Learn the Differences Between Each Legal Business Entity Type
Your individual state will register your legal business entity, and it’s important to understand that not all states recognize every business entity type. The descriptions below are meant to give you a basic understanding of the differences between entities, but you should check with your local government to see which type of business designation is right for your new venture.
Most small businesses choose the legal business entity of a “sole proprietorship”, where one person is the only “owner” of the business. Legally, there is no difference between you and your business, and while this business entity type is preferred by some because of the ease in setting it up and registering it, there is a greater legal risk assumed by the owner of a sole proprietorship. For example, if someone sues your business for infringement or fraud, they will be suing you, and your personal assets will be on the line if the case is taken to court – a disadvantage to this kind of legal business entity. This type of situation is rare to be sure, but from a business standpoint, it has the potential to be a risky move.
An advantage of this entity is the fact that you’re the only owner! You can make your own business decisions without having to consider the opinions of a board of directors, or other stakeholders. You receive 100% of the income from your business, and are free to file your profit on your individual tax return at the end of the year – a huge advantage to choosing this legal business entity type.
As the name implies, a partnership is an entity in which two or more people own a business together. Just like a sole proprietorship, there is no legal difference between the owners / members of a partnership and the business itself. As previously stated, choosing this legal business entity can have potentially negative consequences if someone were to file a suit against you or your business. An entity type of this sort carries an additional risk because of the added element of another person. For example, let’s say your business partner did something illegal and the court has decided to penalize your business assets because of his or her mistake. Although you have done nothing wrong, the whole business may be at risk of going under because of the partnership liability. Again, although this is rare, it is important to consider when choosing this kind of legal business entity. Types of considerations like this can protect your investment in the long run.
Speaking of investment, an advantage to a partnership is the ability to raise more funds with the influence of more people. Instead of having to shoulder all of the capital upon startup yourself, a partnership can help business owners divide the cost of operational expenses. And of course, because you’re sharing costs, you and your partner(s) will have to share profits as well. A benefit of this kind of legal business entity is the financial ease achieved by being able to file your profits under your individual tax return at the end of the year.
When starting a partnership, it is important to draw up a legal agreement detailing how costs and profits will be shared, what to do in the event of a partner wanting to leave the business, how to settle disputes about business strategy, etc.
Unlike sole proprietorships and partnerships, where the owners are legally the same as their business, corporations offer business owners a unique legal and tax benefit in the sense that corporations are granted their own legal status. Therefore, this business entity type is considered as a separate legal business entity from you, your partners, and your shareholders. If your business were to be sued, it would not put you or your personal assets at any risk. So wait…who are shareholders? Whereas you’re an owner / operator / member of your sole proprietorship or partnership, you become a shareholder in a corporation, because this type of business operates with stock, or partial ownership distributed amongst several people. As a shareholder, you “own” a part of the business, but you also have to routinely answer to a board of directors who steer the direction of the company.
The downside to the legal business entity of a corporation is that you have less individual freedom to make executive business decisions, and you are not in total ownership of your business. This business entity type is more difficult to begin and dissolve, and often must comply with a series of complex federal and state regulations and taxes. However, the obvious benefit to this type of legal business entity is that you have more individual legal protection with the separation of yourself from your business in the event of a lawsuit.
Limited Liability Company (LLC)
Finally, a Limited Liability Company (LLC) is a sort of combination of all of the above business structures. Like the “corporation” business entity type, an LLC offers a legal distinction between a person and their company, but like a sole proprietorship or partnership, it offers the owner or member (we’re back to being called members now) control over business decisions, tax breaks, and offers no stock option. There is no limit to how many members an LLC may have, and it is also possible to just have one member. The obvious upside to this type of legal business entity is that it provides the best parts of both worlds, corporation and non-corporation, but the downside is that it is more difficult to file than a partnership (but is still less difficult than forming a corporation). To date, the federal government does not recognize an LLC as a classification when you file your federal taxes, so you must file either as a sole proprietorship, partnership, or corporation.
So What do I do Now?
As with any kind of legal decision, deciding which business entity type is right for your business is a big decision that requires a lot of thought. This is just an overview of the primary differences between each major legal business entity, so before making a decision, check with your lawyer or accountant to decide which is best for your financial and business interests. It seems complicated at first, but once you get registered with the state, you’ll be on your way toward owning and operating your own business!