How Do Business Entities Differ From One Another?
Are you a new business owner or aspiring entrepreneur trying to figure out the differences between business entities? The similarities and differences are important to understand, as choosing one entity over another might make more sense for your business and goals.
A business entity is an organization formed by one or more persons in order to conduct business, partake in a trade, or engage in other similar activities. The type of entity you choose determines which income tax return form you have to file as well as what you or the business are liable for.
One of the first steps to creating a business is choosing a business entity. Sometimes this is referred to as “business structure.”
The type of business entity you use will impact many different aspects of your business, from what taxes you pay and how much you end up paying to how much paperwork you have to complete to what you are personally liable for.
In this article, we will take a general look at the differences between business entity types as well as the legal and tax considerations for each.
We will also focus on the importance of structuring your business to take on venture capital in the future. This is especially critical if you are planning to start a lab or facility that will be investing heavily in research and development (R&D) in the early-stages of the company, as you may need to rely on multiple funding rounds to continue your research.
This article is informative. It is not meant to represent legal advice. Before forming a business entity, it is best practice to check the laws in your state to understand exactly how each entity is treated, as the state laws may vary. Plan on checking in with your CPA as well for their advice regarding business entity formation.
Types of Structures & Why They Matter
First, let’s review some of the common business structures and why they matter. In general, these include:
- Sole proprietorships
- Limited Liability Companies
One of the major differences here is that sole proprietorships, partnerships, LLCs, and S-corporations are categorized as pass-through businesses, unlike C-corporations. As business structures, they are commonly used to avoid double taxation. Pass-through entities are not subject to the corporate income tax. Instead, the members or owners include their share of profits as taxable income in their personal income tax.
As a founder, you have to ask yourself: What are my business goals? How do they impact my decision on deciding what type of business entity I form? Should my partners and I form a simple partnership or should we form an LLC or corporation? ?
The business entity you choose may impact you immediately. If you choose to operate as a partnership or LCC, you might have more difficulty raising outside capital from angel or venture capital investors. But, no entity choice is immutable. If you and your partners decided to form an LLC now, you will still have the ability to convert to a C-corp later on.
A sole proprietorship–also known as a sole tradership, individual entrepreneurship, or proprietorship–is a type of enterprise owned and run by one person. There is no legal distinction between the owner and the business entity.
This does not necessarily mean that the sole trader works alone. Many founders employ other people while operating as a sole proprietorship.
If you operate as a sole proprietor, it means that your net business income or loss is combined with your other income and deductions and taxed at individual rates on your personal tax return.
You may need to make quarterly estimated tax payments if you expect to make a profit, as sole proprietors do not have taxes withheld from their business income. Additionally, you must also pay self-employment tax on the net income reported.
Some pros of sole proprietorships include:
- Easy to start (no registration required with the state).
- Business losses can be deducted from personal tax returns.
- No corporate formalities, paper requirements, or meeting minutes, bylaws, etc.
- Filing your taxes is simple. Fill out and attach Schedule C-Profit or Loss From Business to your personal tax return.
However, there is no separation between yourself and the business, which makes it harder to raise funds from lenders or investors. You are fully responsible for all debts and liabilities. And without being a registered business entity, it is more difficult to build business credit.
Simply put, a partnership is a type of business entity comprising two or more partners who run their business together, typically in line with the terms of a partnership agreement. The easiest way to start talking about partnerships is to discuss the types of partners. This includes general partners and limited partners. General partners do the work, manage the business, and make business decisions, while limited partners are more passive, investing in the business while skipping the day-to-day operations.
The three most common types of partnerships include:
- General partnership (GP)
- Limited partnership (LP)
- Limited liability partnership (LLP)
All partnerships are taxed as pass-through entities–meaning that each partner reports a share of business profits and losses on his or her individual tax return–and the business itself is not subject to income tax at the corporate level. Where types of partnerships start to differentiate is how much liability partners want to be on the hook for.
A general partnership (GP) is typically a for-profit entity created by a mutual understanding between two or more individuals. You’re not required to register with the state, nor are you required to sign a formal agreement.
Unlike other partnerships, GPs do not offer any personal liability protection. Each partner is on the hook for any debt or legal obligations.
Firstly, GPs are easy to form and low-cost to run. No state registration means you don’t pay for the costs or ongoing registration fees of forming a business entity.
Secondly, you have solid tax flexibility. Partnerships can ask to be taxed as a corporation using Form 8832: Entity Classification Election.
Lastly, you can have corporate partners. Similar to an LLC or LP, GPs can be owned by individuals and/or corporations. However, the lack of liability protection is typically considered a large drawback.
A Limited partnership (LP), on the other hand, does provide some legal protection. LPs must include at least one general partner and one limited partner, and are structured to legally protect the limited partner regardless of their financial contributions or ownership percentages.
This can make the business more attractive as an investment opportunity to the limited partner, especially if they prefer to avoid the risks involved in running the business. Limited partners are sometimes referred to as silent partners.
On the other hand, a general partner typically manages the business and makes many of the business decisions without needing to consult the limited partners involved. However, the general partner does not receive the same legal protection a limited partner does.
Nonetheless, forming an LP is advantageous to general partners because they are able to retain decision making power while benefiting from the financial contributions of the limited partner. Furthermore, corporate partners can be involved as a limited partner, giving general partners more opportunities for other investors.
A major drawback of a limited partnership for limited partners is that they do not have much control over the business decisions of the company. If they wish to become more “involved”, then there is a possibility that they may have to forgo their limited partner status.
Limited Liability Partnerships
Limited liability partnerships (LLPs) are similar to general partnerships in that the only type of partners are general partners (there must be at least two involved). However, they do provide you with some limited personal liability. The degree of liability can vary depending on the state, so it’s a good idea to check in and see exactly what professions in your state can form an LLP.
