Legal Entity of Business Definition

In simplest terms, a business entity is an organization created by an individual or individuals to conduct business, engage in a trade or partake in similar activities. There are various types of business entities — sole proprietorship, partnership, LLC, corporation, etc. — and a business's entity type dictates both the structure of that organization and how that company is taxed.

When starting a business, one of the first things you want to do is choose the structure of your company — in other words, choose a business entity type.

This decision will have important legal and financial implications for your business. The amount of taxes you have to pay depends on your business entity choice, as does the ease with which you can get a small business loan or raise money from investors. Plus, if someone sues your business, your business entity structure determines your risk exposure.

State governments in the U.S. recognize more than a dozen different types of business entities, but the average small business owner chooses between these six: sole proprietorship, general partnership, limited partnership, limited liability company, C corporation and S corporation.

Which business entity is right for you? This guide is here to help you make that decision. We'll explain the types of business entities and the pros and cons of each so that you have all of the information you need to determine what's best for your company.

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Types of business entities: An overview

As we mentioned above, at a very basic level, a business entity simply means an organization that has been formed to conduct business. However, the type of entity you choose for your business determines how your company is structured and taxed. For example, by definition, a sole proprietorship must be owned and operated by a single owner. If your business entity type is a partnership, on the other hand, this means there are two or more owners.

Similarly, if you establish a business as a sole proprietorship, this means for tax purposes, you're a pass-through entity (the taxes are passed onto the business owner). Conversely, if you establish your business as a corporation, this means the business exists separately from its owners, and therefore, pays separate taxes.

Generally, to actually establish your business's entity structure, you'll register in the state where your business is located. Most business owners will choose from the six most common options: sole proprietorship, general partnership, limited partnership, LLC, C corporation or S corporation. Below, we've explained each of these popular business entity types, as well as the pros and cons of choosing each particular structure for your company.

Sole proprietorship

A sole proprietorship is the simplest business entity, with one person (or a married couple) as the sole owner and operator of the business. If you launch a new business and are the only owner, you are automatically a sole proprietorship under the law. There's no need to register a sole proprietorship with the state, though you might need local business licenses or permits depending on your industry.

Freelancers, consultants and other service professionals commonly work as sole proprietors, but it's also a viable option for more established businesses, such as retail stores, with one person at the helm.

Pros of sole proprietorship

• Easy to start (no need to register your business with the state).

• No corporate formalities or paperwork requirements, such as meeting minutes, bylaws, etc.

• You can deduct most business losses on your personal tax return.

• Tax filing is easy — simply fill out and attach Schedule C-Profit or Loss From Business to your personal income tax return.

Cons of sole proprietorship

• As the only owner, you're personally responsible for all of the business's debts and liabilities — someone who wins a lawsuit against your business can take your personal assets (your car, personal bank accounts, even your home in some situations).

• There's no real separation between you and the business, so it's more difficult to get a business loan and raise money (lenders and investors prefer LLCs or corporations).

• It's harder to build business credit without a registered business entity.

Sole proprietorships are by far the most popular type of business structure in the U.S. because of how easy they are to set up. There's a lot of overlap between your personal and business finances, which makes it easy to launch and file taxes. The problem is that this same lack of separation can also land you in legal trouble. If a customer, employee or another third party successfully sues your business, they can take your personal assets. Due to this risk, most sole proprietors eventually convert their business to an LLC or corporation.

General partnership

Partnerships share many similarities with sole proprietorships — the key difference is that the business has two or more owners. There are two kinds of partnerships: general partnerships, or GPs, and limited partnerships, or LPs. In a general partnership, all partners actively manage the business and share in the profits and losses.

Like a sole proprietorship, a general partnership is the default mode of ownership for multiple-owner businesses — there's no need to register a general partnership with the state.

Pros of general partnership

• Easy to start (no need to register your business with the state).

• No corporate formalities or paperwork requirements, such as meeting minutes, bylaws, etc.

• You don't need to absorb all the business losses on your own because the partners divide the profits and losses.

• Owners can deduct most business losses on their personal tax returns.

Cons of general partnership

• Each owner is personally liable for the business's debts and other liabilities.

• In some states, each partner may be personally liable for another partner's negligent actions or behavior (this is called joint and several liability).

• Disputes among partners can unravel the business (though drafting a solid partnership agreement can help you avoid this).

• It's more difficult to get a business loan , land a big client and build business credit without a registered business entity.

Most people form partnerships to lower the risk of starting a business. Instead of going all-in on your own, having multiple people sharing the struggles and successes can be very helpful, especially in the early years.

