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Home Running A Business How to Choose the Right Business Entity
Choosing your business structure is one of the most important decisions you’ll make for your business. And—for better or for worse—it’s also one of the first decisions you’ll make. While it’s possible to adjust your business entity down the road, it’s easiest for you to start things off on the right foot.
The entity type you choose doesn’t just add fun professional-sounding designations to your name, like LLC or Inc. Your business structure also impacts how you manage your business, pay taxes, keep records, find financing, and mitigate risk.
To put it in perspective, choosing a specific entity type could lower your taxes and reduce complexities. However, it could also open up your personal life to harmful debts and expensive lawsuits. These are the kinds of opportunities and consequences you’ll need to consider.
While we can’t make the hard decisions for you, we can give you all the information you need to make confident, educated choices regarding your business type.
However, due to the legal and tax ramifications surrounding choosing a business type, it’s always a good idea to involve an attorney and tax professional. These professionals will be familiar with your state’s specific legal nuances and help you make the best decision for your particular business.
This guide will walk you through the 6 types of business entities you should consider. We’ll talk pros, cons, and who benefits most from each entity type. First, let’s get on the same page with a brief overview of business entities and why they matter—then, we’ll get into the details behind each type.
There’s no “best” type of business entity. The right entity for your business will depend on your structure, size, scale, industry, comfort with risk, and personal preference.
Before we dive into deeper terms, let’s define a business entity.
A business entity is an organization formed by 1 or more persons to facilitate business activities or to engage in trade (buying and selling). Businesses are created at the state level, meaning that you’ll need to register your organization with your state and comply with the laws, regulations, and fees required.
Pass-through entities (or flow-through entities) are business types that treat business income as the owners’ personal income. Common pass-through entities include:
Most small businesses (around 95%) opt for the pass-through entity structure to reduce tax obligations and for their easy setup. However, owners will have to pay taxes on income they may never receive as individuals—for example, if the business’s profits remain in the business.
Your entity type impacts everything from your business’s name to your tax obligations to your legal liabilities. Here’s what to consider when making your choice:
There are a variety of business entity types to consider: everything from sole proprietorships to corporations to nonprofits and beyond. It’s a lot to weigh, so we’re going to limit our coverage to the 6 most common (and likely most suitable for small businesses) entity types:
Below, we’ll break down the nuances of each entity type—the good, the bad, and the ugly.
A sole proprietorship is the simplest and most popular business structure in the United States, with over 23 million currently in existence. It’s an unincorporated business owned by a single person (or a married couple). Because a single person owns it, you get complete control over every aspect of your business—you call all the shots.
However, with this complete control also comes total liability. That means you and your personal assets are at risk for any debt or lawsuit issues. It’s scary, but some industries and natures of work are less risky than others.
New business owners who work in an industry with little-to-no liability and who don’t own significant assets that could be claimed in a legal dispute should consider a sole proprietorship. If you’re looking to launch a solo-operated business, consider starting as a sole proprietor and changing your business entity down the road.
Examples of sole proprietors often include:
If you never register your business, then you’re considered a sole proprietorship. As a sole proprietorship, there’s no distinction between you (the owner) and the business—they are one and the same for all intents and purposes. You’ll report your business’s profit and losses on your personal tax return.
If you choose to remain a sole proprietor, you’ll never need to register your company unless you want to set up a retirement account or begin hiring employees. In that case, you’ll need to apply to the IRS for an Employee Identification Number (EIN)—the Small Business Administration (SBA) says “you need [your EIN] to pay federal taxes, hire employees, open a bank account, and apply for business licenses and permits.”
There are 2 main kinds of partnerships: general partnerships (GPs) and limited partnerships (LPs). A general partnership is essentially the same thing as a sole proprietorship, just with 2 or more owners. Each owner shares the business’s profits, debts, and liabilities.
As with a sole proprietorship, it’s not necessary to register a partnership—it’s the default entity type when multiple owners begin doing business together. This simplicity is often a big reason general partnerships form.
Business owners who trust each other and feel confident sharing profits, losses, control, and liabilities should consider a general partnership. If your business is young and you don’t have major personal assets to lose, a general partnership may make sense at the beginning. As you grow, you may want to consider changing your entity type in order to scale your business, reduce personal liability, and access equity financing.
