This article is part of The 45-Minute MBA series, where you’ll learn everything you need to know about business to become an effective leader of your organization (in less than 45 minutes of reading).
As a business leader, it’s important to become familiar with the different types of business entities. You probably don’t need to be a legal expert, but you should know the different types of businesses and their advantages (and disadvantages). In this article, I will discuss the various types of business entities and provide an overview of each.
Before I continue, a quick disclaimer: I’m not a lawyer or certified public accountant and nothing I say or write should be considered professional legal advice. If you’re looking for such advice, I recommend consulting with a lawyer or CPA. Thanks!
So…Why start a business?
1. Liability Protection. A business (with the exception of a sole proprietorship) offers its owners liability protection. If the business is sued or goes bankrupt, the owner is not personally liable for the loss.
2. Tax Advantage. Businesses are allowed to “write off” expenses. Your business can pay many everyday expenses as “business expenses” so long as they are needed to run the business.
3. Professionalism. A business provides a professional image. Your customers will take you more seriously if you operate as a business. Banks are more likely to loan money to a business.
Let’s look at the different types of businesses.
The simplest form of business is the sole proprietorship. In this form, there is no legal distinction between the owner and the business. Anyone who has a business without having created a separate business entity with the state is operating as a sole proprietorship by default.
The primary advantage of a sole proprietorship is the ease of set up. Sole proprietorships require very few legal formalities. You just have to register your business name (DBA) with your state.
Another advantage is the owner receives all the profits. There are no partners to split profits with and no corporate taxes to pay. A sole proprietor only pays personal income taxes on the business profits.
A major disadvantage of a sole proprietorship is that the owner is not protected from lawsuits or financial losses incurred by the business; he or she assumes unlimited liability. The owner’s personal assets are at stake when operating as a sole proprietorship.
Another disadvantage is the sole proprietor’s limited ability to raise capital. It is more difficult for an investor to formalize a loan to an individual than to a business entity such as a corporation or LLC.
Sole proprietorships are most advantageous to entrepreneurs such as freelancers (writers, web designers, photographers, etc.) who have limited exposure to potential liability and a limited need for capital. Upfront costs and legal obligations (such as shareholder meetings and annual reports) are minimal. It’s the cheapest and easiest type of business to start.
Corporations (C-Corporation, S-Corporation)
A corporation is a distinct legal entity that can open a bank account, borrow capital, buy property, and conduct business, all under its own name. The board of directors (who are elected by the shareholders) chooses a team of officers responsible for running the day-to-day operations of the company.
The primary advantage of a corporation is the owners are not personally responsible for its debts and liabilities. If the corporation goes bankrupt, the creditors cannot (in most cases) recover the loss from the shareholders, directors, or officers.
Corporations can also provide benefits such as retirement plans and medical insurance. They have greater limits for retirement and life insurance contributions than the other types of business entities. They also have greater access to capital from banks because they are a widely recognized type of legal entity.
C-Corporation vs. S-Corporation
There are two types of corporations: C-Corporations and S-Corporations. The difference between the C-Corp and S-Corp is the tax structures. The C-Corp faces double taxation meaning the corporation itself pays taxes before dividends are distributed to the shareholders. The shareholders then have to pay personal income tax on the dividends (this is a “double taxation”). In an S-Corp the profits pass through the business to the shareholder directly without being taxed (i.e. there is no corporate tax). The shareholder only pays personal income tax on the dividend received.
An advantage of the C-Corp over the S-Corp is the ability for the owner to “income shift.” If the owner of the corporation pays a higher personal income tax rate than the company’s corporate tax rate, he can choose to retain the earnings in the corporation and pay the lower corporate tax on the business’ earnings. This strategy is relevant to smaller companies that pay a low corporate tax rate.
Limited Liability Company (LLC)
Like a corporation, an LLC is a legal entity offering its owners protection from the potential liabilities of doing business. LLCs have become extremely popular because of their hybrid structure. They combine the personal liability protection of a corporation and the tax advantages of a sole proprietorship, S-Corp, and partnership. An LLC is taxed as a pass-through entity meaning that the profits only get taxed once (there is no corporate tax).
Advantages of an LLC (over a corporation):
1. LLCs have fewer corporate formalities. They are not required to hold regular meetings of the board of directors or shareholders, keep written minutes, or file annual reports with the state.
2. LLCs don’t have ownership restrictions. S-Corps are limited to 100 shareholders and each shareholder must be a U.S. resident or citizen.
3. Members of an LLC are able to place their membership interests in a living trust.
4. Deduction of losses. Members of an LLC can deduct their operating losses from their personal income (to the extent permitted by law).
5. Tax flexibility. An LLC is treated as a pass-through entity meaning profits are only taxed once. Or an LLC can be taxed like a C-Corp if that is more advantageous.
Disadvantages of an LLC:
1. Salaries and profits of an LLC are subject to Medicare and Social Security taxes, which today are a combined 15.3%. With a corporation, only salaries (not profits) are subject to these taxes.
2. Owners must immediately recognize profits. A C-Corp does not have to immediately distribute dividends to its shareholders. This means Corporations’ profits are not always taxed.
3. Unfavorable state taxes. In some states (like California and New York), an LLC must pay higher taxes and fees than a corporation of the same size.
4. Fringe benefits. Employees of an LLC who receive fringe benefits such as health insurance must treat these benefits as taxable income; C-Corp employees do not.
LLC vs. Limited Liability Partnership (LLP)
LLCs and LLPs have many of the same characteristics. In terms of formation, LLCs and LLPs are essentially the same. Both LLCs and LLPs are created by filing Articles of Organization with the appropriate state government agency, typically the Secretary of State. Both types of entities offer similar legal protection to the owners.
Note: the owners of an LLC are called “members” and the owners of an LLP are called “partners.”
The tax benefits are also similar for LLCs and LLPs. Profits “pass through” the entity to the owners without being taxed.
So why form an LLP?
In some states, local laws prevent some businesses from operating as an LLC. One reason large law and accounting firms operate as LLPs is they can form this entity in any state.
Are you ready to form a business?
Legal Zoom is a service that enables you to easily form a business entity online. I recently went through the process of setting up an LLC and it took about 15 minutes from start to finish. It was almost as easy as creating an email address (although a bit more expensive). Prices start at $99 (for the economy package) plus state filing fees. The only information you need is your company name, names of members, and business address. You fill out a questionnaire and Legalzoom takes care of the rest! This is a simple and straightforward way to set up your business quickly and efficiently.
If you’re interested in setting up an LLC (or any type of business) you can find out more here.
I hope you found this information helpful. Setting up a business can be intimidating, but there are tons of resources available to help. If you have any questions or anything to add, I’d love to hear from you in the comment section below.
Update: The 45-Minute MBA eBook is complete! Click below to download…
Thanks for reading and have an excellent week.