Best Business Entity for Your Business – Which to Choose and Why
Starting a business comes with a host of important decisions to make, including what type of business entity to form. Your business entity will affect your taxes and your business risk, so it’s crucial to make a wise choice.
Here we’ll talk about your options and how to make the right choice for your business.
Sole Proprietorship or General Partnership
If you start a business on your own and don’t form a business entity with your state, you’re operating as a sole proprietorship by default. If you start a business with another person or persons, you’re operating as a general partnership.
In both cases, the business and the owners of the business are considered the same entity. That means that you’ll report the profits of the business on your personal tax returns. The business will not be taxed. However, the business owners are responsible for paying self-employment taxes as well as income taxes.
But it also means that you and your partners are personally liable for the obligations of the business. If the business is sued or you can’t pay its debts, your personal assets could be at risk.
Additionally, since you and the business are considered one and the same, your business name must be your name (or you and your partner’s names), unless you register a “doing business as” (DBA) name with your state, which comes with a cost.
Limited Liability Company (LLC)
An alternative is an LLC business structure. An LLC is considered a separate entity from its owners, which means that its owners are not personally liable for the obligations of the business.
An LLC is also a pass-through entity, meaning that, like a sole proprietorship or partnership, the profits of the business pass through to the owners to be reported on their personal tax returns. Again, the owners must pay self-employment taxes.
However, there’s a kicker. An LLC can elect to be taxed as an S-Corp. An S-Corp is also a pass-through entity, but owners must be paid a salary and meet certain corporation requirements. But the benefit of S-Corp status is that profits, after salaries are paid, are not subject to self-employment taxes.
S-Corps have additional administrative costs, which means that for S-Corp status to make financial sense, the self-employment tax savings must exceed those additional expenses.
An LLC is formed by filing a document with your state, which is usually called the articles of organization. Fees to file range from $40 to $500, depending on the state. To elect S-Corp status, you must file Form 2553 with the IRS.
Corporation
A corporation is another option. A corporation, like an LLC, offers personal liability protection for its owners, called shareholders, but its taxation is different than an LLC. A corporation is subject to corporate taxes, and dividends paid to shareholders are also taxed. This is often referred to as double taxation because some profits are taxed twice.
A corporation is also more complex to form and manage. Corporate bylaws must be drafted and filed with the state, a board of directors must be appointed, and corporate officers must also be appointed. The board of directors must also follow the state’s annual meeting requirements and other requirements.
However, a corporation’s shares are more easily transferrable or sold than the ownership of an LLC, which makes corporations more attractive to investors.
How to Make the Choice
The choice depends on the nature of your business and your plans for your company. If your business is a side hustle or a business that is at low risk for legal action and you don’t plan to take on debt, the simplicity of a sole proprietorship or general partnership may be for you. An LLC is a great option if personal liability protection is important to you. An LLC has many other benefits as well, which makes it quite a popular choice for entrepreneurs.
However, if you plan to raise investment capital, a corporation may be a better choice since corporations are more attractive to investors. Just be prepared for the extra requirements and expenses that come with corporate status.
Business Formation Services
If you decide to form an LLC or corporation, there are many business formation services that can simplify the process for you. They will handle your state filing and provide other products and services that can help you get your business up and running.
For example, LLCs should have an operating agreement in place. An operating agreement defines the financial relationship between owners, management roles and responsibilities, and much more. A few states require an operating agreement, but even if your state does not, it’s a crucial document.
Business formation services offer an operating agreement template that you can customize for your business. They can also help you to obtain an Employer Identification Number (EIN), which is a tax identification number for your business.
Often, they offer a library of important business document templates as well, which can save you a small fortune in attorney fees.
In Closing
Selecting a business entity is a crucial decision, so make it wisely. If you’re in doubt, consult with a business attorney and tax advisor so that you make the best choice. Then you’ll be able to focus on growing your company and making money!