be a single member (similar to a sole proprietor except now has a corporate shield) and multi-member LLC’s with more than one individual involved (Similar to a partnership).

Additionally, owners will now be able to take advantage of some favorable tax rates depending on how the LLC is created and how profits are shared.

LLC Overview

How is an LLC created?

The LLC will need to be registered with your state of business and will require any legal licenses & permits. Additionally the LLC is required to file the Articles of Organization with the secretary of state.

While an operating agreement is not always required with each state, it is highly recommended as it will clearly lay out the rules and responsibilities of each owner involved.

Additionally, LLC’s have the ability to be structured either as a sole proprietorship (single owner) or a partnership (multi-owner) depending on how many individuals will be involved. In some states, single owner LLC’s are still considered sole proprietorships thus making it easy to pierce the corporate veil that the LLC provides.

 

How do I get paid in an LLC?

Members of the LLC are not employees. An LLC cannot have employees as the LLC does not pay a salary. Instead members are paid in distributions of the total profits. This income will then be passed through on the individual member’s tax return. 

How is an LLC Taxed?

Generally, under the typical partnership tax election, income generated from the LLC will be passed through to the members and counted as ordinary income. Members will then file their own tax returns each year.

Alternatively, an LLC can be taxed as a corporation opening up for various tax advantages. With a corporation tax elective, the LLC will run the exposure of a double taxation. 

It is recommended you speak with a tax advisor to discuss which election is best for your business.

When is an LLC the best choice?

LLC’s work well for startup’s and small business’ as they bring forward the benefits of a corporation and the flexibility of a sole proprietorship. You will also often see LLC’s used in real estate as they provide great business structures in this space.

Are there any drawbacks of an LLC?

LLC’s are limited on their ability to scale. Since an LLC does not payout shares of stock, outside investors are not as easily inclined to get involved. 

Additionally, as the LLC generates more revenue, the LLC could face paying some significant taxes if is it not registered as corporation.

Lastly, an LLC is not permanent and will need to be renewed every 2 years (renewing your LLC is a very simple process and can be completely managed by your registered agent).

SETTING UP YOUR LLC

How do I get Started?

Forming an LLC takes some additional paperwork but it is not very complicated to create. On average most LLC’s take under 30 minutes to set up online using a Registered Agent and will cost you anywhere from $50 – $300 depending on the state. 

Although you can set up your LLC on your own, we recommend using a registered agent as they will simplify the process dramatically for you.

Here are some possible registered agents that work well.  

Corporations

Corporations have been around the longest and were created to provide legal protection for the owners and operators of the business. A key difference from all other business structures is corporations will issue shares of stock that can be distributed to outside investors and loyal employees. They also will allow a salary to be paid to the employees compared to LLC’s distribution of profits.

Since we are focused on startup’s and small business’ we will not be discussing large publicly traded corporations and instead focus on smaller entities with one or several incorporators.

What is a Corporation?

A corporation is a legally separate entity from the individual(s) who own and operate it. You may own 100% of the stock in your corporation but as long as the operating procedures are followed correctly, the corporation will be recognized as a completely separate entity. 

This in turn provides limited liability protecting each of the operators from personal damages that may be caused by any misdeeds within the corporation such as:

  • Debts including bills, outstanding payments for equipment, etc.. (excludes outstanding taxes and personal guarantees)
  • Injuries suffered by individuals that could not be covered under insurance
  • Misdeeds of an individual within the organization

Corporation Overview

How is a Corporation Created?

A corporation can be created by a single or many incorporators and will be formed under the laws of the state where it will be registered. For example to file a Delaware corporation (most commonly used) you will need to file a Certificate of Incorporation with the Delaware Department of State.

The Certificate of incorporation includes: 

  • The name of the corporation
  • Name and address of the registered agent 
  • A statement of the purpose of the corporation
  • Total number of shares of stock being issued and the par / nominal value of each share.

Once the Certificate of Incorporation is filed, the corporation comes into existence.

Additional documentation will also need to be created appointing the first board of directors where they elect the appointment of officers, issuance of stock to the founders and initial investors, adoption of corporate bylaws, and the opening of bank accounts.

Finally to complete the process, the corporate must also obtain an EIN number and have all founders and employees sign confidentiality and invention agreements while all share holders will sign a shareholder agreement.

How am I Paid In A Corporation?

A typical for profit corporation will pay a salary to employees and dividends to shareholders. If you own 100% of the shares and are the only employee of the corporation, you will get paid twice.

How is a Corporation Taxed?

Unless a corporation is provided special treatment from the IRS, the corporation will be required to pay federal, state, and possibly local taxes.

When shareholders receive a dividend, each shareholder will pay taxes on the dividends received. 

When is a Corporation the Best Choice?

Corporations work well for cash-flowing startup’s and small businesses looking to scale and seek outside investors. Their primary benefits include providing the limited liability for the stockholders, give the ability to raise capital through the sale of stock, and corporate tax treatments.

Are there any drawbacks to a corporation?

Corporations are very structured and will require more paperwork and costs to set up and manage. For someone looking for a more simplistic business structure, a corporation would not be the first choice.

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