Small business legal entity types

By: VentureHow Staff Writer

Updated on: May 19, 2021

Small business legal entity types can seem complicated. The legal entity type of your business impacts virtually every component of it. It determines how much you pay in taxes. It also defines liability matters related to your personal assets. The best way to select the right business structure for your business is to weigh the options available to you.

Small business legal entity types: Brief Overview

Sole Proprietorship

A sole proprietorship is the simplest of all business structures. It requires taking no steps. If you start a business today as a single owner, it is generally classified as a sole proprietorship unless you take steps to change that format. This formation places a great deal of responsibility for the business on your shoulders in the form of liabilities and assets. Here’s a closer look.

You can operate your business under your name or a different name. You will likely need to obtain proper licenses and permits based on your local, county, and state laws, which is the case for any business formation. When it comes to taxes, in this structure, there is no differentiating between your income and your business income. At the end of the year, you’ll report your income and losses on a Schedule C and file it on your personal Form 1040. This format also means all of the liability in the business is your own. Should your company lose money or be sued, your personal assets are not protected.

Benefits of a sole proprietorship:

• It is inexpensive to form and easy to set up. The only costs are about obtaining necessary permits, licensing, and operational costs.
• You maintain complete control. You make all of the decisions.
• Tax prep is easy because there are no separate business income taxes to file.

Disadvantages of a sole proprietorship:

• Personal liability is at risk. You are personally held liable for the debts and all obligations for the business. This may include employee action-related liabilities.
• It is difficult to obtain third-party funding because there is often a lack of credibility initially.

Partnerships are a secondary form of a sole proprietorship. The only real difference here is that more than one person is responsible for and faces responsibility. However, several types of partnerships can change this including limited partnerships, general partnerships, and joint ventures.

Limited Liability Company

The second form of small business legal entity types is the Limited Liability Company or LLC. There are limited features in this type of legal business format, but even for small businesses, it can be ideal because it shields personal assets from business liabilities. The owners of an LLC are called members. There can be one or several, but they are not shareholders individually. LLCs are not taxed in the same way as a business entity. This means that all profits and the losses of the business are passed through to the members (owners). Each member then must report the gains or losses of the company on their personal federal income tax return each year. The IRS does not recognize the LLC as a separate tax entity.

Regarding liability, there is some protection here for individuals. Members of the LLC are protected from personal liability claims against the business. If the company incurs debt or is sued for another reason, the members’ individual assets are most often protected legally from claims. However, there is still some liability in the area of wrongful acts, such as those an employee may cause.

Benefits of an LLC:

• The limited liability of an LLC is vital for protecting individual member property.
• There is less required accounting and recordkeeping compared to other business structures.
• Profits are shared among the members of an LLC as you see fit. Members decide earnings from the business.

Disadvantages of an LLC:

• Self-employment taxes may apply. Because members are considered self-employed, they must pay taxes towards Medicare and Social Security with this format. The net income of the LLC is deemed to be taxable.
• Limited life is another crucial aspect. If one member leaves the company, the business is dissolved under some state laws, leaving other members to decide the next steps to take.

Corporations

Another type of legal entity type is the corporation, which is more complicated, more expensive to establish, and ideal for those companies with employees. The business is owned by shareholders. As a result, the business itself is held liable for the actions, debts, and other liabilities of the business. It is a recognized entity by the IRS. Corporations are formed under state laws, require registration, and licensing.

Corporations pay taxes to the federal, state, and local governments and must register with the IRS to do so. The corporation pays taxes on its income, not the owners. Shareholders in the company are paid a wage and then pay taxes on their income to the IRS.

Benefits of Corporations:

• There is significant liability protection for the business’s shareholders. The shareholders are only responsible for their investment in the stock of the company.
• It is easier to raise funding for corporations more so than other companies.
• Corporate tax treatment applies, in which owners only pay taxes personally on the income they are paid.

Disadvantages of Corporations:

• Corporations are expensive to set up and can have high administrative costs.
• Double taxation is a factor. Some corporations will pay taxes twice – when the company makes a profit and then again when dividends are paid to the shareholders.

Other small business legal entity types also exist and may be appropriate in specific situations. Which business structure is right for you? It is often best to work closely with an attorney to determine this or to consider the taxes and liabilities on each form based on your business’s needs.

For a more detailed exposition of the topic, please review the business structures guide.

Disclaimer: The article Small business legal entity types is informational. Please consult your accountant and attorney for appropriate advice regarding your situation.