If you’re interested in launching a new business or product line, you will inevitably need to choose the best legal entity type. This comes up in my line of work, where I interact with the leadership of many early startups and growing companies who will make or have recently made a decision like this.
Your choice will, among other things, determine how you pay taxes on your business earnings. While I don’t consider my level of expertise in this topic as strong as my expertise in, say, injection molding or mechanical design, my limited knowledge may help guide your decision.
The simplest way to do business is to act as a sole proprietor. This simply means that all of your business assets (and liabilities) would be under your name and is technically not a business classification at all. Becoming a sole proprietor requires no formal legal action outside of reporting your business income on your personal tax returns, from which one can deduct all business expenditures. While the simplicity of this entity may be attractive, there are two distinct disadvantages. One disadvantage is that some states make it difficult to conduct business as a sole proprietor under a name other than the legal name of the proprietor – so you won’t be able to give your business a name. The other disadvantage is that all of the business’s debts and liabilities are held by the business owner, meaning that the business owner’s personal assets are at risk in the case of a liability. Given these disadvantages, most business owners I work with stay away from sole proprietorship.
The simplest and most popular business classification is the LLC. This type of business can be formed online and is very flexible. If the LLC consists of only single member, then it will be taxed in the same way as a sole proprietor – company’s owner will be taxed at their personal tax rate, and will not have to pay any additional income tac for owning a business. If the LLC consists of multiple members, then it will by default be taxed as a partnership. This means that business’s income, losses, and expenses will be “passed through” to the individual members’ personal tax returns. However, an LLC can also elect to be taxed as a different entity, like a corporation or an S-Corporation, which generally simplifies the process. The LLC functions in a manner laid out in a paper called the “governing document”. This document, penned at the company’s inception, specifies the rights and responsibilities of the members and the rules pertaining to the management of the company. The LLC is the most flexible of all the business entity types and is easily the most popular entity within our network. However, if you are thinking of forming an LLC, know that you may run into trouble should you ever wish to offer a stock-options program as an employee benefit.
The corporation, another entity type, is considered the most formal of all the entities. These can be formed online in most states with fees depending on the number and value of the stock issued. One advantage of being classified as a corporation is an increased ability to provide and deduct employee benefits. By default, corporations are considered C-Corporations, which are unattractive because of the way in which they are taxed. In a C-Corporation, the company pays a corporate income tax based on the magnitude of its profits. Then, shareholders must pay personal income tax on their distributions. This is known as “double taxing” and can be avoided by classifying the company as an S-Corporations. The S-Corp entity allows all income, losses, and deductions to be “passed through” to the shareholders, much like an LLC. Certain qualifications must be met to become an S-Corporation. These include being a domestic company, having no international shareholders, only issuing one class of stock, and having no more than one hundred shares.
The last entity type I will discuss is a Partnership, the oldest type of business classification. There are several different kinds of partnerships available, including registered partnerships, limited partnerships, and limited liability partnerships. The differences in these classifications can get a little technical, so I won’t get into it. However, partnerships usually share profit and expenses according to their ownership but make the partners personally accountable for all debts and liabilities incurred by the partnership. In this way, it is similar to how a sole proprietorship operates, but can formally include more than one owner.
As one of the first decisions you must make as you start a business, it’s important to choose your entity type wisely. The differences between these entities, and the way each can affect how you work and pay taxes, can be subtle and complex. Best practice is to consult a lawyer as you make your decision.