Choose the Right Type of Business Entity for You

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. Most importantly, it determines your level of personal liability, in case the business defaults on a loan or gets sued.

Choosing the right legal structure of a business is an important first step for any new entrepreneur, especially because it may be difficult to change later. Common business structures include corporations, limited liability companies (LLCs), partnerships and sole proprietorships. We’ll help you decide on the best fit for your small business.

What is a business entity?

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

Here are the key areas in which business entities differ from one another:

• Ownership: Whether you’re a sole owner or starting a business with partners, the number of founders will affect 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 would be 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 perhaps the actions of your business partners.
• Taxes: Tax requirements vary for each business entity. Some “pass through” business income and expenses to the owner’s personal taxes, including LLCs, while other types are taxed separately. You may have some choice in the 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 would likely make your selection 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 about each.

Sole proprietorship

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 don’t have to register a sole proprietorship with your local or state government if you’re doing business under your own name. 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 are not separate from your personal assets, which means you can be held personally liable for business debts. Sole proprietorships have low barriers to entry, but they usually cannot sustain long-term growth, especially if you plan to hire employees, buy property or expand in other ways.

Partnership

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 has unlimited liability, 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.

Partnerships can be a good idea for professional groups, like practicing attorneys, or a group of owners who want to test their business before forming a more formal company. Once you’re ready to change structures, an LLC structure would protect your personal assets and potentially allow you to pay a lower tax rate than you would with a corporation.

Limited liability company (LLC)

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

LLCs are popular because they offer personal liability protection, as we mentioned, but also provide more flexibility at tax time than a corporation (which we talk about next). 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.

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 and submit an annual report (plus 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

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

When a group of shareholders with ownership of a company incorporate it, 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. Either type of corporation is a separate entity from its shareholders, allowing them to continue operations 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 — this gives C corps a financial advantage, because they could 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 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

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.

Still, a benefit of making such a request is that these S corps will be taxed as pass-through entities, like sole proprietorships and partnerships, instead of paying corporate income tax like a C corp. You should, however, check with your state to be sure it will also recognize your tax status — some states, like New York, may not automatically 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 you meet the following criteria:

• Registered as a domestic corporation
• Have allowable shareholders
  • May be individuals, estates and certain trusts
  • May not be partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
• Only one class of stock
• Be an eligible corporation

B corporation

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

A benefit corporation, also called a B corp, differs from a C corp in its purpose and transparency, though both types of corporations are taxed the same. In a B corp, shareholders are responsible for holding the company accountable for producing public benefit in addition to financial profit. B corps may be required in some states to turn over annual benefit reports that show their contribution to the community.

Nonprofit corporation

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 political campaigns.

Choosing a business structure

There are advantages that come with each type of business structure, but choosing which one makes the most sense for your business would 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.

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, whereas business owners are required to file state-specific forms and pay varying fees to establish a corporation or an LLC, as well as some types of partnerships. In addition, after the business has been established, business owners will need to keep detailed company records — and you may need to hire additional people to handle those responsibilities.

The upside of choosing an LLC or corporation structure is the personal liability protection. But if you don’t need such strong protections, spending the time and money on that type of business entity may not be worthwhile.

3. Plan for the future.

If you have aspirations to take your company public or sell stock to employees or others, you would need to set your business up as a corporation. The corporate structure is the only one that allows the sale of ownership shares; this can be beneficial in hiring employees by offering them stock, as well as getting a business loan for the company.

However, if your goals don’t include selling public stock, then 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.