Starting your own business can be an equally scary and exciting time. It’s a time for making big decisions that can have a lasting impact on the success of your organization and even the course of your life. Arming yourself with the necessary information will help to ensure you make the correct decisions to set your business up for success.
We don’t want to brag, but we’re basically the small business tax services equivalent of Superman (minus the pecs and effortless flight). You’re already swimming in a sea of unfamiliar jargon that’s probably your own personal Kryptonite. We’re here to save the day by making some sense of it. Today, let’s tackle entity types. What does entity type mean anyway? And how can it impact your business? Let’s find out.
What Does Entity Type Mean?
You may wonder what an entity type is or at least want a little more insight than you already have. Business entities are organizations created to conduct business or engage in trade. An entity type is simply the legal structure of your organization.
Why is entity type important?
Your entity type is important because of its potential legal and financial implications. Entity type determines how much you pay in taxes for the organization and your legal liability if your company comes under fire from litigation. Your business’s entity type also impacts your share of the profits and the growth potential for the organization, such as how easy it is to get a small business loan or to secure investors. Choosing the right entity type for your business will set you up for success while minimizing potential risk for you and other executives.
When do business owners define entity types?
Deciding how to categorize your business is one of the very first decisions you’ll make as a new business owner. You’ll define your business entity type early when registering in your business’s home state. Your entity type informs the income tax return you’ll have to file, so you’ll also need a tax ID number plus any applicable licenses and permits.
Need help defining your business entity? Consider small business tax services to get a better handle on your business from a financial perspective.
Types of Business Entities
U.S. state governments recognize many different legal entity types, but most small businesses incorporate under one of five entity types: sole proprietorship, partnership, C corporation, S corporation, or limited liability company (LLC).
Sole proprietorships are the simplest form of a business entity in which the business has a single owner: you. As the sole owner and operator, you personally take on all financial responsibility and legal liability for the business. Forming a sole proprietorship happens automatically when you begin selling goods or services; it requires no formal paperwork or registration. You record profits and losses for the company in your personal tax documents at the end of the year.
Example: If you run an auto repair business on your own, with no employees or shared responsibility, you’re a sole proprietor.
Of course, this entity type has its highs and lows. On the plus side, you don’t have to file a wide variety of reports with the government, and you call all the shots—from keeping all profits to shuttering the business at your discretion. But it’s also harder to raise capital, and you assume 100 percent liability.
Partnerships are a separate entity type and fall under one of two groups: general partnerships (GP) or limited partnerships (LP).
GPs are similar to proprietorships in that they start automatically alongside business operations and typically don’t require formal registration with your state government. With a partnership, all founders are personally liable for legal action against the partnership, and you report profits on personal tax forms.
Example: You and your long-time friend start a catering business with equal stakes and liability for successes, failures, and legal needs.
LPs are different in that some founders have personal liability, while limited partners have little to no liability. This makes it easier for business founders to bring on investors without giving over control of their business. Unlike GP entities, you must formally register LPs and file with your state government.
Example: You, your brother, and a former colleague open a new law firm together. You and your brother hold majority ownership, and consequently, all liability for successes, failures, and legal needs. Your former colleague and new partner is a partner in name only and does not share in any liability.
What’s appealing about partnerships is that you get decision-making and creative support and more capital. But it’s also challenging because of the liability burden and because you share authority with someone and won’t always agree.
C corporations are legal entities independent from their founder(s). This means the business itself is liable for legal action, while the founder(s) and owner(s) are legally separate from the organization. Filing as a C corporation requires that you adhere to additional governance, such as holding board meetings and creating company bylaws. Taxation occurs twice for C corporation owners: The business is taxed and so are personal earnings from company dividends.
The plus side to operating as a C corporation is that the business is perpetual and can be passed on to heirs—not to mention that individual liability is limited to however much each person invested. But you do face double taxation and must obtain a corporate charter from your state.
S corporations take advantage of reduced personal liability afforded to C corporation owners minus the double taxation. But there’s a catch. S corporations can only have 100 shareholders, reducing your ability to grow compared to C corporations.
What’s nice about operating as an S corporation is that it’s simple for stockholders to sell off their shares of the business or even go all in and raise capital to expand the company. But S corporations are limited. They’re only legally allowed to operate in the state specified by the corporate charter unless you otherwise obtain permission.
Limited liability company
Limited liability companies (LLCs) provide owners the flexibility to choose how their business is taxed. LLCs are separate legal entities from the owner, and profits flow through to the owners who recognize that income on their personal tax returns. Regulations concerning bylaws and board meetings don’t apply to LLCs, making LLCs appealing to most small-business owners.
LLCs are among the most appealing entity types because they provide freedom and flexibility. For one thing, the world is your oyster when it comes to customizing the structure of the business, plus you can’t be held fully liable if things somehow go wrong. But LLCs are also strict, needing 360-degree operating agreements because of how flexible other aspects of the business are.
Picking the Entity Type that Fits You Best
GP? LP? LLC? What does entity type mean for the future of your business? Choosing the right option sets you up for success by giving you the right amount of room to grow while mitigating personal risk.
Need help navigating the financial side of your small business? Ignite Spot is ready and waiting to partner with you. We’ll provide you with guidance throughout each phase of your business, from founding day to your 1 millionth sale. Contact us today for your free tax consultation, and learn more about how we can help you thrive.