5 Things To Consider When Choosing A Business Entity

So, you're trying to decide what type of business entity to form. Ideally, you have a CPA and a business attorney to advise you, but if you're like most small business owners I know, you're probably bootstrapping costs and doing most of the formation research yourself.  As a business owner, you can choose to structure your business as:

• Sole proprietorship
• Professional corporation
• General partnership
• Limited partnership
• Corporation
• Non-profit
• Limited liability companies

 For a good general description of these entity choices, check out the Secretary of State’s website where you're forming your business.  The state’s website usually provides resources and explanations of the entity requirements in the state. Now that you know your entity choices, let's talk about the essential factors when considering which entity is the best for your business.   

Qualification to be a certain entity

Make sure you business is qualified to be a particular entity. For instance, an S-corporation allows only a limited number of shareholders and an out of country resident cannot be a shareholder. Certain kinds of businesses cannot qualify to be a certain entity.  In California, law firms cannot be limited liability companies but can be formed as a professional corporation or limited liability partnership.  Check your state’s business law requirements to see if your business structure qualifies to be a particular entity.   

1. Liability protection

Most entrepreneurs think of protection from liability when they think of incorporating.  A sole proprietorship or a general partnership will make you fully personally liable for legal claims and debts to creditors. Consider your business industry and whether it is likely a lawsuit will ensue. For instance, if a business owns property and has a number of employees, it has a higher potential for a lawsuit than perhaps a small part-time service business.  For added protection beyond liability insurance, incorporating or forming a limited entity could offer more peace of mind.   

2. Ease of formation

For some people, the ease of keeping up with the formalities of a business entity is important.  Generally, a sole proprietorship does not have any requirements for entity formation other than to follow the local government business regulations.  However, corporations require following additional formalities, such as having shareholder meetings and formally documenting corporate actions. One important consideration is where your company is headed in the future (a great reason to write a business plan).  Forming one entity in the beginning may mean a difficult process to convert to a different entity in the future.  Changing from an LLC to a corporation, for instance, can be quite the challenge, depending on your state’s rules.   

3. Tax treatments

Each entity type has its own tax requirements and benefits.  Most business owners want to have as small a tax hit as possible. Depending on the amount of profits and whether an owner decides to take it as salary or leave it within the business, are important factors in choosing the entity type.  If you choose to incorporate, a C-corporation has a different federal tax treatment than an S-corporation. Consult a tax adviser to go through the nuances of each and whether your business is right for one or the other.   

4. Ability to raise capital

When a business wants to raise money from venture capitalists or other investors, it is often better to have a corporation than another type of entity, such as an LLC. Investors often want to be shareholders of a company so that they have proven ownership interest.  A corporation offers different classes of stock to allow for different levels of investors, such as the opportunity to be involved in voting on key corporate issues.   

5. Recommended government reading:

The IRS provides a list of business structures, qualifications and tax forms at http://www.irs.gov/businesses/small/article/0,,id=98359,00.html. The government site, Business.gov offers some great basics on business entities here. The US Small Business Administration is a great website for small business owners and offers information on everything from drafting business plans to providing links to women’s business resources.  

What questions do you have about choosing a business entity? Let us know in the comments.