What is an entity structure? Tips to choose the right one
There are many options to consider when opening a business, but there is only one right answer for structuring your entity. Each entity structure has different benefits and requirements that can either catalyze your success or complicate your growth.
The structure you choose will imbue your organization with a distinct character, not to mention determine how much it pays in taxes, who is liable for different legal aspects, how and when you can raise money and even what documents are required to be compliant in running the business. While the business entity structure is not the only determinant in these processes — location, stakeholders and industry all play key roles as well — it is the most important.
This guide is not intended as advice to help you establish your business. Instead, it offers a jumping-off point for the larger conversation you should be having about how to structure your business, including:
- What company structure means
- Why choosing the right entity structure is important
- The four most common types of entity structures
- How to choose an entity structure
What is entity structure?
An entity structure refers to the way an organization or business is organized. The structure an organization chooses at inception dictates its legal obligations, financial operations, tax burdens, operational processes and strategic planning.
All entity structures have distinct features across seven components:
- Legal structure: The law holds different entities to different standards. Choosing a limited liability corporation (LLC), for example, comes with legal and tax responsibilities unique to a sole proprietorship.
- Ownership structure: Entities must also decide how ownership is divided, whether there’s a sole owner, a partner or groups of shareholders or members.
- Governance structure: These structures dictate which mechanisms control the corporation, including the roles and responsibilities of the board of directors (if there is one) and executives.
- Operational structure: As the name implies, this component encompasses how the entity will operate and considers hierarchies, reporting lines and more.
- Financial structure: This involves how the entity arranges its finances, such as capital structure, financial management and budgeting.
- Regulatory and compliance structure: Entities of all types must comply with certain regulations, but the requirements will vary greatly. This refers to the systems and processes the entity will use to manage compliance with relevant laws, regulations and standards.
- Strategic structure: Entity structures should be tailored to the organization’s mission, vision, and goals and the arrangement most likely to achieve them.
Why is entity structure important?
How you structure your business significantly influences various aspects of how the organization operates and its ability to succeed. Choosing a structure that will propel your business forward is essential, and it’s not always easy.
Your goal is to find a “just right” structure that offers you a balance of freedom to grow your business and the structures to remain competitive in your industry landscape. As a result, entity structure is crucial to:
- Legal and tax implications: Entity structure determines which laws you must follow and taxes you must pay. Choosing the wrong one could expose you to unnecessary legal liability or tax obligations.
- Liability protection: Certain entities hold the business and the individuals behind it as independent entities, giving individuals limited liability protection that shields their personal assets.
- Control: How do you want your entity to make decisions? Choosing the right entity is essential to having an appropriate governance framework and supportive structures in place.
- Efficiency: A well-defined entity clearly defines roles and responsibilities for all stakeholders, reducing miscommunications, duplication of efforts and resource wastage.
- Funding: Investors may feel more confident investing in some entity types over others. Appropriately setting up your entity can help you gain access to a wider pool of funding and investment opportunities.
- Growth: Some entities scale more easily than others. If growth is part of your vision, choosing the right entity at the start will streamline eventual expansions, mergers, acquisitions and more — as will adopting the right software to manage it all.
The different business entity structures
Entity structure #1: Sole proprietorship
Sole proprietorships are one of the most common entities in the U.S.; individually owned businesses have tripled since the 1980s while the number of traditional corporations has shrunk. This is because, in many ways, a sole proprietorship is the most uncomplicated option for opening a business.
It is best for small businesses with only one interested party running the operation. It is the most common business entity structure and tends to involve the least amount of paperwork. These businesses can be owned jointly by a single individual or a married couple. The main drawback is that there is no separation of the owner from the liability of the business, meaning that the owner is responsible for any legal or financial penalties levied on the business and taxes.
Entity structure #2: Partnership
Partnerships involve two or more individuals who agree to be liable for the losses of or share in the profits of a business venture. Without getting too technical, there are generally four types of partnerships.
- General partnerships are the least formal and consist of any unincorporated businesses. General partners take part in the day-to-day operations.
- Limited partnerships are incorporated businesses with both limited and general partners. Limited partners tend to be more passive in business operations, i.e., they act as investors.
- Limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) overlap because they both provide greater liability protection for the partners involved, while LLLPs provide less liability protection for certain partners.
If you expect to have many passive investors, one of the limited partnership options (LP, LLP, LLLP) is the best option here. The main benefit of a partnership is that the taxes on any profits or losses are 'passed through' to the individual owners, and when they file their individual tax returns, they report the income there. This means more profits upfront.
