Business Entity: Entrepreneurs' First Big Business Decision

One of the first decisions that an entrepreneur must make is also one that can affect their finances for years to come. That decision is which business entity they should use. What is a business entity? What options exist? And how do each affect both the company and the owner(s)? Here are some answers to your questions. 

What Is a Business Entity?

A business entity is a broad term that refers to the type of organization under which a given business operates. Each entity type has its own legal, financial, reporting, and taxation rights and responsibilities. The person setting up the business can choose from a range of entity types. Some of these are very informal and highly connected to the person while others are very distinct from the owner themselves. 

What Are the Categories of Entity?

In general, there are four main categories of business entities that most people use for their small business. The first is the simplest: sole proprietorship. This business isn't its own entity by legal and tax standards. It is inextricably linked to the owner. Its assets and obligations are their assets and obligations—and vice versa. If an entrepreneur makes no formal choice about an entity, they're generally a sole proprietorship.

The next level of separation from the owner's personal finances is a limited liability company (LLC). LLCs are a hybrid of the simplicity of a sole proprietorship and the liability protection of a corporation. The owners of a limited liability corporation may choose to have the business taxed as a sole proprietorship or a corporation.

If you want to operate a business with one or more partners, you may form a business partnership. As with LLCs, partnerships are somewhat separate from the partners' personal finances. The partners are protected by the partnership agreement, which sets forth how management and profits are divided, how to resolve disputes, how to transfer ownership, and more. Partners may be general or limited. 

Finally, there are corporations. These provide the most separation between the owners and the company's activities. This is because the corporation is treated as entirely distinct from those who own and operate it. Owners are actually stockholders. The corporation may be an S corporation, which is known as a pass-through entity, or a traditional C corporation. 

Why Does Business Entity Matter?

If you just want to start a small business, all this may seem like unnecessary complications. But choosing the right (or wrong) entity has serious consequences. What are some of these? 

First, there are the finances. If your business fails to take off and it incurs substantial debt, a sole proprietor is personally responsible for those debts. Partners in the same situation are personally liable for business debts according to the terms of their agreement. Stockholders in a corporation, though, are not responsible for company debts. Neither is the company responsible for theirs. 

Taxes are another important concern. Corporations pay income taxes just like individual Americans do. However, the stockholders also pay taxes on the portion of profit they declare as their own income. This is known as double taxation. On the other hand, the taxes on profits of pass-through entities (such as sole proprietorships and LLCs) are paid by the individual owners. 

Finally, some entities are easier to open, close, and transfer ownership. To transfer ownership of a corporation, you simply sell or gift your stock in it. But you can't really sell a sole proprietorship as an entity since it has no legal existence apart from you. You would sell its assets instead. And partners must adhere to the agreement about how to transfer each person's stake in the business. 

Where Should You Start?

Does all this seem complicated to you? If so, you're not alone. The best resource to help you make the right choice is an experienced business attorney in your state. The Law Office of W. Randall Holcomb, PLLC, assists North Carolina entrepreneurs and business owners with all their legal needs. Call today to make an appointment.