Entity types: which option is best for my business?
The first decision most entrepreneurs face when starting a business is to choose its structure or entity. Entity choice is a critical decision, as it has far-reaching legal and tax consequences.
At some point, you will likely ask yourself: Should I form a C-Corporation? An S-Corporation? A Sole Proprietorship? An LLC? Should I even bother forming an entity? How will this affect my liability, control and taxes?
Below, the most common business entities are detailed, including advantages and limitations of each. Keep in mind that there is no one-size-fits-all entity type. The structure of your business should be determined by your product or service offerings, finances and number of business owners or partners.
If you own your business, have no partners, and have not filed any documents with the Secretary of State, your company is a Sole Proprietorship. The advantages of a Sole Proprietorship include flexibility, pass-through tax liability (also known as single taxation), simplicity, low cost of formation and elegance of management. However, a Sole Proprietorship leaves your personal assets unprotected. If someone sues your business and wins, they can go after your home, for example.
If your business is owned by more than one person, but you have not filed documents with the Secretary of State, your entity type is a General Partnership. All members of a General Partnership remain personally liable for the debts and obligations of the business. Similar to a Sole Proprietorship, a General Partnership also offers pass-through tax liability, low cost of formation and flexibility, but does not protect the personal assets of partners.
A Limited Liability Company, more commonly referred to as an LLC, is currently the most common entity choice for new businesses. The LLC offers protection of personal assets, pass-through tax liability and significant flexibility in the management, ownership and operation of the company. Individuals with an ownership interest in an LLC are called members, with one or more members being designated as the managing member(s). The biggest advantages of an LLC include flexibility to establish management, voting rights and dissolution rights in accordance with the members’ desires. An LLC also offers less annual maintenance and lower legal costs than, for example, a Corporation. This is because LLCs do not have the obligation to hold annual meetings, prepare minutes or report to a board or shareholders.
The S-Corporation entity is frequently chosen for many of the same reasons that an LLC is. It offers protection of personal assets and is taxed on a pass-through basis; however, it has notable limits. With an S-Corporation, you are unable to have more than 100 shareholders — including any foreign or entity shareholders — or issue preferred stock. Forming a Corporation requires filing documents with the Secretary of State, as well as payment of a fee.
A C-Corporation protects your personal assets but is taxed at both the entity level and the individual level (double taxation). C-Corporations are attractive to certain investors because they can be beneficial tax-wise depending on other holdings. With a C-Corporation, you can issue preferred stock and have as many shareholders as you want, including foreign or entity shareholders. You will pay a premium for these rights via higher taxes. All public corporations must be C-Corporations; however, if you don’t plan on going public within three to four years of opening your business, it is likely more cost effective to operate as an S-Corporation or LLC and convert to a C-Corporation prior to going public.
In addition to the above, there are also Professional Corporations, Limited Liability Partnerships and Limited Partnerships; however, these entities are typically only advisable in narrow circumstances which do not apply to the majority of new companies. Of the entities discussed in detail above, Corporations and LLCs are the only two entities with corporate shields. Their corporate shields are identical, in that they offer the same protection of your personal assets. Where they diverge is the following:
- LLCs offer more flexibility and lower maintenance costs than Corporations
- LLCs have few disadvantages aside from the possibility that your future investor/buyer might have a slight preference for Corporations and may require you to convert
However, investors are becoming increasingly comfortable investing in LLCs, and with all of its other advantages, the LLC is the ideal choice for most small businesses.
At the end of the day, you will want to choose the entity type that makes the most sense for your business. If you’re still unsure of which entity type to choose, you can take a quick survey here.
About the author
Heather Orr is an accomplished business law attorney who, after many years as a litigator, built a practice dedicated to keeping small businesses and startups out of the courtroom. She has served the entrepreneurial community through her firm, HSO Law, since 2009. Heather also served as an adjunct law professor at Loyola Law School for three years, where she taught a course on business planning, and is the author of How to Like Being a Lawyer.