Starting a Business: How to Choose a Business Entity

You're starting a business. Congratulations! This is an exciting time and you may be feeling overwhelmed about your next steps.

Whether you are going to work with a start-up lawyer or looking to DIY, knowledge is power, and you should always try to educate yourself about as many aspects of your business as possible so that you can go toe-to-toe with your advisors and investors.

The correct legal entity for your business must be evaluated on a case-by-case basis, and largely depends on 4 main factors:

1. _{1. People:} How many are there?
2. _{2. Liability:} What are your liability concerns?
3. _{3. Taxes:} How do you want to pay taxes?
4. _{4. Flexibility:} How much flexibility do you need?

Here’s a breakdown of the most common business types.

Not sure what kind of business to form? A seasoned business attorney can help you select the ideal legal entity structure for your business.

Your attorney will draft the required state documents for filing, satisfy any publication requirements, draft your internal Operating Agreement, Partnership Agreement, or Bylaws, help you file your tax paperwork, and ensure that you have everything in line to launch your operations. Some business attorneys offer flat fee arrangements and quick turnarounds for this service.

What Is a Business Entity?

U.S. and state laws recognize many types of legal entities with rights and obligations under the law:

• People
• Business entities
• Trusts
• Charitable organizations

A business entity is a legal entity organized for the purpose of doing business, just as a trust holds property or a charity does charitable work.

Why Is Business Structure Important?

Different business entity types have different legal rights and responsibilities with respect to the following:

• The owners and investors
• The government
• Third parties, like customers and vendors

These legal relationships determine how owners deal with each other and with outside entities, particularly the IRS.

There is no perfect entity type. Each entity will offer trade-offs among these features:

5 Common Business Entity Types

New York law gives you several options for choosing a business entity type. Bear in mind that not every entity type may be available for your business. For example, a sole proprietorship can only have one owner.

The five most common choices are:

• Sole proprietorship or Doing Business As (“DBA”)
• Partnership
• Limited liability company
• S-corporation
• C-corporation

These entity types have unique formation requirements, along with distinct advantages and disadvantages.

1. Sole Proprietorship or Doing Business as (“DBA”)

A sole proprietorship or Doing Business As (“DBA”) is the easiest type of business entity to form. You simply go into business and list yourself as the business owner. You are the sole proprietor.

You do not need to use your personal name for the name of the sole proprietorship. You can file for a fictitious name, also called a DBA, for your business.

• Advantages of Sole Proprietorships

Some of the advantages of a sole proprietorship include:

• Total control
• Pass-through tax entity so you will not pay double taxes
• Eligible for IRS tax deductions for health insurance and IRAs
• Inexpensive and easy to form and close down

Because of these benefits, sole proprietorships are often used for solo or family businesses.

• Disadvantages of Sole Proprietorships

Since the sole proprietorship acts as the owner's alter ego, they have significant disadvantages:

• Owners assume personal liability for debts and other liabilities
• There are no protections for the owner's personal assets
• Sole proprietorships cannot, by definition, have investors
• A DBA cannot be sold, as you do not have a legal entity to sell

Because of the significant disadvantages of a sole proprietorship, many solo business owners choose to form a single-member LLC or single-member S-corporation instead. These entities provide most of the benefits of a sole proprietorship without many of the burdens.

2. Partnership

A general partnership is also very easy to create. These business structures happen when two or more people go into business together. Each business owner is a general partner. You do not need to file anything with the state or federal government to create a general partnership. But you will usually have a partnership agreement to define the roles of the partners.

Limited partnerships, also called limited liability partnerships, happen when owners start a partnership but elect liability for one or more owners. Limited partnerships differ from general partnerships because one owner of the limited partnership is the general partner and the other owner or owners are the limited partners.

A limited partnership takes more work to create. You must file a document with the state identifying the general partner.

• Advantages of Partnerships

Partnerships have the same advantages as sole proprietorships:

• Simple and inexpensive formation
• Pass-through tax liability onto the partners' personal tax returns
• Tax deductions for business owners for health insurance and retirement accounts

These advantages apply to both general and limited partnerships.

• Disadvantages of Partnerships

The general partners in a general partnership or limited partnership face the same difficulties that sole proprietors do:

• General partners do not have personal liability protection
• The assets of the general partners are at risk

Limited partners do not suffer from these disadvantages; their limited liability gives them protection from the company's debts and liabilities. But the exposure of the general partners makes it difficult to find owners willing to form this business structure.  Typically partners will elect to instead file an LLC or Corporation to manage the partnership, and protect the partners.

3. Limited Liability Company (LLC)

A limited liability company (LLC) has attributes of many other business entities. The members of an LLC form it by filing articles of organization with the New York Secretary of State and paying the state filing fee.  In New York, there are newspaper legal advertisement publication requirements.

• Advantages of Limited Liability Companies

The greatest benefit of this business structure is its flexibility. LLCs can have one owner, like sole proprietorships, or multiple owners, like limited or general partnerships.

Similarly, the LLC operating agreement can set up almost any ownership structure. Thus, certain members might have smaller ownership interests than other members.

Equally importantly, you can set up almost any management structure. An LLC can be member-managed or manager-managed.

In a member-managed LLC, all the members participate in the day-to-day decision-making. In a manager-managed LLC, a manager handles day-to-day decisions and the members vote only on major issues.

Other benefits of an LLC include:

• Limited liability protection for owners that protects the owners from personal liability for the LLC's actions
• Pass-through tax treatment so that profits only get taxed once on the owners' personal tax returns
• Add and remove members easily

These benefits apply regardless of the number of owners, ownership structure, or management structure.