Entity structure #3: Limited liability company
Limited liability companies (LLCs) and professional limited liability companies (PLLCs) are the intermediate steps between a partnership and a corporation. They offer both the 'pass-through' taxation that is so beneficial in partnerships and the greater liability protection that exists in corporations.
There are certain drawbacks to this, as these organizations are — depending on jurisdictional law — mandated to dissolve upon the death of a partner. PLLCs are a special form of LLCs for professionals such as doctors or dentists.
Entity structure #4: Corporation
A corporation is the most complex form of business entity structure we have discussed so far and, as such, the most expensive to arrange. They are completely separate, legally speaking, from their investors. This engenders an incredible degree of protection in terms of liability for those who create the corporation. Still, it also means that there are more tax and regulatory issues to deal with.
Corporations are responsible for their own debts, and thus, the owners assume no risk to their personal assets. The costs associated with a corporation are due largely to operations and taxes. Business operations involve a much heavier load of accounting and regulatory/compliance resolution, as they are incorporated within a certain state and must navigate the laws of that state.
The burden of taxation on corporations is much higher because corporations must pay taxes, and the profits paid to shareholders are also taxed on their individual tax returns. Depending on the corporation's structure, sometimes individual taxation can be avoided by paying profits as salaries, as corporations are not required to pay taxes on profits dispensed as reasonable compensation. However, given how the Internal Revenue Service (IRS) defines 'reasonable,' these are muddy waters and should be navigated with the help of a legal expert.
There are two types of corporations:
- S corporations: These are the most popular form of corporation due to their structure. An S corporation protects the corporate veil with tax benefits more akin to a partnership; income and losses pass through to individual shareholders to be reported on their tax returns.
- C corporations: Also called standard corporations, these are the entity structures most people think of when they hear the word “corporation.” They are composed of shareholders, directors and officers. The tax benefits of a C Corporation can be split between the shareholders and the corporation, resulting in a friendlier tax bill overall. C corporations can also deduct certain expenses, such as employee benefits like health insurance plans.
How to choose an entity structure
Choosing the right entity structure is critical to your business. The structure becomes foundational to your success and sustainability and has far-reaching implications for your operations, finances and more.
As you seek to start a business, evaluate which entity structure is right for you:
- Understand the types of entity structures: We outline the four most common types of entities above, but those details are just the beginning. Thoroughly research each and the laws governing them in your area to understand their function and whether they suit your goals.
- Assess your business needs and goals: Refer back to the seven components explained above and consider your needs for each. Determine how much liability you need, the tax implications, such as income and self-employment tax, how you want to make decisions, whether you plan to raise capital and the operational flexibility you need.
- Evaluate the pros and cons: There is no wrong entity structure, but each has very real pros and cons.
- Sole proprietorships: Inexpensive to set up and offer full control, but with unlimited personal liability and difficulty raising capital.
- Partnership: Easy to establish with shared responsibilities, but carries personal liability for partners and potential for conflict.
- LLCs: Limited liability and flexible management with pass-through taxation, but more complex than sole proprietorships and partnerships.
- Corporations: They have limited liability and are easier to raise capital, but they have more regulations and require expert help to set up and increase the tax burden.
- Consider your industry and location: Some industries have specific requirements or common practices related to entity structure that you must follow to be competitive. State laws also vary, so the benefits of each structure can depend on where you live.
- Consult a professional: Laws related to entity structure are complicated, and it can be wise to seek expert advice. An attorney, an accountant and a business advisor can each offer counsel about different aspects of your business.
- Define your future vision: How will your entity look in five or ten years? Your long-term goals for growth, potential sale or transfer of ownership can all influence which entity structure is right for you.
- Consider documentation and compliance: Once you choose a structure, you’ll have to file the necessary documents and maintain compliance with regulatory requirements related to it, often using a governance platform. Anticipate these obligations and determine whether you can adhere to them.
Complex entity structures require adaptable entity management systems
The more complex the business entity structure, the more complex the documentation. The needs of a business with many different interests across multiple industries are too much to document in the old-fashioned way, and the responsibility for finding the right solution will often fall on the corporate secretary. There is only one right answer in this predicament: a powerful entity management system that can be customized and optimized to cater to the precise needs of the business in question.
Diligent Entities, part of the Diligent One Platform, alleviates the administrative burdens of entity management. Centralize all your critical business information in a simple, secure platform accessible anywhere and tailored to help entities of all kinds visualize their structure.
