Before creating a business entity, you need to choose the right business structure. Although it may seem like a small detail, a business entity’s structure can significantly impact its day-to-day operations, taxes, and more. As such, you need to choose a business structure that gives you the protection you need.
Read on to learn about the three main types of business entities and which of them fits you the best.
What is a Business Entity?
A business entity is an organization created by one or more people. Since they are created according to state laws, business owners must file documents with state agencies, like the Secretary of State, to set up business entities.
There are three main types of business entities:
- Default entities (Sole proprietorships and partnerships)
- Limited liability companies (LLCs)
Business entities can be incorporated or unincorporated. Incorporated businesses are entities created by a formal filing with your Secretary of State or equivalent state office and exist as separate entities from the business owner. These entities account for their own losses and profits and file their own tax documents, separate from the individual’s cash flow management and tax filings.
Many businesspeople elect to incorporate to protect owners from liabilities they may incur from running the business. These entities also pay lower tax rates than individuals.
In contrast, unincorporated businesses, like sole proprietorships, are not considered separate from their business owners. You don’t need to file formal paperwork to create them but the individual business owner(s) remain personally liable for the business activities.
Three Main Business Entities
This article will touch on the three main types of business entities.: LLCs, sole proprietorships, and corporations.
1. Limited Liability Company (LLC)
A limited liability company (LLC) is a formal legal structure that provides liability protection to all of its owners. There are no restrictions on the types or number of owners of an LLC.
LLC owners are called members and have separate private assets from the LLC. This means that the owners’ and members’ private assets, such as their bank accounts, and homes, will not be at risk if the LLC gets sued or goes bankrupt.
There are three main types of LLCs:
- Professional LLCs: These are LLCs created by licensed professionals to form a business. Licensed professionals who create LLCs include doctors, accountants, lawyers, and engineers. Some states, like Arizona, have a special designation, such as the professional limited liability company (PLLC) for these professionals. Other states have alternatives like professional corporations and registered limited liability partnerships.
- Member-managed LLCs: These are common because they are straightforward and work like general partnerships. Each member can enter contracts on behalf of the whole LLC.
- Manager-managed LLCs: Unlike member-managed LLCs, manager-managed LLCs divide management from ownership. Members can choose a manager or managers to run the business. From that point on, only the manager will be able to enter contracts for the LLC. For this reason, manager-managed LLCs are more like corporations than general partnerships. As a result, many manager-managed LLCs use corporation concepts like corporate officers, CEOs, board of directors, and bylaws.
Note that not every state has all types. The exact definition and associated rights and obligations of each type may vary across jurisdictions.
LLCs have become increasingly popular in recent years. Since they’re essentially a mix of corporations and partnerships, they are a great pick for new businesses. However, this doesn’t mean that LLCs are the best choice for every business, as you will find out below.
Forming an LLC is quite simple. All you have to do is:
- Choose the state where you want to create the LLC. Delaware is often chosen because of its robust laws.
- Name the LLC and file the LLC articles of organization with the Secretary of State or equivalent entity in your state..
- Write the LLC operating agreement. This document lays out the members’ management, financial, and other responsibilities and rights.
- Get an employer identification number (EIN) if you want to hire employees for the LLC. The EIN is also called a federal tax identification number.
LLCs usually have pass-through tax status, which means they do not pay income taxes on their income. Instead, the LLC’s income is divided among members, and each member will then pay taxes on their share.
2. Sole Proprietorship
A sole proprietorship is the easiest business entity to create. Any individual or married couple can be the sole owner of the business. Consultants, freelancers, and other service professionals often work as sole proprietorships.
One of the key downsides of this business structure is that there is no separation between the owner and the business. Owners are automatically responsible for their business’ liabilities and debts. If someone wins a lawsuit against your sole proprietorship, they can take your personal assets, such as your home, car, and private bank accounts.
Sole proprietorships can also make it difficult for you to obtain a business loan and raise money. This is why most investors and lenders prefer corporations or LLCs.
You automatically form a sole proprietorship when you create a new business and are the only owner. You don’t need to register your sole proprietorship with your state, although you may need business permits or licenses depending on the nature of your business. For example, you still need an active law license if you’re planning to run a sole proprietorship law firm.
Sole proprietorships are pass-through entities like LLCs, so they’re taxed the same way you are. If you’re self-employed via your sole proprietorship, you must report all of the business’ losses and income on your personal income tax return.
