How to Choose the Correct Legal Entity Type for Your New Business

Legal Entity

When starting a new business, entrepreneurs must quickly make a number of very important decisions.  They must decide on a marketing strategy, pricing strategy, physical location (for certain types of businesses), business name, and many other things.  Unfortunately, one of the most critical choices new small business owners must make sometimes does not get the consideration it deserves, and that is what type of legal entity to use for the business.

Why Choosing the Right Legal Entity is Important

To someone without any entrepreneurial experience who is starting a new business in which they will be the owner and (at least initially) the sole employee, forming a legal entity for their business might not seem like a big deal.  They may even think to themselves, “I’ll just start with a sole proprietorship to keep things simple, and change it later once my business grows”.

What this person may not realize is that, as a sole proprietor, any liability incurred by the business is shared by them as an individual.  That means that a mistake or miscalculation on their part could potentially lead to personal financial ruin.  That’s why it’s worth taking some time to research the different types of legal entities used by small businesses before putting out your shingle.

Typical Legal Entities Used by Small Businesses

Small businesses often choose from several common legal entity types based on their specific needs and goals. These entities offer various levels of liability protection, tax advantages, and operational flexibility. Some of the typical legal entity types for small businesses include:

Sole Proprietorship: A sole proprietorship is the simplest and most common form of business ownership. The business is owned and operated by a single individual, and there is no legal distinction between the business and the owner. However, the owner is personally liable for all debts and obligations of the business.

Partnership: A partnership involves two or more individuals or entities (partners) who agree to share profits, losses, and management responsibilities. There are different types of partnerships, including general partnerships (where partners have equal responsibility and liability) and limited partnerships (where there are both general partners and limited partners with varying levels of liability).

Limited Liability Company (LLC): An LLC is a flexible business structure that combines elements of both a corporation and a partnership. Owners, known as members, have limited liability for the company’s debts and actions. LLCs offer pass-through taxation, where profits and losses are reported on the members’ personal tax returns.

Corporation: A corporation is a separate legal entity that provides limited liability protection to its owners (shareholders). Corporations have a formal structure, including a board of directors, officers, and shareholders. There are two main types of corporations: C corporations and S corporations. C corporations are subject to double taxation (at both the corporate and individual levels), while S corporations offer pass-through taxation but have certain restrictions on ownership and structure.

S Corporation: An S corporation is a special type of corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes. This avoids double taxation on corporate profits. S corporations have limitations on the number and type of shareholders they can have.

Nonprofit Organization: Nonprofits are formed for charitable, educational, religious, or other purposes, rather than for the purpose of generating profit. They operate similarly to other business entities but have specific rules and regulations related to their tax-exempt status and mission-driven activities.

Choosing the Right Legal Entity for Your Business

It’s important to note that the optimal legal entity type for a small business depends on factors such as liability protection, taxation, ownership structure, growth plans, and the nature of the business itself. Consulting with legal and financial professionals can help you make an informed decision based on your specific circumstances, but below are some general guidelines.

Understand Your Business Needs and Goals: Consider what your business does, its size, industry, growth plans, and funding sources. Are you a solo entrepreneur, a partnership, a small business, or a high-growth startup? Your goals and needs will help narrow down your options.

Liability Protection: Consider how much personal liability you’re willing to take on. Sole proprietorships and partnerships expose owners to personal liability for business debts, while LLCs and corporations generally provide limited liability protection.

Tax Implications: Different types of business entities are taxed differently.  In certain situations, this could have significant implications on the business’s bottom line.  Here’s how some of the most common types of businesses are taxed:

  • Pass-Through Taxation: Sole proprietorships, partnerships, and LLCs (in most cases) allow business income to “pass through” to the owners’ personal tax returns.
  • Double Taxation: Corporations can face double taxation, where the corporation is taxed on its profits, and shareholders are taxed on dividends. However, C-Corps can also have certain deductions and benefits.
  • S-Corporation: Avoids double taxation by passing income directly to shareholders’ personal tax returns, but has certain restrictions on ownership and can have complex tax implications.

Ownership and Management: Depending on how many owners a business has and whether or not there will be others involved in managing the business besides the owner, different types of legal entities might make more sense than others.

  • Single Owner: Sole proprietorship or single-member LLC may be suitable.
  • Multiple Owners: Consider partnership, multi-member LLC, or corporation, depending on ownership dynamics and goals.

Administrative Complexity: Corporations typically have more administrative requirements, such as regular meetings, minutes, and formal record-keeping, compared to LLCs.

Funding and Investment: If you plan to seek outside investment or issue stock options, a corporation might be more suitable due to its established structures.

The guidelines above should give you a sense of which legal entity would be best for your business.  At Cooke, Lavender, Massey & Company P.C., we offer a variety of new business services including a free startup consultation, during which we provide guidance on legal entity selection.  If you are starting a new business, please take advantage of our services or the services of other professional advisors to help you get started on the right track.