By Harrison Greenspan
When launching a new small business (especially during these trying times), picking a specific type of business entity (also known as a legal entity), is a particularly significant consideration to make. And not only is registering your small business as a specific type of business entity important, when you do so is as well. We’ll go through the different types of legal entities, the benefits and drawbacks of each, and of course whether or not now would be a good time to file your type of business entity with your respective Secretary of State. And finally, I’ll recommend which type of business entity to launch for your small business situation.
A sole proprietorship is the easy shortcut to having a business entity, as it requires no governmental filing, although some states require a fictitious-business-name statement (it can be as simple as the name of your small business or even your own name), which discloses the name under which the business will be conducted, as well as the owner’s name and address. However, due to the fact that sole proprietorships give you complete and utter control of your business, as you are the sole owner of the small business, you (the owner), assumes unlimited liability. This means that the entirety of your assets are at risk, as your business assets and liabilities are not separate from your personal assets and liabilities. Additionally, banks are typically more hesitant to lend money due to risk and to add fuel to the fire, stocks cannot be sold to raise money. This is because a sole proprietorship can't have additional owners, meaning the proprietor can't bring on investors or partners by selling shares of stock. As such, it is simply a bit more difficult to raise funding. Keep in mind you can be a sole proprietor with employees.
Is a Sole Proprietorship the Right Choice for YOU?
So, what kind of small businesses should consider using sole proprietorships as their legal business entity? Low-risk small businesses that want to test their business idea before forming a more formal business entity. At the end of the day, you are probably testing the market, as you are unsure of how much a commitment you can make with the respective small business idea. This notion is especially true since you’d be saving costs, such the miniscule filing costs and fact that there is no minimum tax (in some states). Just be cautious if your idea can lead to any sort of risk, although risk can be mitigated through insurance.
A partnership is a form of business entity involving two or more owners, so that’s you and whoever else you want to go into business with. And more specifically, there are three types of partnerships: general partnerships, limited partnerships (LP), and limited liability partnerships (LLP).
In a general partnership, each partner is a general partner with unlimited liability for the debts of the partnership, as well as the power to incur obligations on behalf of the partnership within the scope of the partnership’s business. As such, each general partner acts as an agent for the partnership. And just like with a sole proprietorship, liability concerns and potential claims for personal injury or those resulting from errors or omissions can be mitigated through insurance.
Limited partnerships have only one general partner with unlimited liability, and all other partners have limited liability, which is limited to the amount of their capital commitment. The amount of control by a limited partner is documented in a partnership agreement. Profits made are passed through to personal tax returns, while the general partner must also pay self-employment taxes.
And finally, limited liability partnerships are a sort of hybrid between the aforementioned, as they give limited liability to every owner. An LLP protects each partner from debts against the partnership, as they won't be responsible for the actions of other partners (to the extent of the partnership’s assets), but still assumes unlimited personal liability (such as medical malpractice). Typically, professional partnerships (such as law and accounting firms), use LLPs as some state laws restrict organization as limited partnerships.
One last note to keep in mind is that a partnership can be formed with or without a written or verbal agreement. For example, signing a lease together would constitute a partnership.
Is a Partnership the Right Choice for YOU?
Partnerships can be a good choice for businesses with multiple owners, professional groups (like attorneys and accountants), as well as groups who simply want to test their business idea before forming a more formal business entity.
Limited liability company (LLC)
A limited liability company is a popular choice for many small businesses because it intends to incorporate (pun intended) the benefits of both the corporation and partnership business structures; an LLC combines the pass-through federal tax treatment of a partnership (more information on-pass through taxes HERE), with the liability protections of a corporation. Thus, an LLC protects you from personal liability in most instances, meaning your personal assets such as your vehicle, house, and savings accounts won't be at risk in case your LLC faces bankruptcy or lawsuits. And just like in a partnership, profits and losses can be passed through to your personal income without facing corporate taxes, which is the pass-through federal tax treatment. Basically, an LLC is taxed once the owner gets paid versus getting taxed twice like corporations when the corporation as an entity gets paid, then again when the owner gets paid. However, members of an LLC are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security.
Forming an LLC requires a minimal amount of paperwork to be filed with your respective Secretary of State’s office, as you’ll typically only need the articles of organization (which is the name, address, and organizational purpose), along with an operating agreement that outlines the operating rules for your LLC (click HERE for some more information on Operating Agreements for your small business). Filing fees and additional taxes (in some states) are required as well.
Is an LLC the Right Choice for YOU?
LLCs can be a good choice for small businesses with medium to high risk, especially if owners have personal assets that they want to protect. Additionally, you can pay a lower tax rate than if you were a corporation.
Corporations are business entities owned by its shareholders, managed by a board of directors, and operated by its officers. There are numerous specific types of corporations, each with their own benefits. Today, we’ll talk about C-corps (which some also refer to as simply a corporation), S-Corps, B-Corps, and non-profits.