A corporation, also known as a C corp, is a business entity that is separate from its owners. Corporations are considered individuals or “legal persons” under the law, so they can borrow and loan money, hire employees, enter contracts, pay taxes, own assets, and sue and be sued. Like LLCs, corporations offer limited liability. This means that corporation owners are not personally responsible for the business’s debts.
Unlike the other business entities, corporation ownership is determined by the percentage of capital stock ownership. This means that every shareholder — companies, people, or institutions that own at least one share of a corporation’s stock — are considered an owner of a corporation. Since they own the corporation, they can reap the benefits of its success through the stock they own. On the other hand, when a corporation loses money, the share price will drop, causing shareholders to lose money.
Corporations are the go-to choice for large businesses, particularly established names such as Coca-Cola, Microsoft, and Apple.
Corporations can take more time to form than other types of business entities. There are many steps you have to take to create a corporation:
- Choose a corporation name and check whether the name is available. Register a trade name if needed.
- Appoint directors and file your articles of incorporation. The articles of incorporation are a legal document submitted to the Secretary of State or a similar institution to establish a corporation within your state.
- Write your corporate bylaws. These are the rules your corporation will follow.
- Create a shareholder agreement that establishes the nature and structure of the shareholders’ relationship to the corporation and each other.
However, note that each state has its own laws for corporations. These steps are only meant as a general guide, so please refer to your state’s government website for more information.
A corporation does not have pass-through status and is taxed as a separate entity. It may also be subject to double taxation, which means that:
- The corporation has to pay tax on entity level profits, and
- Shareholders have to pay taxes on dividend distribution, which are not deductible to the entity.
However, not every shareholder is subject to this double taxation. Many shareholders, including educational institutions and retirement accounts, are exempt from income tax.
Other Types of Business Entities
Here are some other business and legal entity types.
An S corporation has a C corporation’s limited liability but has an LLC’s pass-through tax status. As such, your S corporation’s losses and profits pass through to their owners’ tax returns.
Note that an S corporation is not a business entity. It is created by filing an S-election status with the IRS, so it is a form of tax treatment. Corporations and LLCs can elect to be treated as an S corp for tax purposes.
To file for S corp status, you need to meet the following requirements:
- Be a domestic corporation.
- Have only one stock class (i.e., only common stocks).
- Have a maximum of 100 shareholders.
- Have only “allowable” shareholders. These include individuals, estates, and certain trusts. Corporations, partnerships, and non-resident alien shareholders are not allowed.
- Not be an ineligible corporation. Ineligible corporations include insurance companies, certain financial institutions, and domestic international sales corporations.
If you meet all of these requirements, you can elect an existing LLC or corporation to be treated as an S corp by submitting form 2553 election by a small business corporation to the IRS. Form 2553 must be signed by all of your corporation’s shareholders. Read instructions for form 2553 for more information.
It’s important to see how your state treats S corporations before deciding to incorporate your business as one. Not every state taxes S corporations the same way, but most recognize the pass-through status. There are also some states that:
- Don’t recognize S corporations, so they will treat them as a C corporation. These include Louisiana, New York, Tennessee, the District of Columbia, and Texas.
- Tax S corporations on profits above a specific threshold. These include Kentucky, New Jersey, North Carolina, New York, Maryland, Rhode Island, and Delaware.
- Shareholders (the owners of the S corporation) don’t have personal liability for the corporation’s liabilities and debts.
- There is no double taxation and no corporate taxation since S corporations have pass-through tax status.
- Like C corporations, S corporations are more difficult and costly to create. They require you to register your corporation with the IRS.
- You need to follow corporate formalities such as holding shareholder and board meetings and drafting bylaws.
- You need to follow the IRS’s limits on issuing stock. There are a lot more limits for S corporations than C corporations.
A general partnership is one of three types of partnerships you can create. A partnership is the most straightforward way for two or more people to start and own a business. All partners equally share responsibilities, liability, and profits.
General partnerships are budget-friendly and easy to create. Like a sole proprietorship, it doesn’t require formal or legal paperwork. All you have to do is find and register a trade name, a registered tax number, and a bank account. You may also want to create a partnership agreement that outlines each partner’s ownership share, responsibilities, capital contribution, profit distribution, and operating procedures.
