One of the key considerations when starting or developing a business is the business entity type. A business entity is, in short, an organization that one or more individuals start to engage in a trade, conduct business, or engage in other activities of a similar nature. Depending on the type of business and certain determining factors, there are different business entity types available. While a business may start as one type of entity, it may be in the best interests of the owners to convert to a different type at a later time.

Here we’ll go over the specific business entity types along with some of the reasons why you might want to convert to different types over time.

Sole Proprietorship

A sole proprietorship is both the most popular and simplest type of business entity, with over 23 million people qualifying as sole proprietorships, i.e. 73% of all American businesses. Any individual who starts a new business and is the sole owner is automatically made a sole proprietorship, without any need to register as one. However, depending on the type of business, owners may need to obtain local permits or business licenses. In many cases, service professionals such as consultants and freelancers operate under a sole proprietorship, but some more established organizations with a single owner may also qualify. 

Limited Liability Company (LLC)

Limited liability companies, or LLCs, are almost a blend of the other types of entities. LLCs, similar to corporations, offer limited liability protections that eliminate personal liability. On the other hand, like sole proprietorships and partnerships, they prevent the need for as much paperwork and requirements. It’s also possible for LLC business owners to determine how the IRS will tax them, as the IRS can treat the LLC as either a pass-through entity or a corporation. In pass-through entities, profits and losses “pass through” to the business owner’s personal tax returns. Many small business owners and freelancers choose this entity for their business as it gives them corporation-like legal security with the simplicity of a sole proprietorship.

S-Corporation (S-Corp)

S-corporations, or S-corps, are somewhat similar to sole proprietorships and partnerships in that they qualify as a pass-through entity when it comes to taxes. Like LLCs, owners don’t have personal liability, and unlike C-corporations, there isn’t any taxation at the corporate level. For businesses that want more flexibility regarding taxes while benefiting from a corporate structure, an S-corp structure is typically ideal.

C-Corporation (C-Corp)

Although many small businesses neglect to consider C-corps because of their complicated structure, they are often appropriate for businesses that need sufficient legal protections as they grow. C-corps function as independent legal entities that don’t fall under the business owners. A board of directors, officers, and the owners in the form of shareholders are capable of controlling a C-corporation. However, a single person can control the entirety of the C-corp. The main drawback of a C-corp is the level of regulation and taxation, with many aspects with which to remain compliant. C-corps are limited liability and come with more tax deductions, but double taxation is also possible if shareholders intend to offer dividends.

Reasons to Change Business Entity Types

Depending on a business owner’s fluctuating needs when it comes to taxes, personal liability, reporting requirements, and other aspects as the business grows, there are certain reasons for changing business entity types. These reasons could include:

Liability

Business owners will want to consider the type of personal liability that suits their situation. In the case of a sole proprietorship, personal assets are shared with the business’s assets, which can be safe for a solitary business owner such as a freelancer. As the business grows, however, and that owner wants to hire additional employees, liability can become a bigger issue. In these cases, an LLC or a C-corporation might be more appropriate, seeing as these businesses effectively separate business assets from personal assets to protect the latter.

Tax Minimization

Tax burden is another big consideration when selecting a business entity type. LLCs often have a heavy self-employment tax burden, for example, while C- or S-corporations allow for reduced personal Medicare and Social Security tax obligations.

Fund Raising and Business Growth

Over time, businesses could expand and require additional funds to achieve growth objectives, which can be a challenge for LLCs. By converting to a C-corp, along with selling stock, the business could more efficiently raise funds that facilitate growth in the long term.

Expanding Products, Services, and Geographies

With the addition of more products and services, a business may also want to convert from a sole proprietorship or LLC into an S- or C-corp for more protections. If those services cross national borders, international taxes will apply, which could make things even more complex and require the advice and guidance of a tax professional.

Ultimately, there are many reasons why you might convert to a specific business entity type, based on the size and scope of your business, along with tax and liability requirements. Choosing the right entity can help you manage and grow your business while remaining consistently compliant and legally protected.

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