Entrepreneurs have the option to carry on business as several different business entity types. The appropriate business entity type is based upon the nature of the business and the state of business growth. Often, the business will have a change of entity type along its growth or lifecycle. Let’s discuss the many options for your business formation.
In this article, we discuss the primary types of business entity, the various considerations for choosing a business entity, corporate governance, and the how these characteristics match with the business lifecycle.
Types of Business Entity
Sole Proprietorship (SP) – This is one individual carrying on any form of commercial activity for a profit (or loss). There are no filing or other procedures necessary. Just by carrying on business, you have formed a sole proprietorship business. The sole proprietorship business is not really a business entity, as the business activity is one in the same with the sole proprietor.
General Partnership (GP) – This is similar to a sole pro proprietorship, except that it involves two or more people. These individuals carry on a commercial activity for an intended profit (or loss). The key is that the individuals share in the profits or losses. This is different from where one individual receives any profits or losses and any other people are paid a salary.
Limited Liability Company (LLC) – An LLC is a very popular business entity for small businesses and early-stage startups. It allows a great deal of flexibility in its organization and structure. It can be organized more like a corporation or more like a partnership, depending upon the needs of the owners.
Corporation (Corp) – The corporation is the most structured form of business entity. Most larger companies and companies seeking to distribute shares to employees or investors end up as a corporation. The corporation can choose to be taxed under Subsection C (C-Corp), Subsection S (S-Corp), or Section 501 (Non-Profit) of the Internal Revenue Code.
Business Entity Characteristics
The primary characteristics of a business entity include:
Formation and Dissolution – This concerns how the business entity comes into existence, business formation, and what cause it to dissolve. A SP and GP come into existence just by carrying on business activity. In a GP there must be sharing of profits or losses. An LLC and Corp must be filed with the state to come into existence. If the sole proprietor or a partner leaves a GP, it dissolves. This is generally not the case with an LLC or Corp.
Maintenance – The SP, GP, and LLC have very little maintenance requirements. The LLC requires limited annual filings and registration fees with the state government, but there are very few internal governance procedures. Corps have numerous internal governance procedures, such as meetings, voting, disclosures to owners, etc.
Ownership & Control – One individual owns and controls the SP. In a GP, the partners own and control the company. In an LLC, the owners are the members. The managers can be the owners or professional managers hired/appointed by the owners. In a Corp, the shareholders are owners. The board of directors and officers control the company. There is a very formalized ownership and control structure in the Corp. Internal governance is managed by the board of directors.
Owner Personal Liability – The LLC and Corp provide protection to owners. They are not personally liable for the debts or obligations of the business. This is particularly important if the company get sued and is subject to a judgment. The GP and SP do not offer the owners this protection. Internal governance is also managed by the board of directors.
Compensation & Taxation – A sole proprietor reports any SP profits on her personal income tax return. The business does not pay taxes itself. The GP must file an informational tax return, but it does not pay taxes. The profits or losses flow through the entity to the owners. Owners working for the GP cannot receive a salary. They must receive any compensation as draws from profits. Corp shareholders receive a share of profits as dividends. Officers and employees receive a salary. Shareholders can also serve as officers and employees. In an S-Corp profits or losses flow through to owners. The business entity does not pay taxes. Any profits flowing through to owners receive a 20% discount (i.e., this amount is not taxed). In a C-Corp, the business entity pays taxes on profits or holds any losses. If the profits are distributed as dividends, the shareholders pay taxes on the dividends. An LLC can choose to be taxed as a partnership or corporation. This will affect with the members working in the LLC can receive a salary or must be compensated strictly from profits.
Business Entities at Stages of LifeCycle
When a startup is in the business formation stage, it is common for individuals to work together to develop intellectual property or to get operations of the grounds. At this point, it is common to carry on as a general partnership. The reason is that there is no formal operations yet. It is very difficult to determine how the company should be organized, internal governance, and who should be owners. Also, there is little or no public interaction to result in potential liability.
Most startups later become an LLC. This allows the business to organize its operating structure and internal governance. Further it provides personal liability protection to owners. The company identifies its owners and establishes the percentage of ownership each member will hold. Normally the business converts from an LLC to a Corp when it needs to distribute ownership interests to employees or investors.
Early startups may organize as a Corp and choose S corp taxes. To qualify for S corp taxes, there can be a limited number of shareholders (all must generally be people who are US citizens). Also, there can only be one class of stock. These rules make it difficult to distribute equity to investors (who are often organized as a business entity and require preferred shares). So, when the startup reaches the stage of seeking equity investors, it is common to organize as a C-Corp. This allows for the distribution of preferred stock to equity investors (such as angel groups or VC funds). Further, it provides the division of responsibilities (shareholder, directors, and officer) common for a business entity.
LawTrades Knows Business Entities
Choosing a business entity is a foundational decision in the life of a business. You should make certain that you are choosing the business entity that is appropriate to allow your business formation to maximize its potential. Let the legal experts at LawTrades help you with the process. We can advise you on the necessary considerations with internal governance as well as help you in the business formation process.