Business Entity Types for Small Businesses
In this blog post, I’ll be discussing the various types of legal entities that you might want to use to structure your small business. Parts of what I will share with you may apply to many countries. However, for simplicity’s sake, the entity names and structures I’ll use are specific to the current options available in the United States. The options available to you will vary considerably according to the law of the country or even the region that you live in. For this reason, I strongly recommend you seek the advice of qualified legal and accounting professionals when it comes to choosing your business entity type.
There are four main categories of business entity types in the United States: a sole or single proprietorship, a partnership, a corporation, and a limited liability corporation or LLC. I’ll be discussing general advantages and disadvantages of each kind of entity. As you consider the advantages and disadvantages of each entity type, I encourage you to make some notes and come to a basic conclusion as to which entity you think would be best for you. Then, take those notes and those conclusions to your qualified legal and financial adviser, and let them help you make the final decision. They can also assist you in the process of setting up the entity properly.
First, the sole proprietorship, which has many advantages. The owner has direct control of the business. In short, the business is you. They’re extremely easy and inexpensive to form. Sole proprietorships may require less paperwork to maintain. Also, there are many potential tax benefits that you can discuss with an accountant. Finally, all the profits of the business go directly to you.
The disadvantages of sole proprietorship are that you have unlimited liability. This means that if there’s a risk of someone suing your business, they can sue you directly and potentially take not just the assets of the business, but your personal assets as well. Often, it’s difficult to raise money for sole proprietorships because since the business is you, there are no shares to give to investors.
While you can get a lone as a sole proprietor, if you plan on bringing in partners in any capacity, you’re out of luck. Similarly, sole proprietorships lack continuity. In other words, if you pass away or become incapacitated, the business ceases to exist. It’s much easier to sell or hand off a business to someone else with a corporation or a limited liability company. That said, despite all the disadvantages considered, in most cases, I recommend new business owners start as a sole proprietorship. Why? It’s the easiest way to begin.
There are two exceptions to this recommendation. First, I don’t recommend a sole proprietorship for businesses which you might have high liability such as working with children or any kind of personal care or legal and financial advisers. Second, if you are a startup immediately looking for funding, this is not the entity for you. In my experience though, most businesses that are looking for funding are doing so too early anyway. It’s better to start as a sole proprietorship, then later convert to a corporation or LLC as the business progresses.
Next, let’s consider partnerships. Partnerships are also easy to form. Usually, with a simple written agreement. They also have low startup cost. A partnership does provide some opportunity for venture capital that a sole proprietorship doesn’t provide. Meaning, a single investor can contribute money to the business in exchange for a percent of ownership. It also spreads out some of the management by bringing in additional people. There are some potential tax advantages to having partners. Like a sole proprietorship, there’s limited outside regulation by the government.
The disadvantages are the same as the sole proprietorship in that you have unlimited liability, and there’s a lack of continuity. If all partners pass away, the business can cease to exist. Also, it can be difficult to raise additional capital beyond the initial partnerships. Also, partnerships have the added issue of divided authority. Responsibility between partners often overlaps and creates tension and confusion. Finally, it can become challenging to find a reliable partner to work with.
Most businesses find that partnerships create incredibly difficult situations. For this reason, I almost always advise people against forming a partnership. It’s much easier to have 100% control over your business, and instead, hire people to work for you rather than giving up a piece of equity and having confusion between your roles. If you do wish to bring in partners, I’d recommend the other two entities as healthier alternatives. This leads to corporations. Before we dive in, I should mention there are two types in the United States, C and S.
S corps share some of the similarities to an LLC and may be a better fit for smaller businesses than a more traditional C corp. Again, talk with your legal adviser to get the fine details. Corporations have the advantage of reducing liability. This means that in most cases, if someone sues your business, their capacity to take assets from your business is limited to just that, your business. Also, corporations have the advantage of more easily transferring ownership to someone else. If you sell the business or bring on additional shareholders, it means that the business potentially has a continuous existence.
Also, corporations function as a separate legal entity. This means the business itself has certain protections and privileges separate from you, which can have advantages down the road. Also, there are potential tax advantages by being able to split dividends and salaries of you as the business owner and of the shareholders in a way that gives you the best tax position possible. Finally, it’s easier to raise capital with a corporation because you can provide shares in exchange for money invested in the business.
The disadvantages of corporations are that they are closely regulated. Most governments have many restrictions upon what you can and cannot do in a corporation. You must create a set of documents and bylaws by which the corporation operates, and you have to demonstrate on a regular period that you are abiding by those bylaws in order to maintain your corporation. Also, it is the most expensive entity to organize in terms of the initial governmental fees, plus the consultation cost of working with financial and legal advisers.
Finally, corporations in some instances have the issue of double taxation. This means you as an individual may be required to pay taxes on your salary and dividends, and then the business must pay taxes itself. Typically, I recommend that business owners, after being in existence a few years or after they reach a certain amount in sales, for instance, a million dollars, proceed at that point with forming a corporation or the next entity type, the limited liability corporation or LLC.
The advantages of an LLC are that your personal assets are protected. If someone sues you, typically, the risk can’t go beyond the entity itself. The investors’ own risk is only limited to the amount of money that they put into the business. Also, if you’re working with partners, LLCs make the taxation issue much easier to deal with because partners can be taxed separately. Also, the LLC blends nicely the limited liability with the greater ability to control your day-to-day operations. Also, a separate entity such as a living trust can be a member of an LLC, providing more flexibility on how ownership can be divided. Finally, financial losses of a limited liability corporation are passed through to the investors, which is a potential tax advantage.
The disadvantages are that LLCs can be a bit complex to form. This requires greater expense on your part as you’ll want to enlist qualified legal and financial advisers. Also, LLCs are subject to a great deal of regulation from organizations such as the IRS in the United States which will affect the terms of the partnership. Now that we’ve explored the advantages and disadvantages of the four basic entities, it’s up to you to take the next step.
Make your best guess as to which entity is a fit for your business. Then, take your thoughts to your trusted legal and financial advisers, and discuss with them which option would work best for you and your business.