• Disadvantages of Limited Liability Companies

The benefits of an LLC come at a cost. Some disadvantages of LLCs include:

• More costly and complicated to create due to its formal legal structure
• Unwieldy decision-making when the LLC has many owners
• Adding investors can dilute the votes and profits of the original owners
• Owners pay self-employment taxes on their personal tax returns for their entire share of the profits rather than the amount they get paid

LLCs are best for small businesses with only a few owners. As your business grows, you will want to choose a business structure that will allow you to take on investors and shareholders without losing control over the management of your business entity.

4. S-Corporation (S-Corp)

• Advantages of S-Corporations

The greatest advantages of S-Corporations come from their hybrid nature, which is defined by their tax treatment and combine many of the benefits of both corporations and LLCs. These include:

• An S-Corporation does not pay federal taxes at the corporate level. Any business income or loss is "passed through" to the business owners who report it on their personal income tax returns. This means that business losses can offset other income on the shareholders’ tax returns.
• An S-Corporation protects the personal assets of its business owners. Creditors cannot pursue the personal assets (house, bank accounts, etc.) of the owners to pay business debts.
• S-Corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.

• Disadvantages of S-Corporations

An S-Corporation may have some potential disadvantages since its structure falls between an LLC and a C-Corporation. These include:

• Many states impose ongoing fees and annual reporting requirements on S-Corporations that a sole proprietor or a general partnership would not incur (these fees are not expensive and can usually be written off as the cost of doing business).
• An S-Corporation can have only one class of stock and there cannot be more than 100 shareholders. Since there can’t be different classes of investors who are entitled to different dividends or distribution rights, this limits the company's ability to bring in outside investment from angel investors and venture capitalists.
• An S-Corporation is not allowed to carry forward net operating losses (NOLs), which can be a significant concern if the NOLs are large.
• Tax-free fringe benefits (such as accident and health insurance premiums) are not available to the shareholders in an S-Corporation that hold more than a 2% interest in the business.

5. C-Corporation (C-Corp)

Most of the largest business entities in the world are structured as C-corporations. This business structure allows the company to take on a virtually unlimited number of shareholders, making the entity type perfect for publicly traded corporations.

You form a C-corporation by filing articles of incorporation with the state of New York. The default tax treatment for corporations falls under Subchapter C of the tax code. As a result, a corporation will automatically get treated as a C-corporation without filing an election with the IRS.

Nonprofit corporations fall into this category, although they are taxed differently as a 501c3 if they qualify for tax-exempt status.

• Advantages of C-Corporations

C-corporations provide many benefits to their shareholders, including:

• Personal liability protection to insulate shareholders from being held personally liable for the company's actions
• Infinite life
• Designed to take outside investment with unlimited classes of stock and unlimited numbers of shareholders

These benefits are the reason that most publicly traded companies are structured as C-corporations.

• Disadvantages of C-Corporations

The disadvantages of C-corps come from their costs, such as:

• High costs of paying corporate taxes, forming the business structure, reporting to shareholders, and governing the business entity
• Double taxation on corporate profits
• Board of Directors governs decision-making
• Impractical for sole proprietors and small businesses with few owners

Because of the disadvantages of the C-corp business structure, many businesses will start with a different entity type and incorporate it as a C-corp when they grow large enough to justify the costs and business taxes.

What to Consider Choosing the Best Business Entity for Small Business Owners

As you consider business structures for your start-up, you must consider your company's present and future. In other words, think about where you are and about where you expect your business to go.

The factors that you should consider include:

Number of Owners

The number of owners could limit your options for business structures. It could also affect how you plan to manage your business.

If you have many owners, you might want to consider a C-corporation. These business structures are designed for large numbers of shareholders.

If you have a small number of owners, consider a business entity like an LLC or S-corp. These structures will help you maintain control over your business and take advantage of each owner’s talents.

Liability

Sole proprietorships and general partnerships are rare. The exposure to business liabilities creates too much risk for the business owners. Even limited liability partnerships are often too risky for the general partner.

It's usually best to lean toward limited liability business structures. LLCs and corporations protect the personal assets of owners and investors. When a lawsuit happens, typically only the business assets and owners’ investments in the business will be at risk, except in cases of extreme negligence or willful misconduct, such as fraud.

Taxes

A company’s tax liabilities can create a barrier to profitability. A double-taxed corporation might not produce enough return on investment to the shareholders after paying taxes. For small businesses with few owners, a pass-through tax entity will almost always provide tax benefits.

But as the company grows, the bookkeeping burden of a pass-through entity grows. As you add more owners, you should consider converting to a different legal structure even if it may be subject to double taxes.

Flexibility

Your business structure should match your needs. But your needs may change. Consider what you might face during your first few years in business so you can choose a structure that will accommodate your changing needs.

Some structures, like C-corps, are better suited to taking on outside investment. But this entity type has high costs that might not work for start-ups.

Other structures, like LLCs, have low costs and allow you to take on additional members, but the additional members can dilute the profits and voting rights of existing members.

Best Entity Type for Small Business: Final Thoughts

Choosing the best business structure for a small business depends on the owner's specific needs. A business formation lawyer can outline your legal options, explain the pros and cons, and guide you to the right decision.

There is no perfect choice for every small business. As you plan, you should involve a business law firm that understands your needs. Contact Lawyer for Business to discuss your start-up and how you can find the entity type that fits your business.