How Do You Choose the Best Legal Entity for Your Business?

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How Do You Choose the Best Legal Entity for Your Business?

Strong buildings, whether a modest family home or a towering skyscraper, have one key element in common: They are built on a solid foundation. By starting with the right structure, they can grow, evolve and stand the test of time. The same is true for businesses.

If you’re in the planning stages of launching your business, laying the right foundation is integral to your future success. But how do you know which of the business structure types is right for you? We’ve got the insight that will help you make one of the most fundamental — and most impactful — decisions that will set the course for your new business.

Incfile | Entity Comparison

What Is a Business Legal Structure, and Why Is It Important?

The legal structure of a business, also known as a business entity or legal entity, refers to its government classification, which is used to determine tax responsibilities (at the federal level) as well as other legal obligations and requirements (at the state level). While the Internal Revenue Service (IRS) may view each of the business structure types as cut and dry, they can be a bit confusing to those starting out and wondering why they are important at all.

The importance of business structure types comes down to several factors, all of which can make a difference to the way your business is operated. This is also why choosing correctly, in the beginning, is essential for your future success.

Taxes

Not all business structure types are taxed the same way, and in fact, there are a few options where all business income is taxed as personal income — effectively, the same way that you've been filing taxes your whole life. C Corporations, however (as you'll see below), are taxed at a corporate rate, and business income remains completely separate from personal take-home pay.

Liability

The most common of the business structure types, the Limited Liability Corporation (LLC), separates business and personal assets so that you don't risk losing your house in the event of a lawsuit or if your business goes bankrupt. Sole proprietorships don't have this same protection, nor do partnerships, and the protection is only recognized at the state level. To guarantee the same liability protection at the federal level, you'd need to form a C Corporation — though not every business needs this.

Hierarchy

If you've heard the term "board of directors" before, know that that doesn't apply to all business structure types. LLCs, for example, don't have boards of directors, but C Corporations are required to have them, as are nonprofit organizations. The purpose of having a board is to ensure that the company can remain operative even when the original owner leaves or passes away and also functions to represent stakeholders' interests.

Paperwork

There are various forms and other required paperwork that differ for each of the business structure types. These include Articles of Incorporation, which are filed when the business is formed, as well as government reports and other regulatory paperwork. Failing to file the correct paperwork can cause big problems. Understanding your business needs can help you determine which entity type to choose and help you keep all of your ducks in a row.

Registration

Some businesses require special licenses or permits in order to operate, and in order to obtain these, a legal entity is required. Only listed business structure types can apply for an Employer Identification Number (EIN) which then enables you to apply for permits, hire employees and open corporate bank accounts.

Fundraising

Businesses often raise funds by issuing stocks to the public; however, not all business structure types can do this. Only corporations are permitted to issue and trade stocks — if you've heard the term "going public" or "taking it public," it's typically in reference to changing a private company over to a public company so that the business can raise funds through stock issuance. LLCs, sole proprietorships and partnerships aren't generally permitted to do this, so depending on your long-term business goals, it's definitely something to consider.

Business Structure Types

Now that we've covered some of the factors that determine the importance of choosing the right entity, it's time to dive into each of the individual business structure types to identify what they mean. Each comes with its own unique benefits…and its own pitfalls.

Deciding on a structure is a highly personal process and depends greatly on the goals and vision you have for your business. Read on to learn more about the business entities Incfile can help you form, and when you’re ready, take our Business Entity Quiz to confirm which one best suits your needs.

Limited Liability Company (LLC)

While it’s not a one-size-fits-all approach to doing business, there’s a reason LLCs are the most popular business entity for Incfile customers and businesses worldwide. In fact, more than 80 percent of small business owners choose an LLC when forming their company.

LLCs offer a hybrid structure that allows owners more control of their business while protecting their personal assets in the case of financial or legal hardship.

 

Pros:

  • LLCs are flexible entities managed by an individual or multiple owners.
  • They are considered a “pass-through entity,” which means all profits and losses are filed on the owner’s personal tax return without facing corporate taxes. You’ll need to file a Schedule C and Schedule SE with your personal 1040 tax form.
  • An LLC creates separation between your business and personal assets so that your car, home and personal savings will be protected should you face bankruptcy or lawsuits.

Cons:

  • LLCs are not indefinite entities. They are filed by state, and each state has different regulations for changes to the business. You may need to dissolve the business and reform if you move to another state, if another owner leaves the business or if a new owner is added.
  • Compared to other structures, LLCs can require more legwork on the part of the business owner, with forms and state filings. Fortunately, that’s why Incfile exists: to make the formation process seamless, simple and hassle-free.

S Corporation

S Corps are similar to both C Corps and sole proprietorships in different ways. They offer the protection of a corporation while avoiding the double taxation challenge that faces C Corps. S Corps are better choices for small businesses that want ownership flexibility and tax benefits while lowering personal risk.

If you own an S Corporation, you can declare a portion of your income as salary and other income as distributions to reduce the overall amount of self-employment tax that you are required to pay, as distributions aren't subject to self-employment taxation.

 

Pros:

  • Like LLCs and sole proprietorships, S Corps are considered “pass-through entities,” reducing tax liability for shareholders.
  • Because of their pass-through setup, S Corps are not subject to the same double taxation as C Corps.
  • Like a C Corp, S Corps operate as a separate entity from owners, so when a shareholder leaves or passes away, the business continues relatively undisturbed.

Cons:

  • S Corps have more restrictions than C Corps and must have fewer than 100 shareholders.
  • They must also be considered domestic businesses, with all shareholders required to be U.S. citizens or legal residents.
  • S Corps are restricted to only one class of stock, meaning they may have more problems raising capital.

how to choose the right business structure types

C Corporation

A C Corp is most often found in larger businesses. By forming a C Corp, you create an entity that is entirely separate from its owners. It can generate a profit, it's taxed apart from its owners and shareholders and it's legally liable in its own right. Corporations also have liability protection at the federal level, while LLCs are only subject to liability protection at the state level, and are generally the only entity type that can issue stock.

