Whether or not incorporating a business is the right decision for your startup is an important question to answer before getting too far down the entrepreneurial road.
Some new small business owners grumble at the thought of trying to figure out all of the different business entity types, what they mean, how much they cost, and how complicated they are to run and manage over time.
Most often, they structure their business as a sole proprietorship simply because it’s the easiest way to get started – they’re unclear how to incorporate.
While business formation can be a little tricky, and the process does have costs, the long term benefit of selecting the proper entity for your business will absolutely pay off in the long run – especially if you have big plans for your new ideas (don’t we all).
The purpose of this section of the site is to provide an overview of the different types of business entity classifications, what they mean, and how they compare to one another. If you’re forming a business entity then you’ll want to make sure to understand all of the options available as well as the pros and cons involved.
Types of Legal Entities When Incorporating A Business
Without getting into all of the different flavors, there are really five entities to consider when starting a business. The outcome of incorporation is dependent on the type of business you run, the environment in which you run it, and the risk exposure to your business.
The five entities we’ll cover in more detail in this section of the site are:
- Definition of Sole ProprietorPartnershipCorporationLimited Liability Corporation (LLC)Non Profit Business
Again, the decision of which entity is right for your business depends on what your business needs in terms of legal protection, ease of entity maintenance, and tax consequences. Spend some time researching each type to make sure that it fits your (and your business’) needs.
Each business type requires certain steps to get started (for example, most all businesses require filing a DBA – “Doing Business As“). Whether you decide on a sole proprietor or corporation, take your time and follow the setup steps carefully. In many instances, it makes a lot of sense to have a professional do the setup for you.
The most straightforward and easiest business entity, as well as the most common for small business owners, is the sole proprietor. In a sole proprietorship, you as the individual owner and your business are legally considered to be the same thing.
Starting a business as a sole proprietor is typically much easier than incorporation. It’s also fairly inexpensive. Furthermore, it takes less of the business owner’s time to manage the administrative paperwork associated with a sole proprietorship than it does with some other entity types.
On the down side, your financial and legal risk exposure is higher as a sole proprietor than with other entities. Because the courts see you and your business as the same entity, legal issues against your business could turn into legal issues for you as an individual.
If you’re going to start a business with somebody else (i. e. your spouse or friend), you’ll have to pick another entity besides a sole proprietor. Forming a partnership is usually the most common approach since it’s easier and cheaper to manage than the corporate cousins; namely the Corporation and Limited Liability Corporation.
The fundamental problem with forming a partnership is that partners are legally bound by the actions of the other partners, regardless if they have anything to do with the activity or deal in question. Since all partners are legally tied together under the partnership, this kind of engagement can cause issues over time – especially when there are fundamental differences of opinion regarding how to manage or grow the business.
The reason why most small business owners form a corporation is because the entity structure of a corporation provides liability protection for the business owner. In other words, if your business was sued by a customer or competitor, any damages can only be awarded from the company assets. In other words, the lawyers can’t come after your personal stuff.
While a corporation structure can help protect the business owner, there are some downsides to consider. First, Corporations suffer from a kind of double taxation. The company is first taxed on its profits. The company owners then must also pay tax on the income and profits they receive. We’ve oversimplified this example to make a point.
It’s good to compare both the corporation vs LLC when evaluating your incorporation options.
Depending on the income level for a corporation, there may be times when the tax burden is less as a corporation than some other structure. A good accountant can help explain the differences in corporate tax structures. Read more to learn how to start a corporation.
Limited Liability Corporation
The limited liability corporation (LLC) business entity has grown in popularity much faster in the past few years than any other entity type. From a legal perspective, it’s a relatively new entity with features that can be quite attractive to small business owners when incorporating a business (learn more about the pros and cons of an LLC).
Incorporating a business and starting an LLC both provide the business owner(s) with limited personal or legal liability (as opposed to the sole proprietor) and the LLC structure will often provide certain tax advantages over a traditional corporate setup.
A limited liability company does cost more to start and manage than a sole proprietor due to the forms and filings involved. It can also take a bit more time to manage throughout the year. But the costs are often seen as nominal compared with the benefits that the LLC provides.
The final business entity that we’ll cover is the Nonprofit Corporation. Small business owners often choose the nonprofit classification to get tax-exempt status from the government. The key requirement is that the business is used for altruistic purposes: for example, churches, charitable trusts, literary foundations and other educational services.
The tax-exempt status of a nonprofit is alluring to many people; however, the business’ operations must match entirely the criteria imposed by the Internal Revenue Service for this type of business. The IRS is cracking down hard due to a rise in nonprofit, tax-exempt scams.