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How to Choose Your Small Business Entity

Posted by Annie Norris to inDinero Academy, Accounting, Business Advice

The entrepreneurs I talk to are, without exception, smart, motivated, energetic people. They are full of ideas for life-changing products and services and plans for the future. But at some point, nearly all first-time business owners get stuck by a question: “What type of entity should my small business be?”

This may not be the most fun part of starting the business, but it shouldn’t be painful either. If terms like S corp, C corp, and sole proprietorship make your head spin, you’re definitely not alone.

This question is so common that I decided to put together an article to easily explain the different types of entities that work for most small businesses.

Before you go setting anything in stone, you’ll definitely want to consult with a business attorney (we know some really good ones), and every state has different rules for incorporating small businesses entities. That said, the majority of companies of any size are incorporated in Delaware because of a few unique advantages that state offers.

Types of Small Business Entities

Sole Proprietorships

A single man illustrates sole proprietorship small business entity
A sole proprietorship sounds like what it is—a business owned by a single person. In the eyes of the law, you are the same as your small business entity. Many small businesses start as sole proprietorships because they are are simple and inexpensive for one owner to set up.

Pros of a sole proprietorship:

  1. It’s easy and not expensive.
  2. All business income and losses are reported and taxed on your individual income tax return.
  3. Profits directly flow into your personal tax return, so you won’t need to file separate business taxes.
  4. The business is easy to dissolve.

Cons of a sole proprietorship:

  1. You have total liability and are personally responsible for all debts.
  2. It is impossible to issue capital in order to raise funding, and you have to rely on loans.

General Partnerships

Image of two women illustrates the general partnership small business entity
A general partnership is an easy way for two or more people to share a small business’s responsibilities, profits, and losses. If you choose this route for your small business entity, make sure you have a legal agreement that spells out how company decisions will be made.

Pros of a general partnership:

  1. It’s simple and inexpensive to set up.
  2. There’s a shared financial commitment.
  3. All business income and losses are reported and taxed on your individual income tax return.

Cons of a general partnership:

  1. Partners are personally liable for business debts and liabilities.
  2. Each partner is also liable for the debts incurred by other partners—so choose your partners carefully.
  3. The only way to raise funds is by taking out a loan or taking on more partners.

There are also other types of partnerships for partners who don’t want to share liabilities and decision-making equally.

Limited Liability Companies

Image of a bright, fancy office space to illustrate the LLC small business entity

Every state has different rules for limited liability companies, which can be confusing. But there are definite advantages for small businesses to incorporate as this type of entity.

Pros of an LLC:

  1. All business income and losses are reported and taxed on your individual income tax return.
  2. LLC members can deduct any business losses from personal income tax returns.
  3. Members are typically not held personally liable for company debts that they have not personally guaranteed. (So, unless you’ve committed fraud--please don’t--your savings account and house will probably be protected if the LLC goes bankrupt or gets sued.)

Cons of an LLC*:

  1. If you want to give an employee equity, you’ll have to make that person a partner.
  2. Accelerators like Y Combinator or DreamIt usually want their members to be corporations (see below), so that they can easily be granted equity.
  3. Venture capitalists also prefer to invest in corporations rather than LLCs.

*For these reasons, many LLCs eventually convert to a corporation.

Corporations

people looking out of a glass office building illustrates C Corporation and S Corporation small business entity

According to the law, a corporation is a completely separate business entity from its owners.

Advantages of incorporation:

  1. You will be more appealing to venture capitalists and other investors, as well as business accelerators.
  2. Shareholders have only limited liability for the corporation’s debts.
  3. Shareholders are only accountable for their investment in the stock of the company.
  4. Corporations can raise additional funds through the issuance of stock.

Disadvantages of incorporation:

  1. It takes more time and money.
  2. You are monitored by federal, state, and some local agencies and may have more paperwork.
  3. You may have higher overall taxes—the company is taxed at a corporate level, and then profits are taxed again when they are issued to shareholders.

The Difference Between an S Corp and a C Corp

You may have heard of S corps and C corps. So what’s the difference?

C corps are the default type of corporation, and the business is taxed separately from any employee’s or shareholder’s income.

An S Corp is a tax election status that enables the shareholders to treat the earnings and profits as distributions and have them pass directly through their tax return. For companies that meet the requirements, this is a big tax advantage!

accounting terms

About the author
“Annie

Annie Norris

Annie Norris has a lot of fun collaborating with fast-growing companies to get closer to a world free from pencil pushing. Growth hacking, sunrises, and sunsets are three of her obsessions.

Success starts when you take charge of your finances.

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