How to Choose the Best Business Entity for Your Startup - Purple Fox Legal

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How to Choose the Best Business Entity for Your Startup

By Purple Fox Legal

December 1, 2021

Deciding to become a business owner isn’t as simple as buying a building and just opening up shop one day. Instead, there are many important things that must take place first, and one of them is to choose your legal structure. It is vital that you make an educated decision on the legal entity that your business will form. This is because the structure of your business will determine the way you conduct it, including personal liabilities, record keeping, and how much you pay in taxes.

This article walks through the six most common business structures and the way to choose the right one for your startup. 

The Six Common Business Structures and Choosing the One for You

I. Sole Proprietorship

This is the simplest business entity to form and allows you to create a business and operate it as the owner. Those who own sole proprietorships have to use their individual income tax return for business taxes, though a separate bank account is not required. Overall, it’s an easy process to set up a sole proprietorship, and this business model is exempt from corporate taxes. One main disadvantage of having a sole proprietorship is that you (the owner) will be personally responsible for any business liabilities, and this is because you have complete control over this type of company.

II. Partnership

A partnership is a business model that allows for multiple owners and encourages the exploration of business ideas before a more formal business is formed. The partnership business structure is almost exactly like a sole proprietorship, except there are two owners instead of just one. 

In general partnerships, both partners share profits and manage the business equally and are answerable to each other. However, one possible disadvantage of this business setup is that each partner is responsible for the liabilities of the other one.

Limited liability partnerships (LLP) are a lesser common type of partnership that allows for a different power dynamic. In this business structure, the founding partner is granted unlimited liability, while the other partners’ liabilities are limited. This means that the founding partner is given the most power and control and often has veto power over collective decisions. 

III. Limited Liability Company (LLC)

An LLC is a business structure that allows for the protection of your assets. This means that you can’t be held personally liable for the happenings of your business. One advantage of an LLC business structure is that you can enjoy pass-through taxation when it comes to taxes. This means that members can pass profits and losses directly to you, the owner. Multiple members are unnecessary for LLCs, though, which can also be classified as a single-member business structure. 

One main disadvantage of the LLC is that members are required to pay their own self-employment taxes and, in some states, the entire business could be dissolved if a member leaves.

IV. Nonprofit

Nonprofits are a unique business entity that requires you to be engaged in specific charitable, educational, religious, literary, or scientific work. Nonprofits are not required to pay state or federal income taxes on their profits, and this is because the public receives the benefits of their work. While nonprofits are an attractive business model, there are special rules the company must keep in mind to maintain its tax-exempt status. 

V. Cooperative

A cooperative is a unique business structure. It is owned by and operated by the people who are using its services. Profits, earnings, and savings are distributed appropriately to all the members. One downside to the cooperative structure is that each owner only receives one vote in business matters, regardless of investment status. 

VI.Corporation

There are several different types of corporations. They are:

  • C-Corporation:

This is the most common business structure for large companies. C-corporations are classified as for-profit corporations, and their taxes and liabilities are held separately from their owners. There are new requirements for businesses classified as C-corporations, including annual board meetings and record-keeping requirements.

One upside to this business structure is that it’s easier for C-corporations to receive investments than other models. However, these businesses can sometimes be double-taxed: once when the company makes a profit and then again when dividends are paid to shareholders.

  • S-Corporation:

S-corporations are not a business entity but rather a federal tax status. Additionally, there are specific eligibility requirements before the IRS will grant this tax treatment. Businesses who wish to be taxed as an S-corporation must:

  1. Be domestic businesses (i.e., formed in the United States)
  2. Have no more than 100 owners
  3. All owners must be U.S. citizens
  4. Not be an ineligible corporation (international sales corporations, certain financial institutions, and insurance companies)

Business entities that elect to be taxed as S-corporations are pass-through entities that can avoid double-taxation, unlike those taxed as C-corporations. In a pass-through entity, all profits and losses are passed through to owners, who then pay taxes on their personal returns.

The businesses listed in this article are the most common options for a startup business, but discussing the goals of your startup with appropriate legal counsel or accounting professional will ensure that you choose the best entity for your new business.