Business Entity 101
Dreaming of launching your own business? Here’s a primer on just a few of the business models out there.
There’s little more exciting for an entrepreneur than seeing their business dreams take shape. Launching and growing a business, whether it’s home-based or destined for international fame, is incredibly rewarding, fulfilling, and, oh yeah, challenging, too.
Before bringing your next big idea, product or service to market, you’ll want to do plenty of market research, draft a killer business plan, figure out financing, and, choose which business structure is best for you.
Rather than getting blown off course differentiating the SPs from the LLPs and LLCs, here’s a quick overview of the business structures you may encounter.
Sole Proprietorships (SP)
This one is all you man (or woman). An SP is the simplest and most common business structure. In fact, the Small Business Administration [SBA.gov] says over 70 percent of small businesses operate under SPs. Essentially, you, the sole owner, are solely responsible for running the business and on the hook for all debts, losses and liabilities. Outside of the need for some potential licenses, permits and trade names, there are no formal forms or fees required to establish a sole proprietorship. And from a tax standpoint, since you and the business are one and the same, income, losses and expenses are reported on a Schedule C and your standard Form 1040. The SBA and IRS both talk more about the intricacies of this model.
There’s nothing wrong with needing a co-pilot or two or three to get your business off the ground or take it to the next level, but it does require some paperwork. A Partnership is used when two or more people own a single business and contribute money, property, labor and skill in exchange for a share of the business’ profits, losses and liabilities. Besides drafting a Partnership Agreement, you and your partners will need to choose a Partnership type, of which there are three: General, Limited or Joint Venture.
A General Partnership assumes that all profits, liability and management duties are divided equally among partners or as documented in the partnership agreement. The more complex Limited Partnership (LP) or Limited Liability Partnership (LLP) allows partners to have limited liability and management input depending on their investment percentage. Joint Ventures (JV) are essentially time-limited general partnerships formed for short-term projects.
Next, you’ll register the business with your state, establish a business name, and acquire any other licenses or permits you may need to legally operate. From a tax standpoint, Partnerships are “pass-through entities,” so partners are responsible for their respective share of business profits and losses, and any income and self-employment taxes related to them. The SBA covers this and other Partnership details well here.
Limited Liability Companies (LLC)
A Limited Liability Company, or LLC, is the lovechild of Partnerships and Corporations. It’s a hybrid legal structure that provides its owners, known as members, with operational flexibility (an LLC can be formed and owned by a single member or other partnership, corporation, foreign entity or LLC), tax efficiencies (LLCs are not taxed as separate entities, and profits and losses pass through to members just as they would in a Partnership or Sole Proprietorship), and limited liability (members are shielded from personal liability for the LLC’s debts and actions).
While LLCs offer great flexibility and many financial benefits, the pitfalls are that substantially more formal paperwork and legal requirements are required to form and operate an LLC, and the taxation becomes increasingly complex as the number and types of members expands.
The SBA’s LLC overview points out more of the pros and cons.
If you have dreams of “going public,” selling stock to raise funds for continued global dominance, issuing stock options to incentivize your executives, and ensuring your business can carry on even if a shareholder dies or leaves, then incorporating may be your ticket, albeit an expensive and complex one.
Corporations are independent entities liable for their own debts and actions, but owned by shareholders. A B Corporation or Benefit Corporation is unlikely to be your first choice, unless your business is focused on general public benefit and achieving a positive impact on society and the environment. There’s no taxation difference with a B Corporation, but it does have unique accountability and transparency requirements.
Deciding between a C and S Corporation is much more likely. An S Corporation is formed through a special IRS tax election that allows the business itself to avoid taxation; all profits and losses pass through to the personal tax returns of shareholders. It’s a unique structure that comes with limitations, for instance, all owners/shareholders must earn “reasonable compensation”; shareholders are limited to 100 and must be US citizens or resident aliens; and S Corporations can only issue one class of stock.
A C Corporation, on the other hand, is your “regular” corporation, and with it comes far more operating flexibility. C Corporations can be owned by Partnerships, Limited Liability Companies, foreign businesses and other Corporations participating as owners of the company. They also can issue multiple classes of stock and operate in global capacities. Taxwise, C Corporations face a double layer of taxation; they file with the IRS, and owners/shareholders are required to report dividends and distributions received from the company on their personal tax return.
The SBA points out that a Corporation is best suited to large, well-established businesses because of their complex structures, certain eligibility requirements, and tendency to incur costly administrative fees and complex tax and legal requirements at federal, state and local levels. Before going corporate, check out the SBA’s explanation and links to resources..
Cooperatives or Co-ops are businesses or organizations owned and operated by its members for access to services and mutual benefit (like reduced costs for goods based on membership size). Cooperatives are most common in the healthcare, retail, agriculture, art and restaurant industries for this reason.
A Cooperative operates as a Corporation and receives a "pass-through" designation from the IRS, meaning that profits and earnings generated are distributed among members, who then pay federal and state taxes when they file their personal income tax returns.
Forming a Cooperative is different than forming any other business entity though. Per the SBA [https://www.sba.gov/starting-business/choose-your-business-structure/cooperative], a group of potential members must agree on a common need and strategy to meet it. An organizing committee then conducts exploratory meetings, surveys, and cost and feasibility analyses before every member agrees to the business plan. Typically, an elected board runs the cooperative while regular members have voting power to control the Cooperative’s direction. Each state has different laws governing Cooperatives, so it’s best to work with attorneys and advisors familiar with your state.
The business structure you choose sets the course for how much tax you pay, the amount of paperwork your business must file, the personal liability you might face, and your ability to borrow or raise capital. It’s an incredibly important choice to make, but what you choose can always change. Do well enough and you may want to convert your Sole Proprietorship into a Partnership or Corporation. The best thing here is that there’s nothing holding you back from converting your business structure.