What are the four types of business entities?

So you have made the decision to start your business and begin down the exciting path of entrepreneurship. You’ve determined your product or services, researched the market and developed your plan. Now, before you can take the next steps toward making your dream a reality you must determine how you will form your business entity.

The determination of how to organize an entity is one of the most important decisions a business owner will make as they begin their endeavor. The chosen entity is the vehicle in which all operations occur that carry the business forward. The entity formalizes business operations and gives off the professional appearance while also providing the owner with certain tax advantages and liability protections. Just like choosing from the car lot, there are several options and models to choose from.

The four most common business entity types are:

1. Sole Proprietorship

The most basic form of a business entity is a sole proprietorship. There are no formalities associated with this formation and it is established merely by a single person, or married couple, engaging in business activities. There are no formalities that govern the operation of a sole proprietorship and the owners are permitted to co-mingle business and personal assets. While not required, some sole proprietor’s chose to register a business name in the state as a D/B/A, but such registration is merely an operating identity and does not extend any formal protection from personal liability.

While a sole proprietorship is the easiest and most flexible of the entity types from a management stand point, it also provides the least amount of protection. A sole proprietorship operates and contracts in the individual owners own name and the individual remains personally liable for the debts and liabilities incurred by the business. Often sole proprietor’s will obtain business liability insurance policies to provide some buffer protection for potential liability, but if the liability exceeds the insurance limits the individual’s personal assets may be at risk. A sole proprietorship reports the business profits and losses on the owner/operator’s personal tax returns.

2. Partnership

There are two types of partnership structures, general partnership and limited partnership.

  1. General Partnership: A general partnership is the more basic form of partnership. It is established when two or more unmarried people associate and agree to operate a business together. There is no formal requirement for establishing the general partnership, but often times a professional operation will memorialize the terms of their entity governance on a written partnership agreement. The partners agree to share the profits, losses and management of the business and like a sole proprietorship each partner is personally and legally liable for the debts and liabilities of the business. The owners in a general partnership report their share of the profits and losses on their personal tax returns.
  2. Limited Partnership: A limited partnership is a more formalized partnership entity in which there are two types of partners: general and limited. In order to form a limited partnership, the entity must file a certificate of limited partnership with the state. The management and operation of the limited partnership is controlled by the general partner(s) who also shares fully in the businesses profits and losses and assumes the liabilities of the business similar to any partner in a general partnership. Finally, the general partner(s) must pay self-employment taxes on their share of the profits from the company. The limited partners are merely silent partners invested in the entity. Limited partners have no control over the operation of the business but they are also personally shielded from the business liabilities and they are not required to pay self-employment taxes.

3. Limited Liability Company

One of the most widely used business entity types is the limited liability company (LLC). This is often a preferred entity due to its flexible management requirements and ease of operation coupled with the strong liability shield provided to members. The LLC is formed by filing articles of incorporation with the state. In addition to the articles of incorporation members of an LLC will agree to an operating agreement, often in writing, setting forth the governance rules of the entity including management, transfer of interest, and distribution of profits and losses.

The LLC provides its members personal liability shield from the liabilities of the business. Unique to the LLC is the ability of the members to determine how the entity will be managed. While there are some formalities associated with the operation of the LLC’s many of these may be adjusted by agreement of the members. Particularly, members may choose whether the business will be managed by the members collectively, appointed managers, or a board of directors/governs. All formalities related to the operation of the LLC will be provided for in the operating agreement, which may be personally tailored to the desires of the members.

Similar to corporations, LLC’s may choose how the entity will be taxed. Unless elected otherwise, members of the LLC are taxed similar to a general partnership but the members may elect to be taxed as an S-Corp or C-Corp. The c-corporation must pay taxes for the corporate profits and each of the shareholders are taxed on the dividends they receive from the entity. The s-corporation allows for pass through taxation meaning that the entity profits and losses pass through to its shareholders who file on their own personal returns, there is no corporate level taxation for s-corps. Specific determinations regarding the most appropriate tax designation for an entity are best handled on a case-by-case basis to allow for careful consideration as to what will best serve the business and its owners.

4. Corporation

The most formal of all the entities and the most complex to operate. A corporation is formed by the filing of articles of corporation with the state. The shareholders of the corporation will approve by-laws governing the entity operations and may also execute a shareholder agreement specifying the relationship between each other that is not contemplated in the by-laws. Upon formation the corporation must select its board of directors who are responsible for the management of the entity in accordance with the by-laws.

Corporations are legal entities with their own identity and tax structure separate from the shareholders. As a separate legal entity the corporation provides a personal liability shield to its individual shareholders. Corporations are the most formal of private business entities requiring strict adherence to those formalities in order to ensure the tax benefits and liability protections will be duly recognized.

With regard to the corporate tax liability there are two separate structures: S-CORP and C-CORP. The c-corporation must pay taxes for the corporate profits and each of the shareholders are taxed on the dividends they receive from the entity. The s-corporation allows for pass through taxation meaning that the entity profits and losses pass through to its shareholders who file on their own personal returns, there is no corporate level taxation for s-corps.

Ready to start a business in either Minnesota or Wisconsin? Contact us today if you have questions about this topic or if you need assistance determining what business entity may be right for you, 651-439-2878.