A lot is riding on the business entity type you choose. The business structure you decide on affects your legal liability as an owner, tax obligations, growth potential, and compliance requirements you’ll need to satisfy on an ongoing basis. To make matters more complex, the entity type that’s right at the beginning of a business’s existence may not continue to be the ideal choice as the company grows and evolves.
So, what’s an entrepreneur to do? First and foremost, I encourage business owners to consult with a licensed attorney and accountant or tax advisor to get professional guidance. Every situation is unique, so it’s critical to have expert advice before making the crucial decisions of choosing a business entity and assessing when it’s time for a change.
To help you prepare for your all-important discussions with your legal and financial advisors, the following is food for thought about some of the most popular business entity types.
Business entity basics
1. Sole proprietorship and general partnership
Many small businesses start as either a sole proprietorship (one owner or a married couple) or general partnership (multiple owners). When business owners don’t formally register their companies with the state, they are, by default, considered either a sole proprietorship or general partnership. There is no legal or financial separation between the business and its owners.
Pros of sole proprietorships and general partnerships:
- Inexpensive and straightforward to set up and maintain administratively—Usually, there’s no legal formation paperwork required to operate as a sole proprietorship or general partnership. Aside from filing a DBA (fictitious name registration), if someone wants to advertise the business under a name that doesn’t include their first and last name, state paperwork is minimal. Compared to other business structures, sole proprietorships and general partnerships have fewer ongoing compliance formalities to fulfill.
- Pass-through tax simplicity—Business profits and losses flow through to the business owners’ individual tax returns, keeping tax filing simple, too.
Cons of sole proprietorships and general partnerships:
- Personal liability risks—If someone sues the business or the business can’t pay its bills, the owners are directly responsible. That means your personal assets (home, retirement savings, etc.) might be taken to satisfy debts or lawsuits.
- Potentially excessive self-employment tax burden—All taxable business income earned by sole proprietorships and general partnerships is subject to Social Security and Medicare taxes. That 15.3% on all profits can add up to a lofty tax bill.
- Limited opportunities for growth—Sole proprietorships and general partnerships may not sell stock to raise capital. Also, outside investors typically will not fund businesses that haven’t formally registered as a statutory business entity (e.g., LLC or corporation).
- Inability to sell the company—Sole proprietors and general partners may sell their business’s assets. However, they may not sell the business entity itself. Also, if a sole proprietorship or general partnership has outstanding debt upon closing, the business owners will be responsible for what’s owed, even though they are no longer running the business.
2. Limited liability company (LLC)
The LLC business structure may be described as a bit of a cross between a sole proprietorship or partnership and a corporation. By default, an LLC is considered the same tax-paying entity as its owners (“members”). However, the LLC is regarded as a separate legal entity from its members. Articles of Organization must be filed with the state to form an LLC.