If you do go this route, it's very important to choose the right partner or partners. Disputes can seriously limit a business's growth, and many state laws hold each partner fully responsible for the actions of the others. For example, if one partner enters into a contract and then violates one of the terms, the third party can personally sue any or all of the partners.

Limited partnership

Unlike a general partnership, a limited partnership , or LP, is a registered business entity. To form a limited partnership, therefore, you must file paperwork with the state. In an LP, there are two kinds of partners: those who own, operate and assume liability for the business (general partners), and those who act only as investors (limited partners, sometimes called "silent partners").

Limited partners don't have control over business operations and have fewer liabilities. They typically act as investors in the business and also pay fewer taxes because they have a more tangential role in the company.

Pros of limited partnership

• An LP is a good option for raising money because investors can serve as limited partners without personal liability.

• General partners get the money they need to operate but maintain authority over business operations.

• Limited partners can leave anytime without dissolving the business partnership.

Cons of limited partnership

• General partners are personally responsible for the business's debts and liabilities.

• More expensive to create than a general partnership and requires a state filing.

• A limited partner may also face personal liability if they inadvertently take too active a role in the business.

Multi-owner businesses that want to raise money from investors often do well as LPs because investors can avoid liability.

You might come across yet another business entity structure called a limited liability partnership, or LLP. In an LLP, none of the partners have personal liability for the business, but most states only allow law firms, accounting firms, doctor's offices and other professional service firms to organize as LLPs. These types of businesses can organize as an LLP to avoid each partner being liable for the other's actions. For example, if one doctor in a medical practice commits malpractice, having an LLP lets the other doctors avoid liability.

C corporation

A C corporation is an independent legal entity that exists separately from the company's owners. Shareholders (the owners), a board of directors, and officers have control over the corporation, although one person in a C corp can fulfill all of these roles, so it is possible to create a corporation where you're in charge of everything.

With this type of business entity, there are many more regulations and tax laws that the company must comply with. Methods for incorporating, fees, and required forms vary by state.

Pros of C corporation

• Owners (shareholders) don't have personal liability for the business's debts and liabilities.

• C corporations are eligible for more tax deductions than any other type of business.

• C corporation owners pay lower self-employment taxes.

• You have the ability to offer stock options, which can help you raise money in the future.

Cons of C corporation

• More expensive to create than sole proprietorships and partnerships (the filing fees required to incorporate a business range from $100 to $500 based on which state you're in).

• C corporations face double taxation: The company pays taxes on the corporate tax return, and then shareholders pay taxes on dividends on their personal tax returns.

• Owners cannot deduct business losses on their personal tax returns.

• There are a lot of formalities that corporations have to meet, such as holding board and shareholder meetings, keeping meeting minutes and creating bylaws.

Most small businesses pass over C corps when deciding how to structure their business, but they can be a good choice as your business grows and you find yourself needing more legal protections. The biggest benefit of a C corp is limited liability. If someone sues the business, they are limited to taking business assets to cover the judgment — they can't come after your home, car or other personal assets.

Corporations are a mixed bag from a tax perspective — there are more tax deductions and fewer self-employment taxes, but there's the possibility of double taxation if you plan to offer dividends. Owners who invest profits back into the business as opposed to taking dividends are more likely to benefit under a corporate structure. Corporation formation and maintenance can be complicated, but online legal services can help with these things.

S corporation

An S corporation preserves the limited liability that comes with a C corporation but is a pass-through entity for tax purposes. This means that, similar to a sole prop or partnership, an S corp's profits and losses pass through to the owners' personal tax returns. There's no corporate-level taxation for an S corp.

Pros of S corporation

• Owners (shareholders) don't have personal liability for the business's debts and liabilities.

• No corporate taxation and no double taxation: An S corp is a pass-through entity, so the government taxes it much like a sole proprietorship or partnership.

Cons of S corporation

• Like C corporations, S corporations are more expensive to create than both sole proprietorships and partnerships (requires registration with the state).

• There are more limits on issuing stock with S corps than C corps.

• You still need to comply with corporate formalities, like creating bylaws and holding board and shareholder meetings.

In order to organize as an S corporation or convert your business to an S corporation, you have to file IRS form 2553. S corporations can be a good choice for businesses that want a corporate structure but like the tax flexibility of a sole proprietorship or partnership.

Limited liability company

A limited liability company takes positive features from each of the other business entity types. Like corporations, LLCs offer limited liability protections. But, LLCs also have less paperwork and ongoing requirements, and in that sense, they are more like sole proprietorships and partnerships.

Another big benefit is that you can choose how you want the IRS to tax your LLC. You can elect to have the IRS treat it as a corporation or as a pass-through entity on your taxes.

Pros of LLC

• Owners don't have personal liability for the business's debts or liabilities.

