In the United States, anyone can start a new business. One of the first steps is choosing the best type of business entity for the company you’re starting. Let’s take a look at the types of business entities and the business entity definitions.
Key Points
• Selecting a business entity is vital for new businesses, with options like sole proprietorships, partnerships, LLCs, and corporations, each offering distinct benefits and tax implications.
• Sole proprietorships are straightforward and inexpensive but lack liability protection, while partnerships enable multiple owners to share profits or losses.
• LLCs offer limited liability protection and tax flexibility, ideal for businesses planning to hire employees or expand.
• C corporations provide growth potential and liability protection but incur double taxation, whereas S corporations avoid this but have shareholder restrictions.
• Consider financial, legal, and recordkeeping needs to ensure the best business structure fit for goals.
Sole Proprietorships
A sole proprietorship is the simplest type of business entity. Creating one requires little or no paperwork, and it isn’t a corporation. The owner is the business.
Definition and Characteristics
A sole proprietorship is an unincorporated business in which the owner is the only employee. There’s no need to register with the state, but to operate in certain industries, you may have to obtain a business license or permit. If you’d prefer not to do business under your legal name, you can create an alias known as a DBA, which stands for “Doing Business As.”
The advantages of a sole proprietorship are its simplicity and the low cost of creating it. Handling taxes is straightforward: You report the business’s profits on your personal tax return using Schedule C. The disadvantage is that you are personally responsible for any business losses, since there’s no legal separation between your individual and business finances.
Partnerships
A partnership will have multiple owners. This type of business entity has two kinds of legal structure: general partnerships and limited partnerships.
General Partnerships
A general partnership is basically a sole proprietorship with two or more owners. As with a sole proprietorship, you won’t need to file any paperwork with the state. But you will want to draw up a partnership agreement among the owners. The agreement should specify how the business partners will divide any profits or losses, which will be reported on the partners’ personal tax returns. General partnerships also do not shield participants from personal liability.
Limited Partnerships (LPs)
A limited partnership, or LP, requires registration with the state. This type of partnership specifies which people will operate the business and assume liability — called general partners — and which ones will act only as investors. The investors are known as limited partners or silent partners. If additional capital is needed, general partners can raise it via small business loans.
An LP structure makes it easy for general partners to run the business and raise money from limited partners, who aren’t liable for debts beyond their initial investment. If a limited partner decides to leave, the business can continue. Profits are shared based on the terms of the partnership agreement, which should include how and when profits are distributed.
For tax purposes, LPs are considered “pass-through” or “flow-through” entities. This means that the enterprise’s taxes are paid by the individual partners via their personal income tax returns, rather than separately by the partnership.
Another type of limited partnership is a limited liability partnership, or LLP. This is a type of partnership often used by professional services companies, such as law firms or dental practices. It shields each partner from extensive personal liability in cases of, say, malpractice. LLPs involve written partnership agreements and must typically file annual reports in most jurisdictions.
Recommended: Sole Proprietorships vs LLC: How to Choose
Corporations
Corporate types of business entities have more complicated legal structures. The two main types are C corporations and S corporations. The IRS automatically considers all corporations to be C corporations. To secure S corporation status, owners must take additional steps.
C Corporations
C corporations are owned by shareholders, operated by management, and overseen by a board of directors. As a business entity that’s legally separate from its shareholders, a C corporation files its own tax returns and pays income taxes at the corporate rate. Shareholders pay taxes on their share of the profits when they file their personal tax returns. This so-called “double taxation” is a disadvantage of C corporations.
S Corporations
A C corporation can become an S corporation — or “S corp,” as it’s commonly known — by filing IRS Form 2553 and meeting certain IRS eligibility requirements. S corps provide some tax advantages to their owners. In most states, the shareholders can pass the business’s profits and some losses through to their personal income taxes.
Like C corps, S corps still need to create bylaws and hold board meetings and shareholder meetings. But unlike C corps, S corps are limited to 100 shareholders and can issue only one class of stock.
You may have heard of B corporations. That’s not actually a type of business entity. Instead, B corp status is a certification issued by a third party. It’s meant to recognize a company’s commitment to public transparency and the highest standards of verified social and environmental performance.
Close corporations, also known as closely-held corporations, are typically smaller companies. They have less formal corporate governance and cannot publicly trade shares. A close corporation could be operated by a small group of shareholders without a board of directors.
Limited Liability Company (LLC)
A limited liability company, or LLC, has some features of unincorporated sole proprietorships and partnership, as well as elements of more formal S corps and C corps. Like a corporation, an LLC is a separate business entity that limits the liability of an individual. But LLCs require less paperwork, as you don’t need to have shareholders or a board of directors. As for taxes, owners of an LLC can choose to have the income taxed directly (as with a C corp) or pass it through to their personal tax filings.
Forming an LLC is more expensive than creating a sole proprietorship or partnership. The cost of creating an LLC can range between $35 and $300. And while some states don’t charge an annual fee to renew an LLC, most do; California’s annual $800 fee is the highest.
An LLC can have one member or multiple members. For a multi-member LLC, you need to create an operating agreement that sets out the rules and structure for the business.
Licensed professionals such as doctors and lawyers have the option of creating a professional limited liability corporation, or PLLC. The specific criteria vary by state.
Recommended: What Are the Tax Benefits of a LLC?
Factors to Consider When Choosing a Business Entity
Given the many types of business entities, it’s important to carefully choose the one that best suits your needs. For people who are just starting a business on their own, a sole proprietorship offers a speedy, simple and low-cost solution that enables them to begin doing business immediately. There are few tax implications, but also no liability protections.
It’s easy to convert a sole proprietorship into a partnership as your business grows, if that’s what you choose. That way, even with more than one owner, the company retains all of the advantages of a sole proprietorship.
For other businesses, creating an LLC will make more sense. Choosing LLC status offers you a way to quickly register your business, and it allows for the eventual hiring of employees. An LLC’s key advantage over a sole proprietorship or a partnership is the owner’s limited exposure to liability and loss.
A C corp can be a wise choice for businesses that anticipate substantial growth. It requires the creation of a board of directors; protects the owners from personal liability; and allows you to sell shares, making it easier to raise funds. However, profit from a C corp is subject to corporate taxes in addition to personal taxes paid by the shareholders. If your company qualifies as an S corp, you can escape this double taxation.
The Takeaway
The various types of business entities come with different advantages, costs, levels of complexity, and tax challenges. Not all of them will be suitable for your new business. As you consider your options, research their financial, legal, and recordkeeping details to ensure you choose the one that makes the most sense for your business needs.
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