January 13, 2021
Choosing the correct business entity allows an entrepreneur to reduce liability exposure, minimize taxes, and ensure that the business can be financed and run efficiently. When deciding to start a business, you’ll need to know which kind of business you should form. Your business’s structure should be chosen based on your particular needs. You have four basic entity types to choose from when creating your business. Each one has its advantages and disadvantages based on what you sell, your business’s finances, and the number of owners the company will have.
Some questions to ask yourself:
What type of business do I run?
How many owners do I have?
What is my financial situation?
No one choice suits every business, and business owners must select the best structure to fit their needs. Below we compare the most common business entities you can form.
This is the simplest option of the four. Typically, when a business starts out, the owner will not do much research into entity types, and this is the default option. Not only is it easy to create a sole proprietorship, but it also simplifies the tax process come April. All the owner has to do is report its profits or losses on their personal tax record, and that is it.
However, this simple structure means it is tied to your personal assets. If the business fails, you could lose your personal property and savings to repay any lingering debt. You will also likely have to pay a self-employment tax on any profits you make, which could mean paying the government a substantial portion of profits earned.
A general partnership is a lot like a sole proprietorship; if you are working with someone else, it is the default entity type for your business. But, like the sole proprietorship, a general partnership ties the business and personal assets of the partners together. If you choose, you could make a limited partnership as long as neither of the partners personally manages the affairs of the business. This lowers personal liability for business debts but does not eliminate them. A partnership also raises issues of the ownership of ideas if your business is built around one. The lack of inherent protection with these entities means that if one partner chooses to walk away for whatever reason, they may take the idea with them and kill whatever business has been made.
This is a very common entity type, though the paperwork and effort involved in the incorporation process may scare some small business owners. However, by incorporating, you are significantly protecting your personal assets by creating a separate entity from yourself. This makes accounting more complicated, but you pay taxes based on what you choose to pay yourself from the corporation, which means less money being given to Uncle Sam and more to help your business. Any ideas your business is built around also becomes the corporation’s property, not the owner’s. After you incorporate, you could also choose to elect an S-Corporation status, which effectively taxes the shareholders instead of the corporation’s income. However, creating an S-Corporation is complicated, and you could get similar benefits from another entity that is much easier to create, the Limited Liability Company (LLC).
Limited Liability Company (LLC)
LLCs are popular entity types because they give the owner, or owners, many more choices. Typically, owners can either opt for the tax structure of a corporation, in which the corporation’s income is taxed, or the pass-through structure of a partnership or a proprietorship, wherein personal income includes business profits and losses and is taxed accordingly. Some states have not changed their tax law to reflect the IRS’s ruling that this is allowed, so you should try and contact a professional from the state you are trying to form your company in. Whatever tax structure you choose, your personal assets are still afforded some protection if the business fails if you choose to form an LLC.
When choosing the entity type right for you, you must consider your company’s future needs and situation, not just its current position. Each class has pros and cons, but the best-fitting entity will become clear if you consider them carefully. Before doing anything, it is essential to consult with a CPA to ensure all your options are clarified and your questions answered. At Frank Kapitza & Associates, we help businesses get set up the right way and work with an in-house attorney who will handle all the legalities of setting up your new business. Contact us today for a free consultation.