Which Business Entity is Best Suited for Your New Small Business?

The launching of a new small business is inherently risky. Hanging a metaphorical "shingle of your own" requires an investment of money, time and effort, each of which is likely in short supply. However, the risk of launching your own small business can be mitigated with strategic planning.

Part of the strategic element of launching a new small business is selecting the right entity for the enterprise. If you are like most entrepreneurs, you don't have a law degree or knowledge of business law, meaning choosing the optimal entity for your newly-budding business might be intimidating.

From limited liability companies (LLCs) to sole proprietorships, corporations, business partnerships and beyond, there are plenty of different legal entities to choose from. Here's a quick look at each type of business entity including their unique pros and cons.

An Inside Look at Limited Liability Companies (LLCs)

Limited liability companies, commonly referred to with the acronym of LLC, are favorable in a legal context as they minimize the owner's potential legal liability in the event of a lawsuit. Employees, customers, competing business owners and a litany of other overly-litigious parties have no qualms about opportunistically suing your business for alleged wrongdoing, even if the legal foundation for such a claim is shaky.

Choose an LLC entity for your new small business, file articles of organization for bureaucratic and legal purposes and the stage will be set to conduct business without losing sleep over a potentially financially crippling lawsuit. Though most states require the payment of a filing fee to launch an LLC, such fees are nominal and should not be considered a meaningful barrier to entry in the business arena. Furthermore, there might also be nuanced LLC requirements specific to your state to formally register the LLC. As an example, some states require publishing an LLC announcement within the local newspaper to formally create the LLC.

The purpose of launching a new small business as an LLC is to obtain the legal liability protections provided to corporations while retaining sole proprietorship advantages. Though few of those who are new to the world of entrepreneurship know it, it is possible to use the LLC structure for a business entity even if the company consists of a single person. Such a company is referred to as a single member LLC.

If you are on the fence as to whether it is prudent to launch your new small business as an LLC, don't let the comparably high cost and bureaucratic complexities stand in the way. Compare and contrast the complexities necessary to launch a corporation with those of an LLC and you will find it is easier to launch an LLC.

LLC formation separates the business assets from those of the owner, meaning the owner's assets are not susceptible to potential loss in litigation. The icing on the cake is the fact that LLCs are considered to be pass-through entities in the context of taxation, meaning the profits of the LLC are not hit by arguably egregiously high corporate taxes. Rather, the company's profits are considered the business owner's personal income.

Though the downside to forming your new small business as an LLC is that it requires more paperwork and financial investment than a business partnership or sole proprietorship. However, the effort to get an LLC off the ground is generally worth it when you factor in the reduction of legal liability.

The Sole Proprietorship

Sole proprietorships are different from LLCs in that proprietorships lack legal protection in the context of liability should litigation arise. However, sole proprietors benefit from pass-through taxation, meaning the proprietorship is not taxed. Rather, liability for taxation moves through the business while the business owner personally pays federal/state taxes. Another benefit of launching a new small business in the form of a sole proprietorship is that it is comparably easy to form.

Add in the fact that there are fewer bureaucratic requirements for the formation of a sole proprietorship and there is all the more reason to consider launching your new small business as a sole proprietorship. However, if you don't have enough money to launch the business on your own or plan on adding a partner in the future, starting the company as a sole proprietorship does not make sense.

The Corporation

Corporations are entities primarily used by comparably large organizations. The C-corporation structure, commonly referred to with the word "corporation", is a fairly complex business entity type yet it separates the owner from the business for legal purposes. The vast majority of publicly traded companies listed on the New York Stock Exchange, NASDAQ and other stock market indexes are C-corporations. Choose the C-corporation entity for your business and you won't have financial or legal liability for matters relating to the company. Furthermore, C-corporations are beneficial in that they offer enhanced dexterity in the context of financial compensation, especially when juxtaposed with S-corporations.

As an example, those who work for C-corporations can be provided with stock options yet such compensation is unavailable to those who contribute their labor to S-corporations and LLCs. The downside to C-corporations is that they are costly to form. Add in the complexities of the bureaucracy and legal challenges when forming a C-corporation and there is all the more reason to consider other entities for your business, especially if it is small. As an example, corporations must have shareholder and board meetings at specific intervals. Factor in the double taxation required of C-corporations, meaning the company is to pay corporate taxes on profitability and also pay income taxes on dividends distributed and there is even more reason for pause before moving forward with the creation of the enterprise in the form of a C-corporation.

We would be remiss not to mention that C-corporations also differ from S-corporations in that the revenue from S-corporations passes directly to the partners of the company, who in turn report shares in the form of revenue. In short, S-corporations enjoy some of the advantages of LLCs such as limited legal liability and pass-through entity status for taxation. S-corporations are also beneficial in that owner tax liability in the context of payroll is mitigated with the dexterity provided by paying financial compensation including dividends to those who have an ownership stake in the company.

S-corporation drawbacks include their comparably high formation cost, elevated maintenance costs in terms of bureaucratic and legal requirements and other time-consuming minutia such as nuanced bylaws and regular board meetings.

All of the above raises the question: which is better, LLC or corporation? When thinking of officializing your business it's crucial to think about your current business model, funds (or fund raise plans) and future expansion plans. Considering those will help you decide which is best for your unique business.

The Business Partnership

Business partnerships are somewhat self-explanatory in that they are a partnership between two people. Launch a business with another person in the form of a partnership and you'll find taxation is relatively straightforward. Business partnerships are fairly direct entities in which the parties joining together to launch the company create a written or verbal legal agreement. The owners work in unison to manage and operate the company. Revenue from the business moves through the company to each partner. Taxation of revenue is determined by each owner's percentage of income.

The profits of the business partnership are proportionally divided across each of the partners. Partnerships take the form of general partnerships in which each business owner equally shares in the losses, profits and legal liability. In contrast, limited business partnerships are those in which partners work in tandem to conduct business. Alternatively, limited business partnerships can also involve silent partners. It is also possible for limited partnerships to include mere investors who provide financial investment to get the company off the ground and continue its operations yet do not perform actual labor, be it intellectual or physical.

General partnerships are sometimes favored by entrepreneurs as they are comparably simple and do not mandate any sort of specialized registration with the state or federal government. In contrast, limited partnerships are registered business entities with more complex paperwork for bureaucratic purposes. If your aim is to attract financial capital from investors outside of your enterprise while maintaining simplicity, the general partnership structure is optimal.

The downside to forming a new small business as a general partnership is that it lacks what many consider to be sufficient legal safeguard. Those considered to be active business owners and/or operators of a business partnership have legal susceptibility for liabilities and financial debts that arise from conducting business operations. Compare this level of legal liability to that of the LLC and it is easy to understand why many new small business owners take the LLC route.

Carefully Select the Business Entity Type

The moral of the story is it is a mistake to rush the selection of your business entity type. Perform your due diligence at the outset of the process. Consider consulting with a business law expert for guidance. Review all business formation options and you'll move forward in full confidence with the right entity for your new small business.