business entity

A big question for new entrepreneurs is the selection of the business entity. The three most common entities are a sole proprietorship, limited liability company, or S-corporation. All three are different. There is no business entity that works for all. What’s right for one business could be inappropriate for another.

Sole proprietor

It is the simplest form of business entity. In most jurisdictions, the owner acquires a business license and registers the business name. Sole proprietorship works well for many one-person businesses. Many mom-and-pop shops elect this business entity. Only a single person can be a sole proprietor. Either mom or pop will have to be the sole proprietor. In the eyes of the law, only one person is the owner. If a father and son run a business together, either the father or the son would be the sole proprietor. They may run the business as partners, but only one of them is the actual owner of the business. When you select sole proprietorship your business and you are one legal entity. The simplest isn’t always the best. One of the biggest drawbacks of this entity is that it offers virtually no legal protection. For example, your personal assets are at stake if your business fails and you are sued over debts. In terms of taxation, there is no distinction between personal income and business income.

Sole proprietorship Pros:

  • Sole proprietorships are easy to form. If you want very little paperwork, sole proprietorship might just be right for you. It might be great for a side business.
  • Since there are no shareholders you make all the calls, you are in control.
  • There are less government control and bureaucracy to deal with.
  • Taxes are simpler.

Sole proprietorship Cons:

  • You are 100% responsible for all business debts and obligations.
  • If you want investors, they want to deal with corporations.
  • You can create a much more substantial image with a corporation than a sole proprietorship.

Limited Liability Company (LLC)

The LLC is not a federally recognized business entity. The laws regarding LLCs vary from state to state. In most states, LLCs can be formed with a single “organizer” (individual).  Income flows through LLCs and S-corporations. LLCs are considered lower maintenance than S-corporations because they don’t have to maintain corporate requirements. LLCs with one owner don’t have to file separate tax returns for the business. You can add a Schedule C to your personal taxes. LLCs with multiple owners have the flexibility to file as a partnership or a corporation. Yes, an LLC can file tax as a corporation. For tech companies planning to receive multiple rounds of financing with the goal of an ultimate sale, LLCs are not the best option.

LLC Pros:

  • An LLC allows for an unlimited number of members.
  • The members enjoy limited liability. It is not an ironclad protection, but more than that of a sole proprietorship.
  • Your LLC allows for the “special allocation” of profits which means that profits can be handled disproportionately with respect to percentages of ownership.
  • Managing members share of profit is considered earned income.
  • The members’ share of profit is not considered earned income, so it’s not subject to self-employment tax.
  • The managing member can deduct 100% of the health insurance premiums.
  • A corporation can be a member of an LLC which provides an additional layer of protection.

LLC Cons:

  • The managing member’s share of profit is considered earned income and is subject to self-employment tax.
  • As a member of an LLC, you are not permitted to pay yourself wages.
  • An LLC is a newer entity compared to sole proprietorships and corporations and laws and regulations are still evolving.

corporationS-Corporation

S-corporations can have multiple owners. S-corporations must be individuals (not partnerships or corporations) who are U.S. citizens or permanent residents. There are some limitations to the number of stockholders and investors it may have. S-corporations and LLCs have varying methods of accounting for profits from revenue after expenses, and which income must be booked and taxed at what time. C-corporations can book their revenues and profits, but this money is subject to double taxation: once as revenue, and again when it is paid to the owners as income or dividends. S-corps are required to maintain corporate formalities in order to keep their liability protection. They must keep meeting minutes, a board of directors, officers, separate business accounts and records of all business transactions. The shareholders (aka owners) of an S-corp are required to split the income equally among all of the owners. A huge tax benefit of S-corps is that with the Subchapter S election, you have the option to pay self-employment tax (about 15%) on only your reasonable salary as the owner, rather than on the entire net revenue. This can result in big tax savings and is a big incentive to go S-corp rather than LLC.

Corporation Pros:

  • As a business owner, you are – to a larger degree than a sole proprietor – protected from legal liability. As the owner, you limit your liability.
  • As a corporation, you can issue stock which makes your business more attractive to investors.
  • The corporate structure creates a well-defined management structure.
  • You can offer stock options to employees.

Corporation Cons:

  • There is a more substantial time and money investment required for this business entity.
  • You have to follow corporate formalities such as holding regular meetings of directors and keeping records.
  • The profits of traditional corporations may be double taxed, both the corporation and its shareholders are taxed.

I am not an attorney, neither do I play one on television. Check with your attorney prior to making a decision which business entity is the best for you.

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George Meszaros is the editor and co-founder of Success Harbor where entrepreneurs learn about building successful companies. Success Harbor is dedicated to document the entrepreneurial journey through interviews, original research, and unique content. George Meszaros is also co-founder of Webene, a web design and digital marketing agency.