All partners share a general partnership’s profit or loss and report them on their personal tax returns. They also share responsibility for debts and legal liabilities—this is known as joint liability. Joint liability means that each owner is responsible for the actions the partnership takes. For example, if your partner engages in illegal, criminal, or fraudulent activity within the business, you may be held responsible—even if you’re innocent and ignorant of the behavior.
Because each partner is considered equal in the relationship, they each have the authority to enter into contracts or deals on the business’s behalf. For this reason (and many others you may be imagining now), it’s crucial to choose a reliable partner you can trust.
A limited partnership is a more secure version of a partnership, and it requires you to register your business entity with the state. Limited partnerships have 2 types of partners: general partners and limited partners.
Because limited partnerships are a more formal business entity, you’ll need to register your business, hold annual meetings, and create a partnership agreement.
If you’re looking for equity financing and don’t want to form a corporation, a limited partnership can help you maintain more control of your business while also enabling you to pool resources and raise capital. This makes limited partnerships a great option for family-owned businesses or real estate companies that need combined resources but whose investors may not want to share liability with the company.
A limited partnership is still a pass-through entity, so it doesn’t pay taxes on business income. Instead, each partner claims a share of the business’s profit and losses that they report on their personal tax return.
The LLC business type was created with small businesses in mind. It gives owners the option to become a little bit more official and protect their personal liability in the process.
An LLC is a hybrid business type that combines elements of general partnerships and corporations. With an LLC, you separate your business identity from you and any other owners. This means you’re no longer personally liable if any financial or legal issues arise.
Plus, registering your business as an LLC gives your business an air of professionalism. The abbreviation “LLC” will now be included in the legal title of your business—pretty cool, huh?
While an LLC is a little bit more complicated than a sole proprietorship or partnership, it’s certainly less complex than corporations. You’ll still need to register your business and fill out some basic paperwork for your LLC, but you won’t have to maintain the intensive record-keeping and meeting-heavy regulations that C corporations and S corporations have.
LLCs are taxed as pass-through entities, meaning the owners will split their share of the profits and losses to report them on their personal tax returns. You get to choose whichever tax method is most advantageous (and applicable) to your business: sole proprietorship, partnership, or even corporation. On the downside, the LLC members will have to pay taxes on the business’s earnings, even if they never personally receive them.
Now, we enter the realm of corporations. A C-corp is a separate entity apart from the owners, and stockholders share business ownership.
Each stockholder has limited liability in the business, but they also have limited control. Stockholders elect a board of directors, and this board is responsible for making key business decisions (including choosing leadership). Corporations are legally required to have board and shareholder meetings, keep meeting minutes, and maintain more intensive bookkeeping records.
As a separate entity, C-corps must pay their own business taxes (owners do not report business profits and losses on their personal tax returns). As of 2018, all C-corps pay a flat 21% federal income tax. Corporations offer additional tax deductions—and you also mitigate self-employment taxes—but you will face double taxation if you provide dividends.
Consider registering as a C-corp if you want to sell ownership of the company in exchange for capital and want to reduce personal liability.
An S-corp is similar to a C-corp except for a few tax and regulation nuances. S-corps have the same limited liability as C-corps, but they’re taxed as pass-through entities, meaning you’ll report business income and losses on your personal tax return.
If you want the protection, structure, and available equity financing of a corporation with the taxation of a pass-through entity, an S-corp is the right entity type for you.
There’s no best business entity. You’ll need to examine the types, evaluate the pros and cons, and make the most advantageous decision for your business.
If you’re struggling to choose, consult a legal or financial professional. The money they can save you now by making the right decision is worth much more than their consultation fees—a lot more.
And remember—you can always change later. It’s generally easy and straightforward to progress from a sole proprietorship or partnership into an LLC or corporation—although the inverse can be a bit more tricky—but don’t let choosing your entity type slow you down from starting your business!
Jesse Sumrak is a Social Media Manager for SendGrid, a leading digital communication platform. He's created and managed content for startups, growth-stage companies, and publicly-traded businesses. Jesse has spent almost a decade writing about small business and entrepreneurship topics, having built and sold his own post-apocalyptic fitness bootstrapped startup. When he's not dabbling in digital marketing, you'll find him ultrarunning in the Rocky Mountains of Colorado. Jesse studied Public Relations at Brigham Young University.
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