Choosing the Best Entity

Partnership

A partnership is similar to a sole proprietorship, except it involves two or more business owners.

There are two main types of partnership: general and limited partnership. In general partnerships, partners have full control of the business and unlimited liability for its financial obligations, similar to sole proprietors. Unless their partnership agreement says otherwise, they share profits, liabilities, and responsibilities equally.

Conversely, limited partnerships have two types of partners: general partners, who manage the business’s day-to-day operations, and limited partners, who invest capital in the business.

This type of partnership is ideal for those who want to get investors while maintaining control over the business.

Corporation

A corporation is a legal entity that exists separately from its owners or shareholders. It offers one key benefit: limited liability. A shareholder’s personal assets are protected from any financial obligations the corporation gains.

However, corporations have significant drawbacks, such as double taxation and strict regulatory requirements.

Double taxation occurs when a business pays taxes at the corporate and individual levels. Every dollar a corporation earns is taxed once as corporate income. Once the corporation distributes some of its earnings to its shareholders, those dividends will be taxed again as individual income.

In addition, corporations are subject to strict regulatory requirements. They must hold regular board meetings and keep detailed financial records to maintain good standing with the state.

Corporations have significant legal considerations you must weigh when choosing your business structure.

Limited Liability Companies (LLCs)

Limited liability companies (LLCs) combine a corporation’s limited liability and a partnership’s business-friendly tax structure into one comprehensive business entity.

This business entity type is highly popular among small business owners because it combines the best qualities of the other types mentioned earlier.

LLCs offer the same protection as corporations but with less paperwork and fewer regulatory requirements. They also have the same pass-through tax status as sole proprietorships and partnerships, allowing them to avoid double taxation effectively.

Moreover, they are free to choose how they want to be taxed. They can change their tax election to a C-corporation or S-corporation if they want to.

S-Corporations

S-corporations are a special type of corporation created to address one of the drawbacks of traditional corporations: double taxation. The IRS gives S-corporations pass-through tax treatment granted that they meet the following requirements:

• It must be a domestic corporation.
• Must have no more than 100 shareholders.
• Must have only one class of stock.

You can convert your existing business to an S-corp by submitting your Form 2553 to the IRS.

Comparing Business Entities

Here’s a quick summary of the characteristics of each business entity type we’ve discussed:

Sole Proprietorships

• Limited liability protections: None.
• Tax treatment: Pass-through entity.
• Government requirements: Low.

Partnerships

• Limited liability protections: Only to limited partners.
• Tax treatment: Pass-through entity.
• Government requirements: Low.

Corporations

• Limited liability protections: Yes.
• Tax treatment: May be subjected to double taxation.
• Government requirements: High.

Limited Liability Companies (LLCs)

• Limited liability protections: Yes.
• Tax treatment: Default pass-through entities can also be taxed as a C-corp or S-corp.
• Government requirements: Moderate.

S Corporation

• Limited liability protections: Yes.
• Tax treatment: Pass-through entity.
• Government requirements: Moderate, with additional filing requirements from the IRS. 

How to Choose a Business Structure

Choosing the best business structure for your business requires planning and the advice of a legal, accounting, or incorporation professional. Each entity has subtle differences that make it preferable in specific circumstances.

So, to get you started, these are the factors you must consider when choosing a business entity:

Tax Implication

Taxes are one of the most important factors you must consider when choosing a legal entity for your small business. Each business entity option we’ve discussed earlier has varying tax treatments.

If you’re a small business owner, you want to avoid business entities with double taxation, like corporations. You want to choose an entity that’s more appropriate for startups, like LLCs.

The pass-through tax status of LLCs will help you get more out of your profits. It will also allow you to change your tax election later on.

Liability

Liability is another important factor to consider when choosing a business entity. You need a structure with strong liability protections, such as LLCs and corporations, to protect your personal assets from creditors and potential lawsuits.

Although these business entities are relatively harder to form and maintain, the shield they offer to your personal assets is invaluable.

Management Structure

Your chosen entity’s management structure determines how much control you have over your business.

In sole proprietorships, owners have complete and unilateral control over the business and its activities. In contrast, the decision-making authority in partnerships is divided equally among partners or according to their capital contributions.

