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Choosing the Best Entity Type for Your Small Business

When you start a small business, you first need to decide upon an "entity type." The entity type of your business is going to matter -- a lot. It determines how your business is structured and owned and (maybe more importantly) how it's taxed. Let's take a look at the entity types and what they mean for you.

The Different Types of Small Business Entity

There are multiple types of entities, depending on how much legal protection you need, and how the entity will be owned. Here's a general overview:

  • Sole Proprietorship
    • Sole proprietorships don't require any special paperwork to fill out; you must file an additional "schedule C" with your regular 1040 individual tax return. You can deduct business losses from your regular tax return and you can file your taxes quickly. But there's no separation between you and your business legally, which makes you liable for the company's debts and other legal problems.
  • General Partnership
    • A GP is much like a sole proprietorship but involving multiple partners. It's again easy, and it's usually the best choice for people working together. But it can cause issues because of its informality; partners won't necessarily have an agreed-upon legal status and therefore there may be misunderstandings.
  • Limited Partnership
    • An LP is a partnership that is registered with the state. You will need to create business documents. You'll still be responsible for business debts, but people will be able to invest without liability to themselves. It's a good middle ground between being a general partnership and a corporation.
  • C-corporation
    • A C-corporation is an entirely separate business entity, which creates a separation between the business owners and the debts and liabilities of the business. C-corporation owners will pay lower self-employment taxes but may experience "double tax," because the business income will be taxed, and then their own.
  • S-corporation
    • An S-corporation is similar to a C-corporation, but income is passed through the corporation, reducing the amount of taxation.
  • LLC
    • An LLC is a very simple business structure that nevertheless has many of the liability protections and benefits of an S-corporation or a partnership. Owners don't have personal liability for debts and they can choose whether they want to be taxed as an S-corporation or a partnership. When you form the business, you will need to elect to either be taxed as an S-corporation or as a partnership.

These are just the basics; it can get more complicated than that. A business lawyer or tax accountant can tell you more about the differences and how they would impact you.

Largely, you should know that forming a corporation will take more work upfront, but will provide additional legal protections. Forming a general partnership or acting as a sole proprietorship takes virtually no work, but provides no legal protections. An LLC or limited partnership can strike a middle ground.

Further, if you choose anything other than a schedule C or a general partnership, you should be aware that your taxes are likely going to be more complicated. It can be worth it to hire a professional to complete your taxes for you, as there may be things that you'll miss.

Choosing the Right Entity for Your Business

For many small business owners, being a schedule C sole proprietorship has a lot of advantages. As a schedule C, you don't need to file any additional paperwork, and you only have a single tax return every year. But if you want liability protection, an LLC often strikes the balance between being complex and being protective.

It's worth it to take some time to consider what structure your business should take, as it's difficult to change the structure of a business later.

Still not sure which entity type is the best for your business? Consulting with an accounting firm can help. They can give you the information you need on the tax consequences of your selection.

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