How To Choose the Right Type of Business Entity

The type of business entity you select reflects how your company will be structured, affecting everything from how much you pay in taxes to the registration paperwork you may be required to file. It also determines your level of personal liability, which will come into play if your business defaults on a loan or gets sued, for example.

Choosing the right business entity is an important first step for any new entrepreneur. Common business entities include corporations, limited liability companies (LLCs), partnerships and sole proprietorships. In this article, we’ll help you decide which entity is the best fit for your small business.

What is a business entity?

A business entity is the legal structure of a business. You must choose an entity before you register your small business or begin operating. In addition to controlling your tax obligations, the business entity you choose will also determine the number of people who can have ownership of the company and whether you can sell stock to the public.

Here are the main areas where business entities differ from one another:

• Ownership: Whether you’re a sole owner or starting a business with partners, the number of founders will impact your company’s structure. When shareholders become involved, that’s an additional consideration. If you want to form an S corporation, for instance, there’s a cap on how many shareholders your company is allowed to have.
• Liability: Some business structures protect you from being personally liable for your business’s debts, while others do not. If your business structure holds owners personally liable, that means you are responsible for the obligations of the business — and possibly even the actions of your business partners.
• Taxes: Tax requirements vary for each business entity. Some, including LLCs, “pass through” business income and expenses to the owner’s personal taxes, while other types are taxed separately. You may have some choice in this matter. For example, you could set your business up as an LLC, but elect to be taxed as a corporation.

Business entity comparison table

When choosing an entity, you will likely choose from the following common types of business entities:

Types of business entities

Whether you’re starting a business on your own or with business partners, you could choose from several of the business entities listed above. Here’s a bit more detail about each of your options.

Sole proprietorship

Pro: You maintain control of the business

Con: You’re personally liable for business debts

 Best for: A low-risk business or an owner looking to test a concept

One of the most appealing features of a sole proprietorship is its simplicity. You typically won’t need to register a sole proprietorship with your local or state government if you’re doing business under your own name — though you may still need a business license. Plus, because you’re the sole owner, you have the ability to maintain complete control over the business.

Here’s the downside: As a sole proprietor, your business assets aren’t separated from your personal assets, which means you can be held personally liable for business debts. Sole proprietorships have low barriers to entry, but they may need to restructure once the company grows, especially if you plan to hire employees, buy property or expand in other ways.

Partnership

Pro: Relatively easy to establish

Con: General partners may need to pay personal and self-employment taxes

 Best for: A business with more than one owner

A partnership is a simple business structure where two or more people own a business together. There are three common types of partnerships:

• General partnership: Partners share equal control as well as liability. This means you could be held responsible for the actions of your partners.
• Limited partnership: One general partner is liable for business debts, while the others have limited liability. Profits are passed through to everyone’s personal tax returns and the general partner also must pay self-employment taxes.
• Limited liability partnership: All partners have limited liability and are protected from being responsible for the company’s debts and the actions of other partners.
• Limited liability limited partnership: All partners are protected from personal liability in the event of debt or legal action against the business. LLLPs are not legal in all states.

Limited liability company (LLC)

Pro: Option to be taxed as a corporation or a pass-through entity

Con: May need to be dissolved if a business partner leaves

 Best for: Owners who want to limit their personal liability and pay a lower tax rate than they would with a corporation

LLCs are popular because they offer personal liability protection. Liability protection means that, in most instances, your personal car, house and savings would be shielded in the event of a business bankruptcy or lawsuit. LLCs also provide more flexibility at tax time than a corporation.

Ownership

LLC owners are called members, and there is no limit on the number of members that can be involved. Most states also allow single-member LLCs (also known as disregarded entities), where there is a single business owner. Ownership may include individuals, corporations, other LLCs and foreign entities.

Owners would most likely need to file articles of organization to form an LLC and submit an annual report (with an annual fee) every year after that to their state government. The articles of organization would dictate the LLC’s duration and management structure. If anything changes — if the LLC changes its name or a member leaves or joins, for example — an amendment would need to be filed as well.

Taxes

LLC members are required to pay self-employment tax and make their own contributions toward Medicare and Social Security. Profits and losses from the business pass through to your personal income, unless the LLC elects to be taxed as a corporation by filling out IRS Form 8832.

C corporation

Pro: Option to sell stock or acquire investors

Con: May be subject to double taxation

 Best for: Businesses that plan to grow quickly or go public

When a group of shareholders with ownership of a company incorporates, they are forming what’s known as a corporation. That corporation could either be taxed as a C corporation or S corporation, the latter of which we’ll talk about in a moment.

Both types of corporations, C corps and S corps, are a separate entity from their shareholders, allowing operations to continue if a shareholder leaves the company or sells their shares, and providing them with liability from the company’s debts. There is no limit on the number of shareholders allowed for a C corp, giving C corps a financial advantage because they can raise funds through the sale of stock.

