Understanding Business Entity Options
Structure, Status, Designation, & Purpose
Every founder and entrepreneur has had to make the decision of how they want to go about operating business. When it comes to social impact, the general default tends to be 501c3 organizations because that is what is commonly known for prioritizing social purpose. However, as much as we love and appreciate non-profits (better known internationally as NGOs—non-governmental organizations), they are not the only option on the table. Here is a simple guide outlining the most common legal entity structures and tax filing statuses to consider as a mission-driven company or social enterprise. Towards the end, we’ll also share some thoughts on designations and purpose. To learn more about certifications, check out this post here.
Legal Structure versus Tax Status
To understand the wide range of options, it’s important to first clarify and distinguish between legal entity structure and tax filing status. The legal entity structure refers to how the business is registered. It determines how the government recognizes the business. Tax filing status on the other hand is specific to how the business reports income and pays taxes. Depending on certain variables, different structures have more than one tax status option and these may have varying advantages and disadvantages to keep in mind.
Legal Entity Structure
Businesses are typically registered with the state and requirements vary by state for moderate fees. It may also be required to register federally with an FEIN (federal employer identification number), which is a free service of the IRS. Generally there are four primary entities.
Sol Proprietorship: This is the simplest form of business and its owned and operated by a single individual. It may include exposure to liability risks, meaning the owner’s personal assets are not protected should the business assets be insufficient when seeking restitution for a legal matter.
Partnership: This is when a business is owned and operated by two or more individuals. There are generally three types of partnerships: General Partnership (GP), Limited Partnership (LP), Limited Liability Partnership (LLP). Similiar to the aforementioned, partnerships can equally be held personally liable for business debts should its assets be insufficient when seek restitution, unless it has limited liability.
Limited Liability Company (LLC): This is a flexible structure that offers protections so personal assets are not liable for business debts or other liabilities so long as the court does not “pierce the corporate veil.” There are several types of LLCs including single-member (SMLLC), multi-member (such as an LLP), and series LLC (which allows the entity to hold subsidiaries as separate entities), among others. To establish an LLC, the owner(s) will need to create and file “Articles of Organization.”
Corporation (Inc.): A legal entity that is separate from the owners and usually includes a board of directors who are fiscally responsible for the business oversight. It carries many of the same rights and responsibilities as an individual. To establish a corporation, the Board will need to create and file “Articles of Incorporation.”
Tax Filing Status
There are generally four types of tax filing statuses, whereas only two are applicable for corporations. For more details about small business taxes, check out the “Understanding Small Business Taxes” deck by the FDIC. These differ in many ways, including but not limited to:
Who can own the company
How profits and losses are allocated and distributed between the owners
How (and how much) taxes are paid
How profits and losses are recognized
It is important to note, that as your company grows, it may make sense to consider different tax filing status options based on the needs of your revenue increase. We strongly encourage founders and entrepreneurs to work with a CPA to identify the most suitable option for you.
Disregarded (form 1040): A disregarded entity is a business entity that (1) has a single owner, (2) is not organized as a corporation, and (3) has not elected to be taxed as a separate entity for federal tax purposes. Therefore, the federal government will recognize the LLC entity as a sole proprietorship. The pros include pass-through taxation, easy tax filing, and limited liability protection. The cons to consider include a harder time obtaining investors and paying self-employment taxes on top of other business taxes.
Partnership (form 1065): A partnership must file an annual return for income, deductions, gains, losses, etc., from its operations, however it does not pay income tax. Instead, it "passes through" profits or losses to its partners. Each partner reports their share on their personal tax return using Schedule K. It is important to note that partners are not employees, therefore they should not be issued a Form W-2.
S-Corp (form 2553): To avoid double taxation on the corporate income, S corps can elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Their shareholders report the flow-through of income and losses on their personal tax returns and are assessed at their individual income tax rates.
C-Corp (form 1120): This status essentially allows the the owners to be federally taxed twice, once as a corporation, and once as individuals. This is become the profit is taxed to the corporation when earned, and then is also taxed to the shareholders (owners) when distributed as dividends, thus creating a double tax. The profit and loss stay in the company and it files its own tax return with a 21% flat tax on its profit (not earnings). This option is best for those who seek to go public or attract certain investors.
Tax Exemption Designation
The benefit of being a non-profit organization is they are exempt on paying taxes and can offer donors tax deduction for their contributions. This means the entity abides by the Internal Revenue Code (IRC) section 501(c) which has several parts, the most popular designation being 501(c)3.
501(c)(1): Any corporation that is organized under an act of Congress that is exempt from federal income tax
501(c)(2): Corporations that hold a title of property for exempt organizations
501(c)(3): Corporations, funds, or foundations that operate for religious, charitable, scientific, literary, or educational purposes
501(c)(4): Nonprofit organizations that promote social welfare, typically political in nature
501(c)(5): Labor, agricultural, or horticultural associations
501(c)(6): Business leagues, chambers of commerce, and others that are not organized for profit
501(c)(7): Recreational organizations
These entities are typically corporations though in same rare cases LLCs may be eligible to file for a 501(c) designation as well. The key distinction to note is that corporations are generally expected to prioritize shareholder returns, known as shareholder primacy, supported by a 1919 supreme court case of Dodge vs. Ford Motor Co. On the other hand, nonprofits are expected to uphold public benefit and must reinvest all profit back into their cause.
Public Benefit Corporation (PBC)
An alternative to prioritizing shareholder primacy is public benefit corporations (PBC), which maintains the structure of a for-profit company while prioritizing stakeholder governance over shareholder primacy. It means the difference between doing anything else exposes the company to potential shareholder lawsuits for violating its fiduciary duty. This structure enshrines the purpose in the governing documents to guarantee the company remains mission-driven even in transitions and changes (such as mergers or IPOs) through transparency and accountability. Stakeholders are generally defined as anyone materially affected by the company’s decision-making, such as employees, customers or consumers, local communities, wider society and the environment.
Unlike nonprofits, they are focused on balancing a triple-bottom line to ensure their profits do not come as a cost of social or environmental welfare but are not required to reinvest their profits. They are also taxed as normal corporations and do not conduct tax deductible fundraising. Maryland was the first state to enact PBC laws in 2010, and as of September 2023, 36 states have followed suit. Nationwide, more than 3,000 corporations are incorporated as PBCs. To learn more about B Corps, a third-party certification, check out our post on Business Certifications for Mission-Driven Companies.