• You can choose whether you want your LLC to be taxed as a partnership or as a corporation.

• Not as many corporate formalities compared to an S corp or C corp.

Cons of LLC

• It's more expensive to create an LLC than a sole proprietorship or partnership (requires registration with the state).

LLCs are popular among small business owners, including freelancers, because they combine the best of many worlds: the ease of a sole proprietorship or partnership with the legal protections of a corporation.

How to choose the best business entity type

With a better understanding of how the common business entity types work and their respective pros and cons, you can now determine which type works best for your small business. The best course of action, if you can afford it, is to consult a business lawyer and tax professional on which structure is optimal for you, given where your business is currently and where you hope to take it.

As a starting point, however, there are three general factors to consider when choosing among business entity types: legal protection, tax treatment and paperwork requirements. In the section below, you can see how the entities stack up with regard to each of these factors.

Business entity summary

Sole proprietorship

Limited Liability Protections? No. Tax Treatment: Taxed at personal tax rate. Level of Government Requirements: Low.

General partnership

Limited Liability Protections? No. Tax Treatment: Taxed at personal tax rate. Level of Government Requirements: Low.

Limited partnership

Limited Liability Protections? For limited partners only. Tax Treatment: General partners taxed at personal tax rate. Level of Government Requirements: Medium.

S corporation

Limited Liability Protections? Yes. Tax Treatment: Taxed at personal tax rate. Level of Government Requirements: High.

C corporation

Limited Liability Protections? Yes. Tax Treatment: Must pay corporate taxes (but beware of double taxation on dividends). Level of Government Requirements: High.

Limited liability company

Limited Liability Protections? Yes. Tax Treatment: Can choose how you want to be taxed. Level of Government Requirements: Medium.

As you can see, sole proprietorships and GPs are light on liability protections, so they expose you to greater legal risk if someone sues your business. But, taxation is simple when you have a sole proprietorships or GP, and you don't have nearly as many government regulations to comply with. That means more time to do what you love — running your business.

The simplicity of a sole proprietorship or a partnership makes either of these business entity structures a good starting point for freelancers and consultants, particularly if the industry they're in brings little legal risk with it.

Along these lines, fashion and beauty influencer Joanna Faith Williams said: "Being a sole proprietor now seems most appropriate as there is not much that I am liable for at this time. I keep well-written contracts to protect myself, but as I begin to dive more into creating content such as ebooks… or things that my audience will have to pay for, I will definitely consider registering as an LLC."

If your business is in a more litigious industry, on the other hand, such as food service, child care or professional services, that's a strong reason to create an LLC or corporation right off the bat. And regardless of industry, as your business grows and more dollars are at stake, that can be the ideal time to "graduate" to an LLC or corporation. What works for a freelancer or hobbyist likely won't work for someone who is trying to hire employees, bring on additional owners, or expand.

Brett Helling, owner of ridesharing blog Ridester.com, found this to be true. "Initially, I started this blog as a part-time thing. However, once the site began to experience growth at a very rapid pace and began making money, I realized it was turning into an actual business. I quickly realized that I should register an LLC… to shield myself from liability in case something went wrong," he explains.

Although it's certainly possible to change business structures at any point in your business's journey, some changes are easier to make than others. For instance, it's relatively simple to convert from a sole prop or partnership to an LLC by filing the right paperwork with your state.

Converting to a corporation, however, is more difficult, particularly if you plan to issue stock. Additionally, converting from a C corp to an S corp can bring unexpected taxes. Therefore, before changing your business structure, you'll want to think through the possible advantages and potential problems associated with doing so and consult a business attorney for professional advice.

Moreover, you'll want to keep in mind that the IRS places certain limits and deadlines on how often you can change your business's entity type. Plus, it's also worth remembering that different government tax plans can change how business entity types are taxed, and this may contribute to how taxes factor into your ultimate decision.

The bottom line

Your choice of business entity is a very important one. The entity you choose can affect how people perceive your business, and more importantly, it has a big impact on your legal exposure and finances.

All in all, you'll want to keep the following in mind when deciding among the different types of business entities:

• Sole proprietorships and general partnerships are good "starter" entities.

• As your business grows and generates more income, you might consider registering as an LLC or corporation.

• Think through the pros and cons of each business entity type in terms of legal protection, tax treatment and government requirements.

• Work with a business lawyer and accountant to get specific help for your business.

Ultimately, although there's not a single best business entity choice for all small businesses, by referring to this guide and consulting legal or financial professionals, you'll be able to determine which type is right for your business.

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Legal Entity of Business Definition

Source: https://www.nerdwallet.com/article/small-business/business-entity

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