If your small business needs financing, you will need to be able to describe what kind of business entity you own. Our content partner Nav explains the differences between the main types of business entities.
If your small business needs financing, you will need to be able to describe what kind of business entity you own. Our content partner Nav.com explains the differences between the main types of business entities.
Late comedian and actor Milton Berle famously said: “If opportunity doesn’t knock, build a door.” While about 124 million Americans are classified as full-time employees, over 23 million Americans have decided to operate their own business, which is basically “building their own door” rather than waiting for opportunity to knock.
As you set out to “build your own door,” you will be faced with a variety of tasks that must be completed upfront, such setting up your business bank account, finalizing your business plan, making growth projections, constructing your capital structure, and more. You must also decide which business entity to use to structure your business.
Some entities protect you from the liabilities of the business, while some don’t, so understanding all of the business entities are essential to your planning. Here’s a look at sole proprietorships, partnerships, corporations, LLCs, nonprofits, and co-ops.
The Sole Proprietorship
The sole proprietorship is a business entity that actually does not require incorporation, state filings, etc., which makes the accounting-related expenses for this entity very low. This entity structure is basically set up the moment a business owner just “decides” they are ready to go into business (unless there is any specific industry licensing that’s required). There’s only one owner in this entity, and all profits/losses are passed through to the owner’s tax return. However, there’s no liability protection for the owner against potential debts, lawsuits, and other obligations of the business, which means the owner can be sued personally for said commercial obligations.
The General Partnership and Spin-off Partnerships
The general partnership is a business entity that does not require incorporation, state filings, etc., which makes the accounting-related expenses for this entity very low. The structure is set up the moment two business owners decide they are ready to go into business (unless there is any specific industry licensing that’s required). All profits and losses are passed through to the tax return of the owners, based on their share of ownership. There’s no liability protection for the owners against potential debts, lawsuits, and other obligations of the business, which means one owner can be sued personally for wrongdoing coming from the acts of the other owner. There are also two additional types of partnerships:
- The Limited Partnership has just about all of the general partnership characteristics, except that it also allows for the addition of what’s known as “limited partners” who can invest in the business model to share in profits, but have no say in the day-to-day operations of the business, nor are they liable for any debts/obligations. The actual general partners would still run the day-to-day operations and still be held liable for the debts/obligations of the organization, just like in the traditional general partnership structure.
- The Limited Liability Partnership (LLP) has most of the characteristics of the general partnership, except the general partners are actually afforded liability protection from the debts and obligations of the organization. Creating this entity requires state registration.
The C-corporation is a traditional incorporation structure, with no limit on the number of shareholders and is the best entity to use if you might issue stock later on. The entity provides liability protection to the directors, shareholders, and officers, along with excellent tax benefits and higher levels of credibility with prospective suppliers/financiers. However, the C-corporation is the most expensive entity to start, there’s a potential of double taxation, and required corporate formalities are extensive, which increases accounting-related costs.
Owners of the C-corporation can be non-U.S. citizens, and the C-corporation can be owned by another business. You should use this structure if you have growth projections of sales going over or near $7 million to $10 million in revenue, and if you might potentially issue stock for further growth.
The S-corporation brings liability protection with excellent tax benefits, without having the owners of the corporation go through potential double taxation as the C-corporation, because profits/losses are passed through to the owners (shareholders) of the S-corporation. However, unlike the C-corporation, there can only be up to 100 shareholders within the S-corporation at one time and issuing stock isn’t as efficient with this entity as it is with the C-corporation.
Also, accounting-related expenses will be high with this entity, as S-corporations have many of the same required corporate formalities as the C-corporation. You should use the S-corporation if you believe you will mainly operate a small business without the need to issue stock, with under $5 million in annual revenue, and with less than 100 owners of the organization.
The Limited Liability Company (LLC)
The LLC provides liability protection to the owners along with excellent tax benefits, and without the potential of double taxation as profits/losses are passed through to the owners of the LLC. However, unlike the C- or S-corporations, an LLC does has few required corporate formalities, such as the need to record minutes or hold meetings, thus, using this structure will save you significantly on accounting costs. In addition, there’s no limit on the number of owners within an LLC, owners can be non-U.S. Citizens, and the LLC can be owned by another business. You should use the LLC if you believe you will mainly operate a small business with under $5 million in annual revenue and without the need to issue stock. There’s also another type of LLC structure in existence, called The Series LLC.
- The Series LLC is basically multiple, independent, and separate LLCs filed under one main business entity structure (hence the name, “Series LLC”). This structure might be used by holders of real estate where the owner wants to hold each individual property in its own separate LLC, so the debts/obligations of one property doesn’t do harm to the other properties.
The nonprofit is an organization that’s formed not to generate profit, but instead to carry out some intended purpose within either an educational, religious, charitable, literary, or scientific category. If a nonprofit applies for and is approved as a 501(c)3, then it will be exempt from taxation. Nonprofits raise money for their intended causes through seeking foundation or other sources of grant money, as well as through requesting direct donations from a donor base in which said donors can deduct their donations if the nonprofit is a 501(c)3. If your business is one that looks to carry out a specific type of community development-related cause rather than generate a profit, then the nonprofit is the best entity choice–especially if you can achieve 501(c)3 tax-exempt status.
With a co-op, the operators of the business, along with members or clientele of the business, all share in a portion of the profit stream. The organization is seen more as a “let’s work together” type of deal, with a focus on sharing the success of the organization with all those involved in its progression.
This article originally appeared on Nav.com and was re-purposed with their permission.
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