- Simple tax structure
- Less financial burden since you have a partner(or partners) working with you
- Very easy to set up, since you don’t need to file anything with the government
- No limited liability protections, so the partnership is not a separate legal entity from you and your partners. If someone sues your partnership, you and your partners may have to give up your personal assets.
- Can’t make decisions on your own since you must work with your partner(s).
- Increased chance for conflict since you must run all decisions by your partner(s).
- If a partner acts alone, all partners will be held responsible for the decision and results.
- Have to split profits. The more partners you have, the smaller your share of the profits will be.
A limited partnership (LP) is another type of partnership. It consists of two types of partners:
- General partners who run the business and have unlimited liability for debts.
- Limited or silent partners who are not involved in the management and only have limited liability based on how much they invested. They are solely responsible for providing capital.
LPs are usually used as a kind of investment partnership, so they’re often created for investing in real estate and other assets.
Although they sound similar, limited partnerships shouldn’t be confused with limited liability partnerships (LLPs). LLPs are tax and legal entities that allow partners to work together and reduce their liability for other partners’ actions. LLPs come somewhere between general partnerships and LLCs.
- Pass through tax structure, so there are very few reporting requirements.
- General partners make all of the decisions, so if you’re a limited partner, you don’t have to do as much.
- Limited liability for limited partners.
- Require more paperwork than a sole proprietorship or general partnership since most states govern LPs and require registration with the Secretary of State or the equivalent entity in your state.
- Limited partners have no say in running the business.
- Limits on expense deductions.
- Unlimited liability for general partners.
LLC vs Corporation vs Sole Proprietorship – Which Should You Choose?
Now that you know what each legal entity type is like, let’s take a look at which is the best for you.
As you look at the table below, keep in mind that you should choose a business entity type that best fits your particular situation. For instance, if you believe that your business is high risk and you have ample start-up funding, you may consider incorporating it. On the other hand, if it’s unlikely to face lawsuits and you have little start-up funding, you may want to consider a sole proprietorship model.
|Consider a sole proprietorship if your business...||Consider an LLC if your business...||Consider a corporation if your business...|
|is low risk||is higher risk||is high risk
|has less start-up funding||has more start-up funding||has ample start-up funding|
|is less likely to face lawsuits||has a possibility of facing lawsuits||has a high possibility of facing lawsuits|
|is less likely to incur a large debt||is more likely to incur some debt||is likely to incur debt|
|benefits from a simple tax structure||benefits from a flexible tax structure (multiple options)||can handle double taxation|
Pros and Cons: LLC, Sole Proprietorship, and Corporation
To gain a better understanding of which business entity is the best choice for your business it’s helpful to understand the pros and cons of LLCs, sole proprietorships, and corporations.
LLC Pros and Cons
LLCs are defined by their limited liability characteristic, which legally separates the owners’ business and personal assets without requiring separate taxation (no corporate double taxation). If you’ve considered forming an LLC to protect your personal assets but wondered if it’s worth the fees, you’re not alone. Let’s assess:
Creating an LLC requires some effort and money up front, but it may be well worth it. Here are a few benefits of LLCs:
Arguably the greatest advantage of forming an LLC is the protection it affords your personal assets so that if the worst happens — your business goes bankrupt or is sued — only the LLC’s assets can be used to settle debts, not your life savings or home. Operating with this legal protection minimizes your risks when you start a new business.
Limited liability companies don’t have to be taxed separately from the owner(s), even though they’re legally a separate entity. Single-member LLCs are automatically taxed the same way as sole proprietorships — as a disregarded entity, meaning profits and losses are reported on the owner’s personal tax return ( form 1040).
LLCs may also elect to file form 1120 to be taxed like a corporation. High-profit LLCs usually utilize this tax option. Throughout an LLC’s lifespan, members may file to change their initial tax designation ( form 8832 to elect corporate tax status) at most once every five years. Having several options for how LLCs are taxed makes them a great choice for a variety of businesses.
A professional limited liability company ( PLLC), a type of LLC for licensed professionals, also offers limited liability and a flexible tax structure. It may also be the required filing depending upon your state and the type of professional business you are operating.
An LLC can be owned by an individual, multiple members, or even another organization. It’s up to the LLC member(s) to decide if the organization is member-managed vs manager-managed, how profits are divided, and what routine responsibilities look like.
These terms are laid out in an LLC operating agreement or a single-member LLC operating agreement: important documents for designating daily operations and decision-making protocols, as well as simplifying the process of opening business bank accounts or obtaining legal assistance.
