What are the Types of Business Entities? | Legal Entity Management | Articles

Modified May 14, 2020

Business entities are essential for starting, managing, and growing your business. This guide to business entities
covers every major type of legal entity, core concepts, criteria for choosing an entity, and legal entity
management.

Contents

Business Entities: How to Choose?

Once you know where you want to register your business, you must choose your type of legal entity. While legal
entities are not quite like ordering food off a menu after you choose the restaurant, you do have options.

Choices: jurisdiction +
entity type

Best choice of available options under prevailing circumstances

There are many considerations for choosing a legal entity type. This is not an exhaustive list.

Criteria

When choosing a legal entity, ask

• What is the cost?
• How complex is the process?
• Are there constraints on your management plans? and
• Will it support your financial and tax objectives?

Cost of Incorporation

Registering a legal entity costs money: sometimes a little; sometimes a lot. Costs include the filing fee,
renewal fees, professional fees, and franchise taxes. These are direct costs.

Filing fees

Every jurisdiction imposes a filing fee. Fees change frequently. There are often fees for particular kinds of
filings. Fees might also vary by type of entity. Review the fees for your jurisdiction and entity type
carefully.

Here, for example, are the fees to form a business entity Delaware as of August, 2018.

Renewal fees

Registering a company is not a one time event. You must renew the registration to keep it current. Not all
registration renewals are annual. Some jurisdictions do not require renewal for several years. Simply do the
math to annualize registration fees to compare them from jurisdiction to jurisdiction, or entity type to entity
type.

Professional fees

There are three types of professionals you may need to pay: lawyer, accountant, and registered agent.

Legal fees for incorporation can be modest or breathtaking. Business lawyers should be able to tell you about the
costs for incorporation in your jurisdiction before starting any work. Legal fees can rise quickly to cover
complexities beyond the registration.

Fees for accountants follow a similar pattern. Providing initial tax advice and setting up your accounting might
be one cost, but getting help with complex asset transfers, foreign accounts, and the like, can quickly raise
the costs.

Good legal and accounting advice early in the process is money well spent.

Registered agents, sometimes called “local agents”, are people or companies that are empowered to accept legal
notices on behalf of the business. The registered agent address is published to the world. While you can often
be your own registered agent in your own jurisdiction, you might choose to use a registered agent so that any
legal notices do not get mishandled.

Franchise tax

Not all jurisdictions impose a franchise tax, but many do. A franchise tax is basically a tax on the business’
balance sheet. It might be tied to assets or to net worth. The idea is that your registration and renewal fees
are determined in part by the assets of the business.

If the entity operates an “asset light” business, like consulting, then the franchise tax might be low for a long
time. However, for an asset intensive business with equipment, real estate, or large cash balances, the
franchise tax will be a material consideration.

This is an area where good accounting advice about recording the value of your assets is helpful.

Ease of Incorporation

It is not difficult or time consuming to incorporate many entities in jurisdictions that encourage incorporation.
The time and effort, however, can vary. Your local lawyer will have the most accurate estimate, but there
several factors to consider: total time, number of steps, incorporator requirements, minimum capital required,
and the number and type of investors.

You can use the World Bank data on business entity formation to get benchmarks to help you
estimate. While the World Bank data includes some subnational jurisdictions, like states in India, it does not
include any data for individual states in the United States. You cannot compare Delaware to California and New
York, for example.

Management Requirements

Some jurisdictions and entity types require named officers or certain board structures. You can often satisfy
those compliance requirements without interfering with your management plan for operating the business.

For example, if you must name a President and Secretary as authorized signers and you have a co-founder, then one
of you can serve one role while the other serves the other function. This choice does not necessarily have any
effect on the management team you put in place.

Some jurisdictions also impose a dual board structure where one board is charged with governance matters and the
other is the operational management board. Before chasing a dual board structure, make sure that it is required
in your jurisdiction for your size and type of business.

Tax and Financial Objectives

One of the most important factors when choosing a legal entity is the tax treatment of that entity’s income. The
place to start is the financial objective for the business: current income or growth. Of course, everyone wants
both income and growth, but it is a question of priority and scale.

