Business Entities Explained

Perhaps to have driven down the street and noticed that some business signs have acronyms behind them, like Mission Wealth Management, LLC or Apple, Inc.  These three letter indicators identify the type of business entity or structure of the company.

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A business entity or structure you choose for your new business will have both legal and tax related implications for you and your business.  Choosing the best type for your business is one of the first steps to business ownership.  We'll review the multiple types of business entities, share the pros and cons of each and recommend the best type of business entity for you.  It can be a little confusing, so be sure to check out the decision flow chart for a quick and easy reference.

There are four main categories of business entities, Sole Proprietorship, Limited Liability Company (LLC), Partnerships and Corporations.

Sole Proprietorship

A Sole Proprietorship is the most simple and also most common structure chosen to start a business. A business with this structure has only one owner and there is no distinction between the owner and the business.  A Sole Proprietorship is not a legal entity. The owner of the business is entitled to take all of the profits from the business, but they are also responsible for all of the businesses debts, losses and liabilities. For tax purposes, since the owner and the business are considered the same, all business income is reported on your personal income tax return.  Finally, while it's inexpensive to set up, your personal assets may be at risk if the business incurs any lawsuits or files for bankruptcy.

Limited Liability Company (LLC)

An LLC is a hybrid type of legal structure that provides the liability protection of a corporation, with simpler tax returns, and also provides options for multiple owners or members.  Members of the LLC can be one single individual, multiple individuals or even other LLCs.  If the LLC incurs debt or is sued, the members' personal assets are usually exempt.  For tax purposes, LLCs are not taxed separately and members would pass through profit and losses of their company to their personal taxes. 

Partnerships

A partnership is a single business where one or more individuals share ownership.  There are two types of partnerships, general and limited.  General partnerships assume equal responsibility for profits, liability and management decisions.  In this case, a creditor could choose to go after any and all partners for collection of debt.  With a limited partnership, some partners have limited liability and also limited input within the business.  This is typically a good option for investors in short term projects.  For tax purposes, a partnership must file an annual information return to report income and losses, but the company itself does not file income tax.  Profits and losses are passed through to the partners and show them on their personal income tax returns.

Corporations

A corporation is an independent legal entity, separate from its owners, which means greater protection from personal liability in case the company is sued or files for bankruptcy. Corporations are generally more complex than other business entities and tend to have costly administrative fees and complex tax and legal requirements.  For tax purposes, the corporation must pay income tax on it's profits.  Shareholders of the company who are also employees will have to pay income tax on their wages.  A S-Corp is typically the most common type, while the C-Corp is mainly set up for large or high profile ventures.

Our Recommendation

For most of our clients, we recommend setting up your new business as an limited liability company or LLC. It is typically inexpensive to setup and has little effect on your income tax filing as the earnings from the business still pass through to your personal income tax return. The benefits far outweigh the costs (filing fees in your state, etc.) as it provides a significant amount of protection for the owner because assets that belong to the owner personally are protected. The one thing to keep in mind with an LLC is to ensure your personal and business transactions are kept separate.  Simply put, do not use your business credit card or bank account to pay for any personal items.  If you do, and your business is sued for any reason, the opposing side can try to prove you used business funds for personal items and although you claim to be an LLC you are not acting as one.  Therefore, your LLC can be invalidated and your personal assets will not longer be protected.

*Disclaimer: The information above should not take the place of legal and tax advice from your lawyer and certified public accountant.  We always recommend consulting with professionals prior to setting up your business and we are happy to put you in touch with lawyers and CPAs that specialize in small businesses.

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Written by Tom and Allison Barnhill - Owners of Business by Barnhill