LLCs may not be the best option for all business types. Let’s look at some of the drawbacks:
Because LLCs are registered with the state government, business owners have to pay initial filing fees, as well as possible annual fees or additional taxes. In many states, these fees are minimal, especially when we compare LLCs vs corporations, which tend to be pricier and have more filing requirements.
Because LLCs function at the state level, requirements vary along with formation costs. LLC owners need to file the correct documents with their Secretary of State’s office, or your equivalent state office and pay the correct fees on time. Luckily, most state governments have online guides that make the paperwork straightforward.
Sole Proprietorship Pros and Cons
Sole proprietorships are the easiest way to operate a business, and they allow businesses to get started without any bureaucracy or fees. Sole proprietorships are usually best for low-risk, small-scale businesses, but owners should consider whether the ease of formation is worth the potential risks.
Sole Proprietorship Advantages
Forming a sole proprietorship is a painless process. Here are some aspects of starting a business where sole proprietorships stand out:
Compared to other types of businesses, sole proprietorships don’t require any official formation documents or state registration, which means you don’t have to pay a filing fee or other annual fees. However, if you wish to operate your business under a name other than your own, you need to file a DBA (doing business as), which comes with a filing fee of between $10 and $100, depending on the state.
Not only is starting a sole proprietorship less costly than starting an LLC, but it’s also much more straightforward. A sole proprietor operating a business under their own name without employees can use their social security number instead of obtaining an employer identification number (EIN) for tax purposes. The only thing you need to legally operate is the appropriate business license for your profession, such as a building health permit for running a restaurant.
Sole proprietorship owners don’t have to worry about separate tax returns for their business since all profits and losses are accounted for on their personal tax returns.
Similar to a sole proprietorship, if two or more people conduct business together without forming a legal entity, they’re considered a partnership.
Sole Proprietorship Disadvantages
Sole proprietorships have their benefits, but they also put business owners in a risky position. Let’s take a look at some of the cons:
Sole proprietors operate their business under their own name, so personal and business assets are not legally separated. This is referred to as full personal liability, and it puts sole proprietors in a risky position when starting a new business. Unfortunately, sole proprietors could sustain serious personal losses in the event of bankruptcy or legal action being taken against the business.
If you plan on looking for investors for your business, you’ll have more trouble operating under a sole proprietorship because they’re widely perceived as high risk and low credibility. Forming a legal entity for your business gives potential investors confidence in your business plan.
Corporation Pros and Cons
C and S corporations can be a complex way to start a business, but they also offer many advantages. Like LLCs, they separate owners’ personal assets from the company’s. However, C corporations may be subject to double taxation.
It takes time and energy to create and manage a corporation, but incorporating your business can provide many benefits.
Like LLCs, corporations separate owners’ personal assets from that of the business. If your corporation is sued, the shareholders will not be held responsible for legal obligations or corporate debts, even if the corporation doesn’t have enough assets to pay for damages.
Corporations are the only business entities that allow you to offer stock options to shareholders. This is a great way to raise funds and grow your business. Stocks can also save your business from bankruptcy.
Since corporation ownership is based on the percentage of stock ownership, your business can exist for an extended period of time. Stocks are also easy to sell and buy, so ownership can be easily transferred. For instance, if you want to leave your corporation, you can just sell your stocks to someone else.
S corporations offer a number of tax benefits depending on their income distribution. For instance, they have the ability to split their income between shareholders and the business so it can be taxed at different rates. Owner salary will be subject to self-employment tax, while the rest of the income will be taxed on its own level.
Despite these advantages, corporations aren’t for everyone. Here are some disadvantages that come with incorporating your business:
C corporations are subject to double taxation, which means that the business income is taxed at both the entity level and the shareholder level. Luckily, you can avoid this by operating as an S corporation. S corporations only tax each shareholder based on their individual income.
Note that the IRS may tax an S corporation as a C corporation if their records do not meet the IRS’ stringent requirements.
Corporations take a lot of time and money to create and manage. The filing charges are not that expensive, but you need a lot of money to form and maintain a corporation. If you have limited funds, corporations are probably not your best pick.