Consider two business: Great Service Group and Fast Product Company. Great Service is an information technology
service and consulting business. The owners want to take as much money out of the business for their personal
income as possible.

Fast Product makes a mobile app with global market potential. The owners of Fast Product want to reach the
largest market possible as quickly as possible. They only need a minimal income.

Both companies want to incorporate in Delaware, because of the well established corporate law and ease of
incorporation. However, which type of legal entity should each choose?

From a tax perspective, a corporation is a bad choice for Great Service, because they will have to pay double
taxation. Great Service will have to pay income tax on its sales directly. When Great Service pays the owners
through salaries and/or dividend distributions, the owners will pay personal income tax.

If Great Service incorporates as a Limited Liability Company (LLC), then the Internal Revenue Service will treat
Great Service as a disregarded entity for tax purposes and only tax the distributions to the owners.

A corporation is probably the right choice for Fast Product, because the owners will not take much as a
distribution. Fast Product will show little profit subject to corporate tax rates because they are spending to
grow the business, which means expenses are high. The company is paying small salaries to the owners so they do
not pay much personal income tax.

Income versus growth is just one consideration informing your selection of legal entity. The choice is rarely
this simple. Being clear about your financial objectives can help clarify your entity selection.

Tax Considerations

The choice of where to incorporate and the type of entity to create have important implications for your taxes.
Jurisdictions impose a variety of types of taxes.

Types of Taxes

Jurisdictions may impose one or more of the following taxes: personal income, business income, franchise,
property, consumption, and capital gains.

Incorporating a business will probably affect your personal income. It might go up or go down,
depending on the choices you make and your objectives. The critical question is how will your tax jurisdiction
treat your income from the business.

What is the applicable tax rate for business income in your jurisdiction? The choice of legal
entity is probably less important than the character of the income. Current and qualified tax accounting advice
in your jurisdiction is important.

The place of incorporation may also impose a tax on the business’ assets or net worth in the form of a franchise
tax. A franchise tax is typically imposed at the time of registration and renewal by the jurisdiction
where the business is registered.

Jurisdiction also strongly influences property taxes. Any layer of government might impose taxes
on property the business owns or acquires. If the business is asset intensive, then property taxes can influence
where you decide to incorporate and operate.

Consumption taxes come in two flavors: sales and use taxes (“Sales tax”) or value-added taxes
(“VAT”). End consumers pay sales tax that is collected by a retailer who sends it to the taxing authority. VAT,
on the other hand, is paid at each step of the supply chain. Sales and VAT regimes impose different
administrative burdens on your business. Sales tax is the consumption tax used by states in the US.

Finally, capital gains taxes warrant consideration. A business might generate capital gains,
which are profits on the sales of things not in the ordinary course of your business, such as
selling a building. But the most significant capital gains event is the sale of the business after it is wildly
successful. How will the jurisdiction tax that event? As a practical matter, there might not be much choice
about where to live and run the business.

International Taxes

A quick word about a long, complex subject: international income taxes. If a business sells products and services
across national boundaries, tax advice from a tax professional is critical.

Countries tend to take either a territorial or residence approach to taxation
of income earned outside the business’ home countries.

The territorial system only taxes income earned within the country. The
residence system taxes income earned globally for every company residing in the territory.

Hong Kong, for example, generally uses a territorial tax system. A Hong Kong company will pay taxes earned from
sales in Hong Kong, but not on income earned in Australia and Malaysia. If, however, the Hong Kong company
registers in Australia and/or Malaysia, then it will be subject to those countries’ tax regimes.

The United States is one of the most prominent examples of the residence system. US companies pay taxes on income
generated in the US. US companies also pay taxes on global income, once that income is
repatriated to the United States. In this example, income from Canada and Mexico are repatriated and taxed.

So knowing where your customers are and how you will reach them can affect your income tax bill and therefore the
financial success of your business, and ultimately where you decide to incorporate your business.

Conclusion

Business entities are tools to help build a business. Some tools are better for certain jobs. Knowing which
business entity to use and how to structure one requires the advice of a licensed lawyer retained for the
purpose.

After the legal entity is formed legal
entity management software is a critical tool for maintaining the structure you built.