Your Full Breakdown to Picking the Right Business Entity
From figuring out your target audience to selecting the best start-up business loan, big decisions are a basic part of owning a business. One of the first and most important that you’ll be faced with is picking the type of business entity you want to own.
Your business entity type, also known as your business structure, is best described as your company’s legal status. Because of this, it has a huge impact on how you operate in the future. Your tax filing process, ability to get a loan, and even the amount of meetings you hold will all be affected by the type of business entity you ultimately choose.
In this article, we’ll help you make the best choice for your business by providing the pros and cons of every business structure. For the most popular business entities, we’ll give you an even closer look at how they work and what it takes to establish them.
A Complete List of Business Entity Types
The first step to selecting your business structure is learning about what options are available. In the United States, you have a fairly expansive list to choose from, with each type of business entity providing its unique advantages and disadvantages. These can be broken down into six basic categories.
As you go through this list, be aware that just because these business structures exist doesn’t mean that every single state recognizes them. We’ll go over the most common structures, which are recognized across the country, later in this article.
1. Sole Proprietorship
Individuals or married couples that operate a single business can be considered sole proprietors, often by default. This is the simplest type of business entity to select.
Sole proprietors benefit from an easy, low-cost startup process but are personally liable for their company’s financial and legal responsibilities.
If your business has two or more owners, you have the option to set up a partnership. Business owners who opt to form partnerships tend to benefit from a simple startup process but can’t easily access funding, much like sole proprietors. You also benefit from not being taxed twice, as would be the case with most corporations.
Partnerships can be further broken down into a few main types:
The term “partnership” most often refers to a general partnership. This type of structure requires you and your business partner to not only actively work within the company but also to hold immense personal liability for your company’s financial and legal obligations.
A limited partnership (LP) is owned by both general partners, who are active in the company, and limited partners, who don’t need to participate in the company’s daily operations. These partnerships shield the limited partner from liability but still leave the general partner personally liable for the company’s obligations. This also means that limited partners don’t have much of a say in what happens with the company.
Limited Liability Partnership
A limited liability partnership (LLP) is made up fully of limited partners, so neither business owner has any personal liabilities. Because the owners are both limited partners and no general partners exist, both partners have a say in what happens with the company. Neither partner is responsible for lawsuits resulting from the other’s negligence.
Limited Liability Limited Partnership
A newer and fairly rare type of business entity, a limited liability limited partnership (LLLP) has at least one general partner and at least one limited partner. It functions much like an LP but provides some extra liability protection for the general partners.
3. Limited Liability Company
A limited liability company (LLC) can be owned by one or more people and provides great protection against personal liability. LLCs can also choose how they’ll be taxed. When comparing a partnership or sole proprietorship vs. an LLC, the latter does require a lengthier and more expensive startup process but provides more opportunities to get funded.
Some states may also allow professional limited liability companies (PLLCs) to form. These usually function just like LLCs but are dedicated to licensed professionals like doctors and lawyers.
Corporations provide the greatest protection from personal liability possible, since they’re completely separate legal entities that aren’t attached to the owners. These legal entities are expensive to form and come with many requirements that include ongoing bookkeeping and meeting minutes.
This type of business entity is usually chosen when business owners want to sell stocks or expect large-scale growth. Here are the main types of corporations:
The term “corporation” usually refers to this type of corporation. Decision-makers in a C-corp include shareholders, officers, and a board of directors. C-corps are a great option for protecting your personal assets, but they do subject you to double taxation, as your business must pay corporate taxes, while you as the owner must complete personal tax returns for your earnings.
Some states may allow professional corporations to form as well. These are classified as a type of C-corp, but just like PLLCs, they’re dedicated to licensed professionals.
This is a slightly more manageable type of corporation to own because you aren’t subject to double taxation. However, you may not have the opportunity to raise enough capital, partially due to limited shareholders. S-corps also must register with the Internal Revenue Service (IRS).
If you want to contribute to the greater good of the public without giving up your profits, B corps are a great alternative to becoming a nonprofit. You must meet a set of social and environmental requirements, and may need to file a report that proves their impact. B-corps are still taxed twice.
Cooperatives are a unique type of business entity owned directly by the people who are benefiting from its services. While not very common, it can give every member of your business a voice. It’s unlikely that cooperatives will get funded.
A common example of a cooperative is a food or grocery co-op, which allows shoppers to pay membership dues to become partial owners. These owners help decide what is sold and can receive a portion of any profit.
6. Miscellaneous Entities
Beyond the primary structures listed above, you can also regard estates and municipalities as business structures. These business entities perform highly specific functions that are not normally used for a traditional company. Instead, an estate acts as a legal entity to be distributed after its owner’s death, while municipalities act as legal business structures for cities and towns.
Nonprofits are also legally considered a form of business and are technically corporations that are focused on providing value to the public in some way instead of profiting. Because they aren’t taxed, nonprofit corporations have strict guidelines they need to follow.
4 Most Common Types of Business Entities
Choosing the legal structure for your business entity can be hard with so many options ahead of you. To make your selection easier, we’ve narrowed down four types of business entities preferred by the majority of U.S. business owners, so you can get a closer look at how they work.
1. Sole Proprietorship
Formation: It’s extremely easy to get your sole proprietorship started. In most states, you don’t need to do anything to start operating. If you do have any requirements, it’s usually getting a simple business license or an employee identification number. Sole proprietorships are the most common business entities because of this lack of a barrier.
Liability: Sole proprietors are subject to a large amount of personal liability. Because you are not a separate entity from your business, you’re fully responsible for any debt you accrue as well as any lawsuits received.
Taxation: Sole proprietors file Schedule C with Form 1040 as a part of their individual tax returns. This means you’ll be taxed at the personal tax rate instead of at the corporate rate. Getting taxed at the personal rate can actually cost you more as your income rises to about $40,000 or higher.
2. Limited Liability Company
Liability: When you form an LLC, you give yourself a significant amount of protection against your company’s financial and legal obligations. The only cases where you may not be protected are situations where you mishandle money or where you provide a personal guarantee for a business loan.
Taxation: LLCs can select the taxation style of any of the other three most common business entity types listed here. You can also get double taxed as a C-corp, but it’s rare that any LLC owner would choose this route.
3. S Corporation
Formation: S-corporations must file Form 2553 with the IRS and submit your pricey articles of incorporation to your state. Beyond your formation of your new business, you’ll need to keep up with annual filing fees, create bylaws, and follow immense corporate regulations.
Liability: Your company’s liabilities and your personal liabilities are completely separate with an S-corp.
Taxation: S-corps are the only type of corporation that isn’t subject to corporate tax. This means you will benefit from pass-through taxation and never be subject to double taxation.
4. General Partnership
Formation: Much like sole proprietorships, there’s a good chance you don’t need to do anything to form other than agree with a partner to operate and share profits. Some states or cities may require business licenses or EINs. Most partners choose to create a formal partnership agreement among themselves to prevent any disputes.
Liability: General partners are just as subject to personal liability for business obligations as sole proprietors are. You may even be liable for your partner’s negligence.
Taxation: General partners benefit from pass-through taxes, so they’ll only be taxed once on their personal income tax.
Steer Your Business in the Right Direction
The type of business entity you choose will set the scene for how you and your company will operate in the future. That said, it’s important to be conscious of your decision. Instead of just considering which route is the easiest to take, also think about how it will impact your business in the future. For example, even if you are a small-scale solo operation, you may actually benefit from forming an LLC for tax purposes, as you’ll have more flexibility as your income rises.
If you are thinking about forming an LLC, read our article on how an LLC operating agreement can benefit your company as you’re forming.