Capital Investment

Some entities make obtaining capital investment easier than others. For example, corporations can sell shares of stock to investors and secure additional funding for their operations.

Meanwhile, sole proprietorships can only get more capital through their owners or by taking on partners.

Regulatory Requirements

Regulatory compliance is vital for any business, regardless of its structure. Failure to comply with federal and state regulations could have serious legal consequences.

Depending on where your business entity is formed and the type of activities you want to engage in, you may have to fulfill several regulatory requirements to maintain good standing with the law.

For example, businesses that want to sell alcohol and other imported products will need specific licenses and permits to start their operations.

These requirements, simple as they may seem, can take up a lot of your time and resources.

Flexibility

Flexibility is another crucial factor when choosing the best legal structure for your business.

Your startup will grow over time, and its needs will change. Your chosen entity should be able to adapt to these changes and support your changing goals.

Sole proprietorships typically have a much harder time expanding since their ability to raise capital is limited. Meanwhile, LLCs and corporations have more flexibility in getting more funding.

LLCs can attract investors by offering member contributions, and corporations can issue stock to a wider pool.

So, consider your long-term goals before you start finalizing your options for business entities.

Complexity

Lastly, you must evaluate the complexity of forming and maintaining each business entity.

There’s no denying that sole proprietorships are the easiest to form from all the legal structures we’ve discussed. All you have to do is register your business name with the Secretary of State, obtain your business licenses, and you’re good to go.

But to form a corporation or an LLC, you must submit formation documents to your Secretary of State and pay their corresponding filing fees.

Regarding ongoing requirements, sole proprietorships don’t have to submit annual reports and pay annual fees like LLCs and corporations.

We recommend carefully weighing each structure’s benefits against their formation and maintenance requirements. Sure, a sole proprietorship will offer you a quick and easy setup, but it won’t be able to protect you from the risks associated with running a small business.

In addition to this, you can also use the following questions to identify which legal entity is best for your small business:

1. Where will the business be conducted?

• Because different states offer varying degrees of personal protection, a Nevada entity may be the best choice, regardless of where your business is conducted.

2. Who will own the business?

• Using some entities won’t be an option if the owner(s) are other business entities or foreign citizens.

3. How many owners will there be?

• Certain business entities can only have a specific number of owners, like sole proprietorships and S-corporations.

4. Where will you get the capital?

• If it is borrowed, you can use an entity that allows owners to include the debt in their tax basis.

5. Will the business need to retain significant earnings for future needs?

• Accumulated earnings will generate a huge tax bill for some business owners.

6. Do the owners want pass-through taxation?

• Pass-through taxation eliminates the double taxation of profit distribution to owners and allows losses to flow through.

7. Will the first few years of business generate net losses?

• If so, the owners may want them passed through as described above.

8. Do the owners want or need to create different ownership classes?

• Only LLCs and corporations can create different ownership classes.

9. Are the owners concerned about protecting their business from liabilities associated with the other owners?

• Some types of business entities provide this protection, while others don’t.

10. Do the owners intend to offer employee benefits (health insurance, profit sharing, or cafeteria plans) to owners?

• A C corporation can have some advantages if that is the case.

11. Is the business regulated or subject to special licensing requirements?

• Some types of regulated business activity may not be able to use certain types of business entities.

In Conclusion

Choosing the best entity for your startup requires careful consideration and planning.

You must evaluate the benefits of each business entity type and weigh them against any potential drawback you may face. This way, you can ensure that your chosen business entity aligns with your long-term goals.

Getting expert advice from a business specialist can also be helpful. An experienced business specialist will provide insights on structuring your business for success. They can also guide you through formation, ensuring you file the necessary paperwork to register and incorporate your business.

Ultimately, business specialists offer invaluable expertise and will help you set your business up for long-term success.

Find the best legal structure for your business, and contact NCH today! NCH is one of Nevada’s leading business formation service providers. Our team of business specialists has helped hundreds of entrepreneurs find the best entity for their startups.

Call us at  1-800-508-1729 to schedule a consultation with one of our experienced business specialists today. 

Disclaimer: The above material has been prepared for informational purposes only, containing opinions of the provider, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.