While launching a business is usually an exciting and rewarding activity, many factors come into play that make it a daunting process and, occasionally, a risky endeavor. Understanding how to protect your personal assets and establishing a registered business entity are among the ways to reduce these risks.
To reduce the difficulties usually experienced in creating a business entity, it is best practice to understand key concepts such as liability protection and how to conduct business under various structures and learn about the multiple types of business entities and their functions before starting the process.
For tech talents working remotely or individuals keen on building remote or distributed teams, this article explores business entities, their various types, and insights on choosing the right one.
What is a Business Entity?
Simply put, a business entity is a legally recognized organizational structure. A registered business entity is an organizational structure typically formed by one or more people to conduct business activities. It also determines the way the government assumes taxes on a business.
Typically, State laws govern the conduct and formation of business entities. This means that the rights and obligations of the business owners are subject to state laws. Business structures such as limited partnerships and limited liability companies have different duties and benefits. While there are businesses with single owners, there are business entities with multiple owners, and each of these types of business structures has its advantages and challenges.
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Types of Business Entities
There are different types of business entities. Each of them offers unique benefits and organizational structures, such as limited liability protection and other ways to conduct business. The following are the five common business entities with their benefits and challenges.
This type of business entity is regarded as the simplest form of business organization. As the name implies, a sole proprietorship is managed and operated by a single person (or, in some cases, a married couple). The sole proprietorship is the easiest and most common type among the different types of business entities. Under the law, the sole proprietor is the business owner and operator. A sole proprietorship usually requires no form of state or government registration before launch. However, local laws may demand applications for business permits, licenses, and association registration applications. This is dependent on the type of business industry.
The sole proprietor reports business income and expenses on their personal income tax returns, making tax filing relatively straightforward. In this model, one can use their personal assets to support the business, though it increases the risk of losing those assets if the company encounters financial trouble.
While sole proprietors can hire employees, managing payroll and benefits for employees may add complexity to their operations. Also, understanding and correctly filling out a sole proprietorship tax form is vital to maintaining good financial health.
- Ease of formation: Setting up a sole proprietorship is simple, often requiring minimal paperwork and few fees.
- Control: As the only owner, you have total control over business decisions.
- The simplicity of tax preparation: The business is not taxed separately, making tax preparation straightforward.
- Personal liability: Owners are personally liable for all business debts and liabilities, putting personal assets at risk.
- Funding challenges: As a single-owner business, obtaining funding can be more challenging than in multi-owner business structures.
- Heavy workload: The owner is responsible for all aspects of the business, which can lead to a significant workload.
An independent contractor is a person that renders goods or services to another entity under a contract or verbal agreement. They maintain control over how they complete their work and are not considered employees. Thus, they don't benefit from minimum wage, overtime protections, or other rights that cover employees.
Independent contractors are self-employed and responsible for paying their taxes. However, they can deduct business-related expenses on their tax returns, as mentioned in this guide for 2022 tax deductions.
- Flexibility: Contractors have greater control over their work, including when, where, and how it's completed.
- Tax advantages: Business-related expenses can be deducted from tax returns.
- Diverse work opportunities: Contractors can work with multiple clients simultaneously, providing varied work experiences.
- Inconsistency in Work: One of the primary risks of being an independent contractor is the potential for an inconsistent workload. Contractors might have plenty of work one month and very little the next.
- No Employment Benefits: Unlike employees, independent contractors are not entitled to benefits like health insurance, paid time off, or retirement plans from their clients.
- Responsible for All Business Aspects: Contractors must manage all aspects of their business, including marketing, billing, and tax obligations.
- Liability: Independent contractors are generally liable for their own business risks. If something goes wrong on a project, the contractor is typically responsible.
Limited Liability Company (LLC)
A Limited Liability Company guards its owners from debts or liabilities incurred by the business. It takes the positive features of other types of business entities, but with the protection of liabilities lies corporations. Also, a limited liability company (LLC) has fewer requirements and paperwork, like a sole proprietorship and partnership business entity. Additionally, in an LLC business entity, the owner can decide on the method of filing taxes. The owner can choose to file taxes as a corporation or sole proprietorship.
- Limited liability: Owners' personal assets are protected against business debts and claims.
- Flexible tax status: LLCs can choose how they are taxed as a sole proprietorship, partnership, or corporation.
- Less paperwork: Compared to corporations, LLCs face fewer state-imposed annual requirements and ongoing formalities.
- Limited life: In many states, an LLC is dissolved when a member leaves unless an agreement states otherwise.
- Self-employment taxes: Members of an LLC are regarded as self-employed and must pay self-employment tax contributions towards Medicare and Social Security.
A corporation is a business entity where the owners are protected by limited liability. Often referred to as a C corp, a corporation is a legal entity that is capable of generating profits and can be taxed.
Corporations are required to register with the state and adhere to regulations that ensure that the business entities are regarded as separate entities. Such requirements or regulations include drafting articles of corporation, having a board of directors and conducting regular annual meetings.