However, a C corp may be subject to double taxation: It pays corporate income tax on its net earnings, while shareholders are also taxed on the dividends from those net earnings. C corps also require detailed record keeping, such as maintaining extensive notes on financials and operational processes.

S corporation

Pro: Can be taxed as a pass-through entity, like a sole proprietorship or partnership

Con: No more than 100 shareholders allowed

 Best for: Business owners who want protection from personal liability without double taxation

As we mentioned earlier, an S corp acts independently from its owners and can continue operating if a shareholder leaves the company. Unlike C corps, however, S corps have a 100-person cap on shareholders, and all shareholders must be U.S. citizens or have permanent resident status.

Any corporation that wants to be treated as an S corp must make a request with the IRS. The main benefit of making such a request is that S corps will be taxed as pass-through entities, like sole proprietorships and partnerships, instead of paying corporate income tax like a C corp.

However, you should check with your state to be sure it will also recognize your tax status. Some states may not recognize your federal S corp status and may tax you in the way C corps are taxed in that state.

According to the IRS, you can file for an S corp if your business:

• Is registered as a domestic corporation
• Has allowable shareholders
• Is comprised of individuals, estates and certain trusts
• Is not a partnership or corporation
• Does not have non-resident alien shareholders
• Has no more than 100 shareholders
• Has only one class of stock
• Is not an ineligible business type

Nonprofit corporation

Pro: May be exempt from paying federal or state income taxes

Con: Laws governing nonprofit corporations may vary by state, making compliance tricky

 Best for: Charitable, educational, religious or literary organizations

Nonprofits are formed for charitable, educational, religious, literary or scientific-work purposes. Although nonprofits follow organizational rules similar to C corps, they may be exempt from state or federal income taxes. Nonprofits must file with the IRS to be tax exempt. The Internal Revenue Code 501(c)(3) is most commonly used to grant nonprofits tax exempt status. Nonprofits are also barred from distributing profits, including among members or for political campaigns.

Benefit corporation

Pro: Purpose-driven structure encourages a for-more-than-profit approach

Con: Laws surrounding benefit corporations vary by state, which can make compliance tricky

 Best for: For-profit businesses that are driven by mission as well as profit

A benefit corporation, sometimes called a B corp or benefit company, is generally a company that produces public benefit in addition to financial profit.

But benefit corporations can vary quite a bit from one state to the next in terms of taxation, requirements and even what they’re called. For example Utah benefit corporations are taxed like C corps, while Oregon benefit companies can be an LLC or an incorporated business. Utah also has a separate designation for benefit LLCs, while Oregon does not. In some states, B corps may be required to turn over annual benefit reports that show their contribution to the community.

The term “benefit corporation” is commonly confused with “B-Corp certified.” A Certified B Corporation is just a company that’s been certified by B Lab, a private third-party company. If you’re interested in this entity type, research laws in your state to see if your company qualifies.

How to choose a business structure

There are advantages that come with every type of business structure, but deciding which makes the most sense for your business will depend on what you want to get out of your company. Here are some tips for choosing the right business entity.

1. Assess your risk tolerance

When choosing a business structure, one of the biggest considerations you’ll need to make has to do with risk. Depending on your business activities, protection from personal liability may be a top priority. The more risky your operation, the more you would benefit from liability protection. Sole proprietorships and general partnerships are the only business structures that do not provide full liability protection for business owners.

2. Consider your budget

A sole proprietorship costs little to nothing to register, but to establish a corporation, LLC or certain types of partnerships, business owners will be required to file state-specific forms and pay varying fees. The upside of choosing an LLC or corporation structure is the personal liability protection. But if you don’t need those protections, spending the time and money on that type of business entity may not be worthwhile.

3. Consider your operations

As we’ve covered, the business entity you choose will impact the way your company operates. With a sole proprietorship, you will have complete control over business decisions, but with a partnership, an LLC or a corporation, you may share ownership responsibilities with others.

In addition, many business entities require business owners to keep detailed company records — and you may need to hire additional people to handle those tasks. To make your choice of entity, consider the current and desired future state of your business operations, including your ownership structure.

4. Weigh your tax options

Every business entity is taxed differently. Sole proprietorships, partnerships and S corporations are pass-through entities, meaning business profits are passed directly to the business owners. Unless they apply to be taxed as a corporation, LLCs are also pass-through entities. This means at tax time, business revenue is reported on the owner’s personal tax returns.

C corporations, on the other hand, are considered separate entities from their owners, so choosing this structure will require you to pay corporate taxes.

5. Decide if you want to go public

If you have aspirations to take your company public or sell stock, you will need to set your business up as a corporation. This business structure is the only one that allows the sale of ownership shares. This can be beneficial for attracting and retaining employees as well as getting a business loan for the company.

However, if your goals don’t include selling public stock, you may not need to form a corporation. An LLC provides similar protections as a corporation, typically at a lower cost and without the strict recordkeeping that corporations require.