Choosing a business entity type is a crucial step in determining how your business will be taxed and who will have to pay for its debts and obligations. Some of the common business entity types include:
There are some less common types that are. becoming more popular, such as:
The two most popular business entity types are corporations and limited liability companies. Though many entrepreneurs start as sole proprietors or general partners.
LIABILITY: Some business entity types, such as corporations and LLCs, provide limited liability. This means that the owners of a business generally won’t be held responsible for matters involving the business unless they did something in bad faith.
CONTROL: Different business entities are required to manage their businesses in different ways.
Corporations, for example, have a two-tiered structure: A board of directors gives directions, whereas officers carry them out. Shareholders aren’t directly involved in a corporation’s decisions unless they unanimously vote to form a “Statutory Close Corporation.”
By default, LLCs are managed by their members. If their members want, they can choose to have managers, which can be a human being or another entity.
TRANSFERABILITY OF INTERESTS: When a business entity transfers interest, it sells or passes its financial and management rights to someone else. Free transferability refers to a situation in which a buyer would receive both of these rights. For example, the buyer might receive a share of stock, which allows you to control that stock and participate in shareholder meetings. Corporations have free transferability of interests so that when a share of stock is sold then the new owner receives both the financial and managerial rights. For LLCs, that is not always the case and will depend on the law and the internal governing document (typically referred to as an LLC Agreement in most states).
CONTINUITY OF EXISTENCE: Business entities can continue to exist even when their owners change. Corporations have continuity. LLCs are a relatively newer entity type and may encounter cases where continuity doesn’t exist. Though as the LLC has become more common and its statutes have been updated to be more modern, continuity is often available by statute, internal governing document or both.
TAXATION: Certain business entities are considered separate from their owners for federal income tax purposes. As a result, a C corporation’s profits are taxed first at the corporate level and then at the shareholder or individual level. This is the default taxation option for a corporation. An S corporation is a “pass-through” entity type that can be elected for taxation, meaning the entity is disregarded as a separate person for taxation and is reported on the shareholders’ tax returns. Once elected, an informational report via a 1620S filing is required to tell the IRS that taxes will be reported by the owners on their personal tax returns.
An LLC can choose to be taxed as either a C or S corporation. Its default taxation is “pass-through” to the members’ tax filings whether owned by one or multiple members.
Knowing which business entity type to choose is as simple as knowing its advantages and disadvantages. Read on to learn about the most common types of business entities.
The U.S. Small Business Administration says LLCs can be a good choice for businesses that will face medium to high risks, for anyone who wants to protect their personal assets, and for anyone who wants to pay a lower tax rate than they would with a corporation.
In most cases, an LLC business structure will protect your personal assets, such as your vehicle and house, if your business faces bankruptcy or lawsuits.
The profits and losses an LLC incurs can get passed to the owner’s personal income. Be mindful that how your LLC is taxed and managed will impact when and how members incur self-employment taxes for Social Security and Medicare. Your tax lawyer, CPA or accountant can help you choose the best tax options based on your total financial picture.
There are two different types of corporations that can be formed. One is a for profit corporation and what most entrepreneurs choose. The two tax options available for a for profit corporation are C corporations and S corporations. The other type of corporation is a non-profit corporation. Nonprofit corporations are typically used for charitable entities.
The U.S. Small Business Administration recommends the C corporation structure for businesses that will have medium or high risks, for anyone that needs to raise money for their business, and for anyone who wants their business to “go public” or be sold later.
C corporations are the default and most common types of corporations. Owners of a C corporation receive dividends that are considered profits and are taxed as individuals (or if a business entity is the shareholder, then it will be taxed according to its tax status), while the corporation is also taxed separately on its income. This is because the corporation is a person, as is the shareholder.
The U.S. Small Business Administration recommends the S corporation structure for anyone who would otherwise have their business as a default C corporation, but their business meets the criteria for being an S corporation and the shareholders unanimously elect to be an S corporation.
An S corporation can have up to 100 shareholders. Instead of being taxed at two levels like a C corporation, shareholders account for profits and losses on their personal income tax returns after filing an informational report to the IRS via a 1620S.
The non-profit corporation structure is good for someone who wants to dedicate their organization to a special cause.
Non-profit corporations often do work that benefits the public, focusing on causes such as charity, education, religion, literary work or science. They have the option to be tax-exempt, meaning they don’t pay state or federal income taxes on their profits. They must file with the IRS to get this exemption.
Non-profit corporations are required to follow organizational rules that resemble those of a C corporation. There are rules about what they can do with their profits. Two things they can’t do with their profits, says the U.S. Small Business Administration, are to distribute them to members or give them to political campaigns.
The U.S. Small Business Administration recommends partnerships for businesses that will have multiple owners, for professional groups, and for groups who want to test their business ideas before creating more formal businesses.
A general partnership is the simplest business structure in which at least two people own a business together. Partnerships come in many forms, but the two most common ones are limited partnerships (LP) and limited liability partnerships (LLP).
A limited partnership has one partner with unlimited liability, while the other partners have limited liability. The partners form a partnership agreement, which tends to give partners with limited liability limited control over the business. Partners account for profits on their personal tax returns. The partner with unlimited liability typically must pay self-employment taxes.
Limited liability partnerships give limited liability to each owner, protecting them from debts the partnership owes and keeping them from being liable for what other partners do. This partnership type is often reserved for professions.
You now know the basics about business entities in the U.S. If you are planning on starting a business, we hope this guide has helped you choose how to structure it. For more information that you can use to start a business, read our blog post on that subject.