 

Pros:

  • Owners and shareholders are protected in a C Corp, as their assets are never at risk in the case of financial or legal difficulty.
  • C Corps can sell stock, which can help when cash flow is needed. It can also be an attractive benefit to potential employees.
  • C Corps remain mostly unchanged in the event of a shareholder or owner leaving the company.

Cons:

  • C Corps are generally more expensive to form than other business entities.
  • Because of their structure, C Corps are held to more exacting regulations and requirements, with regular filing and reporting required.
  • C Corps often face double taxes, paying first on their profits and then again when dividends are paid out to shareholders.

Nonprofit

If your business goal is more focused on impact than on profit, this might be the right structure for you. Nonprofits direct revenue to causes or organizations rather than to shareholders. They are not owned by an individual or group, and though they can be sold, any assets must be used toward the benefit of the organization.

The main purpose of a nonprofit organization is to achieve something of value and contribute to the public good, so they are prohibited from becoming profitable and must direct all revenue towards their main goal.

 

Pros:

  • Nonprofits, when filed and approved as a 501(c)(3), are considered tax-exempt, meaning all donations to the organization by individuals are tax deductible.
  • As in LLCs and corporations, nonprofit founders are typically protected from legal liability.
  • Nonprofits that go through the formation process are more likely to set stronger missions that help them achieve their goals.

Cons:

  • Government requirements for filing as a 501(c)(3) are stringent, and the filing of incorporation is only the first step in becoming a recognized nonprofit organization.
  • Reporting requirements for nonprofits are much tougher than those of other business structure types and, due to the nature of the organization, are generally under more scrutiny.
  • Compared to other types of entities, nonprofits can be more costly and time-consuming to launch.

Sole Proprietorship

If you’re forming a business on your own, you might think a sole proprietorship is a no-brainer. This structure is the simplest to set up, mainly because there really isn’t any setup. To run a sole proprietorship, you simply need to operate your business. There is no sole proprietorship filing or registration, though if you’re doing business under any name other than your own, you may need to file a Doing Business As (DBA).

That said, however, in the case of sole proprietorships, there's no state or federal-level liability protection that will offer security to your personal assets should your business become involved in a lawsuit.

 

Pros:

  • The easiest and quickest of the business structure types, sole proprietorships give owners total control over every aspect of the business.
  • Taxes are considered “pass-through,” like LLCs, and can be filed with Schedule C and Schedule SE on your 1040 tax form.
  • Sole proprietorships can be good options for low-risk business owners who want to test their idea before an official launch or business formation.

Cons:

  • Sole proprietors have zero protection against risk and liability. In the event of financial struggle or legal problems, the owner’s personal assets are on the line.
  • It can be difficult to secure funding for sole proprietorships due to the increased risk, lack of business partners and inability to sell stock in the company.

Partnership

If you’re forming a business with someone else, you may be interested in a partnership structure. Partnerships come in various forms that will impact the way you do business and the way you share responsibility with your partner(s). General partnerships are very similar to sole proprietorships, in which all parties assume equal responsibility and liability for the business.

Limited partnerships assign a general partner who assumes primary responsibility, while the limited partners are protected from liability. In either case, partnerships do not offer the same protection that comes with an LLC, S Corporation or C Corporation.

 

Pros:

  • In a general partnership, you share both the risk and the reward of operating your business with an individual or team that has just as much at stake as you do in making the company a success.
  • If you are the general partner of a limited partnership, you have the most control over the operations of the business.
  • For tax purposes, partnerships are still considered “pass-through,” and each partner must file a Form 1065 with their personal taxes. Additionally, each partner also reports their own share of income and loss on a Schedule K-1.

Cons:

  • General partnerships offer no protection of personal assets, so while you have equal partners to share the workload and responsibility, you are also equally at risk of financial or legal troubles.
  • In a limited partnership, while partners are off the hook when it comes to risk and liability, they also have no legal control over the company or its daily operations.
  • Limited partnerships are heavy on paperwork, which deters some entrepreneurs from forming them.

What Determines the Best Structure That Fits Your Business?

For some entrepreneurs, choosing from the above business structure types is a relatively easy process because they have a firm grasp on the sort of business activities and even income projections that are anticipated.

Opening a local restaurant, for example, is fairly straightforward, and most would choose to form an LLC to meet their needs and access sufficient liability protection. A tech company, however, is far more uncertain. Perhaps you don't plan to outdo Microsoft or Apple, but growing your business may be difficult without the ability to raise funds through stock issuance. You may also wish to have maximum liability protection if your business will serve a high number of customers.

The best structure for your business is the one that will meet all or most of your needs with regard to your business plan. From taxes and paperwork to liability protection and fundraising, every existing business has successfully chosen an entity type…and so can you.

Not Sure Which to Choose? Incfile Can Help

Ultimately, identifying which of the business structure types is right for you depends on what you want to get out of your new venture. You’ll need to consider if you want to be the sole decision-maker or if you want the support of trusted partners. You must also look at the tax implications of each of the business structure types and determine which will meet your current needs. Finally, and most importantly, ask yourself which business type will offer you the greatest financial and legal protection, should you need it.

If you still aren’t sure, you can download our Business Entity Comparison guide to help you navigate the decision-making process. Remember that by laying a strong foundation now, your business will have the strength and support it needs to withstand any storm.

Not Sure Which is the Right Entity for Your Business? Use Our Free Entity Comparison Guide.
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