C-Corporation (aka C-Corps)
A C-Corp is a business entity that is considered to be legally separate from its members-owners. And unlike partnerships, C-Corps may be owned by a single person who may not only be the corporation’s sole director, but also serve as any and all required officers (for example, the president, treasurer, and secretary). However, it is required to include shareholders, which can be seen as an advantage as it gives you the option to take the company public if you choose to, as well as offering stock and stock options to your employees. And although C-Corps have the option of reaching out to venture capitalists for assistance, due to the current market climate (thank you COVID-19), it’s more difficult than ever to raise funding. As a substitute, click HERE for a easy-to-follow breakdown of 5 alternative ways to VC funding for small businesses.
A primary advantage of the corporate form (a feature it shares with the LLC) is the limited liability it provides to shareholders (or owners of the corporations). As such, creditors are limited to the assets of the corporation for payment and may not collect from shareholders if corporate assets are insufficient to pay all debts and liabilities.
A clear disadvantage is the fact that under federal income tax law, a corporation is taxed on its net income (gross income less allowable deductions) at a rate of 21%. Further, C-Corps go through something called double taxation, which means that C-Corps are taxed before and after the distribution of dividends.
Is a C-Corp the Right Choice for YOU?
C-Corps may seem to have great advantages, but it also has many disadvantages for a small business that is attempting to launch during a pandemic right now. Not only does it have a hefty tax rate, it typically requires financial backing, business advisors, and tax advisors due to its complex nature. Although it may be a good choice down the road once your small business has grown to a degree in which you’re tickling the idea of going public and wanting to build that large dream team with many moving parts, right now it simply not the time. But, keep in mind that you can of course change the corporate structure of your small business at a later date (meaning you can change from an LLC to a C-Corp when the time is right).
S Corporation (aka S-Corps)
S-Corps are the same as any other corporation except for the way they are taxed. Like an LLC, the tax burden for an S-Corp is passed on to the shareholders, avoiding double taxation that C-Corps burden. As such, S-Corps can be particularly beneficial to small businesses due to the tax benefits and the legal protection afforded to its shareholders. However, forming an S-Corp requires you have previously formed as a C-Corp, and limits you to only 100 shareholders (although family members can be counted together as one shareholder).
Is an S-Corp the Right Choice for YOU?
Similar to my stance on a C-Corp, right now probably is not the best time to form as an S-Corp, especially considering the perquisite of forming a C-Corp, which is usually burdensome in itself. However, once your small business has been established and deemed successful, whether that be due to profit margins, long-term sustainability, or the eagerness of venture capitalists wanting to invest, it then may be a good idea to explore this route. One additional note to keep in mind is that lenders for small business loans typically prefer the S-Corp structure.
Benefit Corporation (aka B-Corps)
B-Corps are an especially attractive business entity for small businesses because due to a special B-Corp certification awarded to companies that are leaders in aspects other than just making a profit. Earning this B-Corp certification is a serious undertaking, as you must prove your impact on the communities around you, as well as the environment; shareholders hold the company accountable to produce some kind of public benefit in addition to profit. As such, the test asks numerous questions about your company’s impact on its employees, customers, community and the environment. You can learn more or sign-up to take the test HERE. And although a B-Corp has the word “Corp” in it, whether you’re a partnership, LLC or a C-Corp, you can apply to become a B-Corp.
Is a B-Corp the Right Choice for YOU?
While this is another attractive choice for the future, it is not the type of entity to apply for now, primarily due to the fact that your small business cannot earn B-Corp status until you’ve been in business for at least 12 months. This, however, is an incredibly appealing choice for the future if you’d like to make social responsibility a core aspect of your small business (for example helping combat the current pandemic with health related products and services), especially since customers are becoming more aware and loyal to brands that they can trust do good for their respective community and surrounding environment.
If you’re an aspiring small business with goals other than profit margins, a nonprofit corporation business entity structure will probably be the choice for you. Nonprofits are organized to do charity, education, religious, literary, or scientific work. Because of their work and goals in aiding the public, nonprofits can receive tax-exempt status, meaning they don't pay state or federal taxes income taxes on any profits it makes (which is why they’re also called 501(c)(3) corporations, a reference to the section of the Internal Revenue Code that is most commonly used to grant tax-exempt status).
Unlike other types of business entities, to become a nonprofit corporation, you must file with the IRS opposed to filing with your respective Secretary of State. On the other hand, nonprofits are similar to C-Corps to the special rules they must follow, particularly about what they do with the profits they earn. As an example, your small business nonprofit could not distribute profits to members of the board or political campaigns.
Is a Nonprofit Corporation the Right Choice for YOU?
Not paying taxes is an incredible advantage to have when launching a small business, but it clearly has special requirements that impact the core purpose of your small business at large. Thus, becoming a nonprofit corporation is what you’ll need to consider and decide on from the onset of launching your small business.
Additional Resources When Considering Which Business Entity Is the Right Choice for YOU
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