- Limited liability: Shareholders are not liable for corporate debts or liabilities.
- Easy transfer of ownership: Ownership can be transferred through a stock sale.
- Unlimited life: A corporation continues indefinitely, regardless of ownership changes.
- Double taxation: Corporations are taxed on earnings, and shareholders are taxed again on dividends.
- Costly and complex to form and operate: Incorporating involves more paperwork, expenses, and complex legal and tax requirements than other business structures.
Partnerships are the closest form of a business entity to a sole proprietorship. However, the difference lies in the number of owners. While sole proprietorships are typically a one-person business, a partnership is a business entity with two or more owners. These owners often have equal capital contributions to the company. Also, two kinds of partnerships exist - General partnerships (GP) and Limited partnerships. In the two types of partnership, the similarity is that the co-owners or partners are actively involved in the management of the business. They also share the profits and incur losses equally.
- Easy and inexpensive to form: A partnership is simple to establish and involves low startup costs.
- Combined resources: Partners bring together diverse skills, knowledge, and resources.
- Tax advantages: Business profits and losses pass through to individuals, avoiding the double taxation of corporations.
- Joint and individual liability: Partners are liable for their actions and the business debts and decisions made by other partners.
- Disputes among partners: Disagreements can occur, potentially causing business disruption.
- Shared profits: Profits must be shared according to the partnership agreement, which may lead to disagreements if not clearly outlined.
How to Choose a Business Entity
Understanding the different types of business entities, how they work, and their benefits and challenges enables you to make informed decisions on the type of business entity that will work for you. The following are essential factors to consider before choosing entities in business.
Evaluate Your Personal Liability
The business entities have varying risks and exposure to the owner's assets. Asides from the risk level, some business entities are more capital-intensive than others. For instance, launching a sole proprietorship requires less capital than will be required when launching a Limited Liability Company.
Therefore, it is necessary to factor in how much of your personal liability you are willing to contribute to the business. On the other hand, if your business risk is low and you prefer less formal administrative requirements, then a sole proprietorship or partnership might suffice.
Understand Tax Implications
Each business entity has different tax implications. Sole proprietorships, partnerships, and LLCs generally enjoy pass-through taxation, where profits and losses are documented on the owner's personal income tax return. However, understanding how to fill out a sole proprietorship tax form and knowing the relevant tax deductions for independent contractors and the self-employed can help you plan your taxes efficiently.
In contrast, corporations face double taxation—once on the company's profits and again on dividends distributed to shareholders. This aspect could be a significant factor if you anticipate your business will retain profits for reinvestment.
Analyze Administrative Requirements
Administrative requirements and ease of setup are essential considerations. For instance, sole proprietorships and partnerships are easy to set up and require minimal paperwork, whereas corporations need regular board meetings, extensive record-keeping, and annual reports. Weigh these factors carefully, and remember that you can outsource complex administrative tasks to make the process smoother.
Consider Your Future Business Needs
A corporate structure might be more appropriate if you anticipate attracting investors, selling stocks, or going public. It is also crucial to remember that hiring employees or contractors can change based on your business entity. For instance, hiring employees comes with additional tax and legal responsibilities as a sole proprietor.
When planning for global expansion, understanding international business challenges and the role of culture in international business is essential. You'll also need to be informed about the implications of paying independent contractors in other countries.
Build A Global Business Entity with Skuad
Creating a business entity can be challenging, but it is also an enriching endeavor. Therefore, getting the details right and launching with fewer uncertainties is essential. Whether you're a solo tech talent embarking on a new venture or a tech team aiming to build a robust remote or distributed setup, it's essential to understand these various entities to make an informed choice.
But what if your vision extends beyond borders? The complexities of international hiring, employment laws, and tax regulations can be daunting for tech entrepreneurs and talents aspiring to tap into the global market. This is where Skuad comes in.
Skuad, as a powerful Employer of Record platform, empowers organizations to build global teams in over 160 countries without setting up subsidiaries or legal entities. With Skuad, you can compliantly onboard full-time employees and contractors, manage payroll efficiently, and quickly navigate country-specific employment laws and tax regulations.
Moreover, Skuad's end-to-end solution manages the entire employment lifecycle, significantly reducing your administrative efforts. This leaves you more time and resources to focus on what matters most - growing and scaling your business.
In the complex international business world, overcoming cultural challenges and administrative hurdles is essential for success. With Skuad's robust platform, you can easily navigate these challenges and tap into the global talent pool, ensuring your business thrives in the new age of remote and distributed teams.
What is the difference between a C-Corp and an S-Corp?
The smajor difference between the two types of corporations is how they are taxed. For C-Corp, the income is taxed through the corporation instead of its shareholders, while the shareholders pay taxes in an S-Corp business entity.
What is a Limited Partnership?
A limited partnership is a partnership with one or more limited partners and one or two general partners.