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There are a number of factors to consider when selecting the appropriate entity for your business. Your goals will help determine which factors must be considered and which are most important. Generally, the things to consider are the following:

Ease and Cost of Formation: If a business is going to operate as a sole proprietorship, there may be little cost to the formation and establishment of the business. However, if the business is going to be an entity formed under state law, there are filing fees and possibly minimum annual taxes required. Usually, the type of business venture and its complexity will have a greater bearing on the choice of business entity than will the cost of formation.

Income Tax Consideration: A C corporation is subject to entity-level taxation while partnerships, LLCs and S corporations can elect to be taxed as "pass-through" entities, meaning the tax is imposed on the owners as opposed to the entity. Income tax considerations can also apply to the contribution of property or services by the owners to the entity. States may also impose minimum annual franchise taxes on certain entities. Finally, depending on the type of entity, self-employment taxes may be imposed on the share of income of the owners.

Management and Control: If there are multiple owners, you will have to consider whether all of the owners will have equal say in the management and control of the business. For example, in a general partnership, all of the partners have an equal vote in the management and control of the partnership. However, in a limited partnership, only the general partner is charged with the responsibility of management and control. The limited partners have no right to control the limited partnership, but also have no personal liability for the partnership's obligations.

Liability of Owners: In a general partnership or sole proprietorship, the owners have personal liability for the debts and obligations of the business. However, shareholders of a corporation, members of an LLC, and limited partners of a limited partnership do not have personal liability for the debts and obligations of the business.

Transferability of Interests: With a limited partnership, LLC or closely held or professional corporation, there are generally restrictions on the transferability of the entity's interests. In a publicly-held corporation, transferability of interests is usually a non-issue, due to the free market trading of public securities.

Ability to Raise Capital: Outside investors would prefer to invest in a business where they are insulated from the liabilities of the business. This makes a corporation or LLC a more appropriate entity if raising capital is an important consideration.

Sale of the Business: If you want to sell your business, you may wish to consider a corporation or LLC for ease of transferability of the ownership interest. Income tax considerations are always an important aspect of selling a business and the appropriate entity structure can help you achieve certain tax advantages.

Estate Planning for Families: To facilitate involvement of family in a business while retaining control during your lifetime, you may need to consider an entity that allows for multiple owners. Typical entities for family estate planning are family limited partnerships, LLCs, or a family corporation.

There are many types of legal entities, and the best choice for one particular business may not be the best choice for another. In deciding which entity to use, it is important to understand the characteristics of the various entity choices, considering the pros and cons of each in the context of your own business. Keep in mind that you may want to change your entity type as the business grows and changes.

Advantages and Disadvantages of Sole Proprietorships

A sole proprietorship is a business owned by a single individual. The individual is engaged in the business personally rather than through an entity. The business may operate under a business name, but the assets are owned by the individual. There is no formal separation of the business assets and operations apart from the individual.

The greatest advantage of the sole proprietorship is its ease of start-up. You, as proprietor, simply begin doing business. It is less expensive to establish a sole proprietorship since no formal documentation is required. You do not have to pay yourself a salary, but can simply make withdrawals from your business account as needed. A sole proprietorship also does not require any formalities such as formal meetings, or records of officers’ or directors’ decisions. 

There is no need to obtain an employer identification number (EIN) unless there are employees, or unless you are obligated to remit sales tax for products sold. Also, if the business is operated under an assumed or trade name, you may be required to register that name with the state. This is a simple process that typically involves filling out a form and paying a fee. For low risk “hobby” businesses, a sole proprietorship may be a logical choice. If you are selling stamps on eBay, running a tutoring business, teaching music, repairing bikes, or doing anything else with few risks, your money may be better spent buying a good insurance policy, rather than forming a more complex entity.

The disadvantages of operating as a sole proprietorship include the inability to take advantage of certain tax deductions that are available to other business entities, and unlimited liability for the owner. A sole proprietor is personally liable for any damages that are incurred in the course of running that business, and all of the owner’s assets are at risk – whether inside the business or out. This is a huge drawback, even if the business appears to be free of any liability risk. Even a business as mundane as house cleaning or dog walking can generate huge liability problems for the owner if the business is operated as a sole proprietorship. In summary, sole proprietorships offer no asset protection, few planning options, and few good exit strategies.

In the second half of this article, we’ll discuss some of the pros and cons of partnerships, corporations, and LLCs.