Running a corporation can be trying, particularly if you don’t have a lot of time on your hands. You must follow strict formalities and regulations to maintain your corporation status. For instance, you need to have a board of directors, establish and follow bylaws, hold annual meetings, produce annual reports, and keep board minutes. If you’re running an S corporation, you need to be aware of IRS restrictions at all times (i.e., you can only have up to 100 shareholders, and they must all be US citizens).
Other Factors to Consider When Choosing a Business Entity
Besides considering each business entity’s pros and cons, you should also consider the following factors:
Certain business entities have high formation and administration costs.
Corporations require you to pay fees for incorporation. They also require you to spend money on paperwork and record-keeping for a range of formalities, including:
- Legal compliance records
- Stock purchases and sales
- Board minutes
- Annual records and registration
You need to follow these requirements even if your corporation only has a single shareholder. If you don’t follow these corporate governance rules, the court can pierce the corporate veil* and hold shareholders liable for company debts.
If you don’t have the funds for these activities, you should choose a more budget-friendly entity, such as a partnership, sole proprietorship, or LLC. LLCs are a particularly good choice because they combine the best attributes of unincorporated and incorporated entities. Unlike corporations, LLCs do not have to follow these corporate governance rules. This means you can cut down on administrative costs if you choose to organize your business as an LLC.
* LLCs ( and corporations alike ) benefit from limited liability only if they also make sure to respect the responsibilities that come with it. A legal entity can also lose its limited liability protection, also known as “piercing the veil”. When this happens, personal assets can be used to settle business liabilities and debt.
Constraints to Management Plans
Corporations require you to follow pre-determined management plans. You need to have a board of directors, and your shareholders must vote to approve who gets elected to the board of directors.
This can be limiting, particularly if you don’t have the time or resources to find candidates for these positions. Board directors must act in the best financial interest of the company, and it can be difficult to determine whether a potential candidate has your corporation’s best interests in mind. A board of directors can also lead to micromanagement since they may offer input on everything in your organization.
In contrast, business structures like LLCs and sole proprietorships do not have constraints to management plans. LLCs are particularly flexible since they can be owned by multiple people, an individual, or even an organization. LLC members can also decide whether the organization is member-managed or manager-managed, how profits will be divided, and more.
Tax and Financial Objectives
Finally, you need to ask yourself if your chosen business entity is the best choice in terms of taxes. You should also consider whether it will stay the best choice in line with your future objectives and growth potential.
For instance, if you think your business benefits from a simple tax structure and will continue benefiting from a simple tax structure, you should consider going with a sole proprietorship. However, if your business currently benefits from a simple tax structure but you think that it may benefit from a flexible tax structure a few years from now, you may want to consider getting an LLC.
Although LLCs are separate entities from their owners, they don’t have to be taxed separately. If you want your LLC to be taxed separately, you can file form 1120 with the IRS.
All in all, different types of businesses require different types of business structures. This means that choosing the right business entity is extremely important. Not only does your choice have a significant impact on how others perceive your business, but it also plays a large role in your finances and legal risks.
Although sole proprietorships and LLCs are extremely popular, that doesn’t mean they’re necessarily the best picks for your business. Remember that the best business entity for your company depends on your situation. As such, you need to keep the following in mind when determining the best structure for your business:
- Sole proprietorships are the easiest way to start a business, particularly if you have limited funds.
- You may want to consider registering your business as an LLC once it generates more income. If you want to issue stock and you have the time and resources to follow corporate governance rules, you can consider registering your business as a corporation.
- Think about all of the pros and cons of each business structure in terms of tax, constraints to management plans, cost, and personal liability protection.
You should also consider working with your accountant and attorney to get a better understanding of which business structure best fits your business, particularly if you’re looking to create a corporation.
Business Entity FAQs
The best business entity for tax purposes is an LLC. LLCs provide a lot of flexibility since the owners can file as an S corporation, sole proprietorship, or partnership. This is because LLC is a legal rather than a tax designation.
The best business entity for small businesses is a sole proprietorship. A sole proprietorship is the simplest business structure to create and has the least government regulation. They automatically form when you start a new business and are the only owner.
The easiest business entity to operate is a sole proprietorship. Sole proprietorships have almost no government regulation, and you’re not required to hold annual meetings or elect a board of directors. Essentially, you can run your sole proprietorship any way you like.
The business entity that provides the most flexibility in structure is the LLC. LLCs give you the ability to determine a wide range of issues, including:
- How members are paid
- Who owns the LLC
- Whether the business is manager-managed or member-managed
- What routine responsibilities are like