Have you been dreaming about starting your own business? Congratulations! But now what? There is a lot to think about when establishing your new business. One of the first steps for many entrepreneurs is setting up their business entity—whether you’re a rideshare driver, a real estate professional, or a graphic designer, setting up your business entity is a critical decision because it affects your personal and professional liability and your tax liability.
So, what is a “business entity”? A business entity is an organization created by one or more people to be a business, to engage in a service, or trade. Business entities are formed at the state level, usually by filing documents with a state agency, such as the Secretary of State. They’re often subject to taxation, so the business owners must plan on bookkeeping and filing a tax return for their businesses. The type of business entity determines a lot about taxes, and liabilities. There are five main types of entities that your new business could be—it could be a Limited Liability Company, an S or C Corporation, Partnership, or a Sole Proprietorship.
Sole Proprietorship – A sole proprietorship is one of the simplest forms of business entities that you can start. This entity type requires few forms for set-up, and there is only one owner. Good news: decision making about the business is quick and easy to manage, it also means that all of the profits go to one person, you! But there are downsides too; if you have losses, all of those are yours to bear and if your business goes bankrupt, your personal assets could be sold to pay off those bankruptcy debts.
Partnerships – Partnerships are also fairly easy to set up as very little paperwork is required. A partnership is a business entity owned and operated by two or more people who have contributed money, or effort, to start and run the business. Your profits are split between you and your partners, depending on the ratio of capital contribution of each person, or on a predetermined ratio, based on qualitative contributions (maybe you don’t have a lot of money, but you’re willing to manage your new restaurant day in and day out for a percentage of profits.) Like sole proprietorships, if your business goes bankrupt, all of the partner’s personal assets are at risk of being sold to pay off creditors and debts.
Corporations – Corporations are business entities that are owned by shareholders. The shareholders elect a board of directors who oversee the operations of the business and are accountable to the shareholders. Starting a corporation requires a lot of paperwork and is significantly more expensive to start than sole proprietorships and partnerships.
Corporations operate as completely separate legal entities from their owners and this means that the owners have limited liability for the losses of the business (different from partnerships and sole proprietorships), which is one of the most attractive things about corporations. Corporations can own property, raise capital through stock share, acquire other businesses, and sue/be sued.
There are two types of corporations, S Corps and C Corps, the biggest difference between the two is taxation. C Corps are taxed separately from its owner and in an S Corp, the profits are passed to the shareholders and they are taxed based on their personal returns.
Limited Liability – Last but not least are Limited Liability Companies (LLCs). This entity type operates as a combination of partnerships and corporations, giving you the best of both worlds. LLCs provide limited liability to owners (called members), similar to a corporation, protecting their personal assets. Like a partnership, the profit share and operating agreement is determined by the members and can be modified at any time.
There is a lot to think about when establishing your business entity, not just how it affects you personally and professionally, but also how it affects your tax liability now and in the future. If you’re feeling overwhelmed and not sure which entity is best for you, contact our experts. We’ve helped thousands of entrepreneurs like yourself form their business entities and we’d be happy to discuss your options with you and help you get everything set-up.