Which Entity Structure Should You Choose to Incorporate a Small Business?

by Deborah Sweeney

There are a lot of entity structures to pick from when you decide to incorporate a small business. It’s easy to struggle with finding the formation that feels like the right fit. Some entrepreneurs may feel so overwhelmed that they decide not to incorporate their startup.

Keep calm and always incorporate! Certain entity formations are frequently used to incorporate small businesses across multiple industries, like the ones listed below.

• Sole proprietorship
• Limited liability company (LLC)
• S Corporation
• Partnership

How do you know which entity is a fit for your company? Let’s examine what it means to incorporate as each entity and which types of businesses are best suited for the business structure.

Sole Proprietorship

How does this entity work? A sole proprietorship allows the owner of the business to be the boss. They take full responsibility for everything that happens to the business. There’s not much paperwork involved to set up a sole proprietorship, making it one of the easiest and most affordable entity formations.

Sole proprietorships are a fit for… Any entrepreneur who wants to call the shots of their small business on their own. Sole proprietorships are also ideal for companies where there is little to no liability risk involved, or startups that are still testing out their business ideas.

Keep in mind… There is no separation between the owner and the business entity in a sole proprietorship. The owner takes full responsibility for everything that impacts the company, good and bad. Sole proprietors must be able to pay all business debts and taxes and file annual reports and paperwork on time. Take care not to fall out of compliance as a sole proprietorship.

Limited Liability Companies (LLCs)

How does this entity work? Often considered to be a hybrid entity of a corporation and partnership, an LLC provides its owners (or members, depending on how many you have within the LLC) with liability protection. This creates a separation between professional and personal assets. In the event of an unforeseen circumstance, like a lawsuit against your business, your personal belongings like houses and cars may be liable. However, an LLC protects against personal liability to ensure these belongings are not seized from you.

LLCs are a fit for… Businesses where there is potential for high risk liability, such as a restaurant or construction site, where employees may be injured on the job. It’s also a solid entity for owners with personal valuable assets that would like to protect their belongings.

Keep in mind… LLCs are flexible, due to being a hybrid entity. You may choose how you would like to be taxed under an LLC, including as an S Corporation.

S Corporation

How does this entity work? The S Corporation entity helps entrepreneurs to avoid double taxation. An S Corp allows the profits and losses of the corporation to “pass through” to the personal income of the shareholders. (The alternative would mean being taxed at a personal income and corporate level.)

S Corps are a fit for… Companies that have evolved past the startup phase, established their leadership and organization members, and raised capital from shareholders.

Keep in mind… You must file to elect S Corporation status with the IRS. This may be done using Form 2553. S Corporations also come with certain ownership and stock criteria as well. The business may not have more than 100 shareholders, with all shareholders acting as individual persons and no nonresident aliens. The business must also only have a single class of stock.

Partnership

How does this entity work? A partnership is established between two (or more) individuals interested in going into business together. As partners, they share ownership of the business including profits and losses. They also make decisions together. Generally, this entity is easy to form with little paperwork necessary.

Partnerships are a fit for… Individuals that are equally invested in the idea of going into business together. A partnership may be started with a family member, friend, or another like-minded individual passionate about your business.

Keep in mind… While it’s not a requirement, a partnership formation should include a written partnership agreement. A written partnership agreement outlines the terms of the partnership, capital contributions from partners, and rules for admitting new partners as well as voluntary and involuntary partner withdrawal. This document will help keep all partners on the same page with regulations as they relate to the business.