Picking an entity formation for your startup isn’t a one-size-fits-all situation. A startup’s entity formation depends on the needs of the business. Generally speaking, however, there are three entity formation types that most entrepreneurs choose to incorporate their organization.
- Sole Proprietorship
- Limited Liability Company (LLC)
Some businesses may decide they would like to form a limited liability company, or LLC, because of the entity’s flexibility. Others may choose to incorporate as a corporation, especially if they plan to expand the business and open up global locations. And some entrepreneurs may stick with the default entity formation of a sole proprietorship.
In this post, we will look at three entity formation types that are popular for incorporating a business, the benefits of each legal entity, and how to start the registration process.
What does it meant to incorporate?
We often use the word “incorporate” when discussing small business. However, not everyone knows the definition of this word.
Incorporation is the process of creating a corporate business structure. That structure allows the business to act as a separate, legal entity from its owner. The owner also receives limited liability protection because it has incorporated. Liability protection creates a separation between the assets belonging to the owner and those belonging to the business.
Why do you need limited liability when running a business? Let’s say your business experiences an unforeseen circumstance, like accumulating too much business debt it is unable to pay off in a timely manner. If you had not incorporated, your personal assets may be at risk of seizure. Your house or car could be used as collateral to repay the debt.
However, incorporation separates the assets of the business and owner. The owner’s personal belongings would not be impacted because the business incorporated as a business entity.
A sole proprietorship is often known as a default entity formation. Essentially, that means many businesses begin as a sole proprietor for a few reasons. It’s an affordable entity formation with the least amount of paperwork involved in the filing process. However, one of the primary draws for being a sole proprietor is that this entity formation allows entrepreneurs to be the boss. They get to be in charge of everything and call the shots.
Sounds pretty good, right? There is one catch. Sole proprietors are responsible for good things impacting the business—and bad things, too. What if a customer is injured on their property or valuable information is lost during a security breach? A sole proprietor would need to be prepared to take full responsibility for these incidents.
Sometimes this can prove to be too much responsibility in a sole proprietorship. If this is the case, they may choose to incorporate as an entity formation where there is limited liability to protect their assets. Many sole proprietors will form an LLC. This gives them access to limited liability. It allows the business owner to keep running the company with extra peace of mind that their business has extra protection.
An LLC is a popular entity formation for several reasons. Forming an LLC means businesses have the ability to access limited liability protection for personal and professional assets.
The owner of the LLC, also known as a member, may also choose a flexible management structure for the LLC. Three options are available, including single member LLC, member managed LLC, and manager managed LLC. In a single member LLC, for example, the sole owner manages the LLC. Whereas a member managed LLC would be managed by multiple members of the LLC and a manager managed LLC would allow the LLC to appoint a board of managers to run the company.
Another major appeal in forming an LLC is choosing how you would like the entity taxed. LLCs are taxed as a pass-through entity by default. This means profits “pass-through” to members and are reported on individual tax returns instead of at the business level. Members of the LLC may also deduct losses on their personal tax returns to further offset income and ease tax filing.
LLCs, which are treated and taxed as a partnership on the federal level, often elect to be taxed as a different entity. For example, let’s say an LLC elects to be taxed as an S Corporation. This type of corporation has a pass-through entity status, which allows LLCs to be taxed as a pass-through entity. This helps avoid significant self-employment taxes for the LLC. Incidentally, sole proprietors are also responsible for paying self-employment taxes—which is another good reason to consider incorporating as an LLC!
Of the three entity formations, a corporation is the most structured entity. It shares certain similarities with LLCs, including limited liability and the ability to elect as an S Corp for tax purposes.
However, a corporation is not nearly as flexible as an LLC. Corporations require formal structures to run their business. This includes electing a board of directors and corporate officers. Corporate minutes must be taken during meetings and bylaws must be established as the corporation’s rules and regulations. A corporation may issue shares of stock and sell percentages of the business to its owners, which are also known as shareholders. Ideally, this is the kind of entity that may be the best fit for a business with plans to go public, offer an IPO, and launch a worldwide presence.
Which entity formation should I incorporate as?
These three entity formation types are only a handful of business entities available to incorporate as. Entrepreneurs may also explore Certified B Corporations, partnerships, and C Corporations. Much of the decision depends on the business and its needs. If you have any questions about which entity to incorporate as, consult a legal professional for additional advice.
Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Deborah Sweeney is the CEO of MyCorporation.com which provides online legal filing services for entrepreneurs and businesses, startup bundles that include corporation and LLC formation, registered agent services, DBAs, and trademark and copyright filing services. You can find MyCorporation on Twitter at @MyCorporation.
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