What is the Best Business Entity Type for a Small Business?
by Fundid on Mar 18, 2023 1:47:00 PM
Are you a small business owner ready to take the next step and create an official organizational structure? This is an exciting stage in your journey, and there are several options available. From sole proprietorship to limited liability companies, selecting the right entity type requires researching potential structures and determining which one best suits your unique needs. In this guide, we'll explore the most popular legal entities that small businesses use, review the key features of each type and provide tips on how to choose what is best for you. So let's get started!
Overview of the Different Types of Business Entities for Small Businesses
Starting the journey of becoming a small business owner is exciting, and choosing the right business entity, also known as business structure, plays an important role in how your business operates. There are a few business entity types to consider when you are starting your small business.
Sole proprietorships are composed of one single business owner. This entity type is the simplest to form, as you don't need to take any legal steps to form your sole proprietorship. As long as you are the sole business owner, the day you start conducting business is the day you become a sole proprietor.
Partnerships, on the other hand, bring together the collective knowledge and skills of two or more people, who will each have a percentage of ownership in the business. With this business entity type, it is not required to file any legal documents establishing your partnership, but it is recommended so that both parties are aware of their roles and responsibilities within the business.
A corporation is a business entity that operates independently from its owners. This means that corporations can be sued, enter into contracts, pay taxes, have assets, borrow money, etc., just as an individual can - but the individual owners will not be liable for their debts, and their personal assets will be protected should something happen to the business.
Limited Liability Corporation (LLC)
A limited liability corporation (LLC) can be comprised of one single owner or multiple owners. This entity type provides greater protection to the business owner because their personal assets are separate from the businesses. Unlike a corporation, the business owners will be responsible for paying taxes, not the business entity. This allows business owners to avoid double taxation because they won't have to pay corporate taxes.
Questions to Ask Before Deciding on Your Small Businesses Entity Type
Before you decide on which entity type will be best for your small business, there are a few things you'll want to consider first. There is no one best entity type when starting your small business; you'll want to decide what is best for you and your business's growth.
Question 1: Will you be the sole owner, or will there be two or more owners?
If you will be the sole owner of your business, then a sole proprietorship or single-member LLC might be a great entity type for your small business.
However, if you plan to have a co-owner or business partner, you won't be able to operate as a sole proprietorship. Their input will be important when considering what entity type is right for your small business - do they feel comfortable operating as a general partnership, or would everyone have more peace of mind with a corporation or multi-member LLC.
Question 2: What level of protection do you need for your personal assets?
This can vary by the industry your business is in and the level of risk you are comfortable with taking on. When you operate as an LLC or a corporation, your personal assets are protected from business debts and lawsuits.
This means that if your business is in a lawsuit, they cannot come after your personal assets if your business entity is structured as an LLC or corporation. Sole proprietorships do not offer this same protection which means that any business debts or lawsuits can come after your personal assets in addition to your business assets.
Question #3: What tax obligations are you comfortable with?
Every business entity has its own taxation requirements. Understanding what these requirements are is important before embarking on your small business journey.
As a sole proprietor, your business earnings will be taxed as your income, so there isn't anything additional you'll need to do come tax season.
Corporations are taxed at both the corporate level and the owner level. They are taxed twice because they are first subject to corporate income tax on their profits, which is then passed onto shareholders when distributed as dividends.
However, as an LLC, there are multiple ways you can elect to be taxed. Depending on the elections that the business owner selected, the IRS can treat an LLC as either a corporation or partnership or as part of the LLC’s owner’s tax return.
Considering these questions ensures that you create a solid foundation for your small business, encouraging smooth collaboration with potential partners and achieving peace of mind knowing that your personal belongings are secure.
What is the Best Business Entity Type for my Small Business?
While there isn't a one-size-fits-all answer, reflecting on the key questions above can help you determine the ideal structure for your company. Consider the level of personal liability you're willing to assume, the tax implications, and the administrative ease of each option.
Keep in mind that the perfect choice also depends greatly on your long-term objectives and aspirations. Ultimately, by carefully evaluating these factors, you'll be well-equipped to make an informed decision that best supports your unique business venture, allowing it to thrive and flourish.
Can you Switch from one Business Entity Type to Another?
Yes, you can change your business's entity type, but depending on which switch you'd like to make, it might not be as easy. For instance, switching from a sole proprietorship to an LLC or corporation is generally less complicated, as you'll be creating a more formal structure to protect your personal assets and potentially access new funding opportunities.
On the other hand, it may be slightly more challenging to switch from a corporation to an LLC due to the different regulations, tax implications, and organizational structures. Nevertheless, no matter the direction, you have the option of altering your business entity to best align with your goals and aspirations. This flexibility in choice reflects the dynamic nature of businesses, so rest assured, you're not locked into one type of entity forever.
Related Reading: Switching from a Sole Proprietorship to an LLC