One major benefit of an LLP is that, unlike other types of partnerships and depending on the state you’re in, partners in an LLP can have both liability protection from the business’s debt and other partners’ negligence. This type of partnership also provides management flexibility, allowing partners to determine exactly how much they wish to be involved in both operations and management, without affecting their liability.
A major drawback is that this type of partnership may only be available to certain professions, depending on the state. LLPs cannot change their tax treatment either, and can only be taxed as a partnership. Lastly, LLPs cannot be owned by corporations, only by individuals.
Limited Liability Company (LLC)
An LLC is seen as a type of hybrid business structure. It’s allowed by state statute, and is an attractive option for small business owners due to the fact that LLCs offer both the limited liability features of a corporation and the tax efficiencies–as well as operational flexibility–as a partnership.
Owners of an LLC are referred to as members. Most states do not restrict ownership, meaning there is no limit as to how many members can be a part of the LLC. In other words, “members” can include not only individuals, but corporations, other LLCs, and even foreign entities. This
LLCs are not typically taxed as a separate business entity. Instead, the income and losses are distributed down to the individual members who then report those incomes and losses on their personal tax returns, paying the company’s taxes that way. However, depending on elections made by the LLC and the number of members involved, the IRS treats an LLC as either a corporation, partnership, or as part of the LLC owner’s tax return. A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it elects to be treated as a corporation.
LLCs can be a good choice for medium- or higher-risk businesses, as well as founders with personal assets they want to protect or who want to pay a lower tax rate than they would as a corporation.
Like an LLC, a corporation is a type of business entity that’s separate from its owner(s). It has its own legal rights, independent of its owners, meaning it can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks. Corporation filing fees vary by state and fee category.
Unlike sole proprietorships and partnerships, certain corporations have to pay income tax on their profits, known as corporate tax, and owners of the corporations pay taxes on corporate income distributed to them as dividends. This is referred to as double taxation, and most commonly affects C-corporations.
Despite the downside of double taxation, a major benefit of forming a corporation is that the business can raise funds through the sale of stock, which can also be used to attract employees.
Corporations can be an excellent choice for medium- or higher-risk businesses that need to raise money, as well as businesses that plan to go public or eventually be sold.
There are several variations of corporations, including:
- Closed corporations
- Open corporations
- Non-profit corporations
Some of the advantages of the corporation business structure includes:
- Limited liability. Owners (also referred to as shareholders) are not personally liable for claims against the corporation. In fact, they are only liable for their personal investments.
- Capital. It’s much easier to raise large amounts of capital from multiple investors when your business is incorporated.
- Continuity. Corporations are not affected by the transferring of shares by the owners. The business continues to operate indefinitely, which is preferred by investors, creditors and consumers.
The incorporating process is straightforward. You choose a company name and entity type. In this situation, that’s a corporation. Or, more specifically, perhaps you choose a C-corporation.
Next, if you aren’t located in the state you operate in, you have to select and contact a registered agent who acts a liaison between your corporation and the state you are incorporated in. However, if you operate in the state you’re incorporated in, then you can act as your own registered agent.
Finally, you file a Certificate of Incorporation, or articles of incorporation, which are used to document the formation of a corporation.
The two types of corporations we will focus on are C-corporations (C-corps) and S-corporations (S-corps).
A C-corporation, or C-corp, is a type of business structure that exists separately from the company’s owners, and can protect the owners/shareholders from being personally responsible for any business debts or liabilities. It can have an unlimited number of owners as well as multiple classes of stock: preferred and common. Corporations, not just C-corps, also includes a formal board of directors, which can be made up of different people depending on the corporation’s bylaws.
Unlike an S Corporation or an LLC, it pays taxes at the corporate level. This means it is subject to the disadvantage of double taxation. As well, a C-corp also must comply with more federal and state requirements than an LLC does.
Nonetheless, C-corps are a good option for small business owners looking to attract venture capital and other types of equity financing, as VC investors prefer C-corporations over S-corps and LLCs for a number of structural reasons. Distribution of profits and losses becomes untenable when too many limited partners are involved. If you’re interested in becoming venture-backed, you will likely have to incorporate as a C-corp.
One of the major differences between an S-corp and a C-corp is taxation. Unlike C-corps, S-corps are not subject to federal income tax. Instead, the company’s shareholders pay federal income tax on the taxable income of the S-corp’s business, which is based on their pro rata stock ownership.
If you choose to form a corporation, it is considered a C-corp by default. If you’d like to be designated as an S-corp, you have to file Form 2553. It may not be the only form you must fill out in order to remain an S-corp. But by choosing to form an S-corp, you inform the IRS that you wish to be taxed as a partnership instead of a corporation. This can accomplish a few things.
Firstly, it can help you avoid double taxation. Owners only need to report business income and loss on personal income tax returns. Furthermore, owners of the S-Corp can deduct up to 20% of their business income on their personal tax returns. Secondly, if you do form an S-Corp, you may have the opportunity to write off your business’s losses on your personal tax return as well.
It is important to note that forming an S-corp is more complicated than forming a C-corp. There is less paperwork you need to file if you are simply incorporating.
Which Business Entity is Best for You?
It’s clear how important and impactful choosing a business entity is. And although there are many options to choose from, the factors you should consider remain the same:
- Capital Investment
Determine the direction you’d like to take your business in. Figure out how complex you’d like your business structure to be. Consider what level of personal liability you’re comfortable with. Understand how much control you may give up or retain. Decide how you’d like to pay your taxes. And all plan for fundraising options, now and in the future.
Excedr covers the intersection of science and business. However, our articles are only meant to be informative. Before making any legal or financial business decisions, you should consult with a professional who can advise you based on your individual situation.