How to Choose the Right Business Entity Type

Choosing the right business entity is one of the most important decisions you’ll make when starting your business. What you choose affects everything—from how you’re taxed to your personal liability and the way your business can grow.

In this article, we’ll cover the different business structures and their key advantages, disadvantages, and tax implications.

This guide is also related to our articles on the small business owner’s guide to acquiring a business, how to value a small business, and accounting for startups.

This list includes:

• Business entity types comparison
• LLC vs. corporation
• Sole proprietorship taxes
• S corp vs. C corp
• Choosing a business structure

Let’s get started!

Sole proprietorship

A sole proprietorship is the simplest business structure, where a single individual owns and operates the business. There’s no legal distinction between the owner and the business, meaning the owner is responsible for all aspects of it, including debts, obligations, and liabilities. It’s easy to set up, with minimal paperwork, and doesn’t require formal incorporation.

Pros: 

Easy to start: Setting up a sole proprietorship is straightforward. You don’t need to file formal incorporation documents or pay incorporation fees.

Full control: You have complete control over all decisions and operations of the business.

Lower costs: There are fewer regulatory fees and compliance costs compared to corporations or LLCs.

Direct taxation: The business income is reported on your personal tax return, simplifying the tax process.

Cons:

Unlimited personal liability: You are personally liable for all the business’s debts and obligations. If the business faces legal issues or bankruptcy, your personal assets (like your home or savings) are at risk.

Limited growth potential: Sole proprietorships may face difficulty in raising capital or attracting investors since there’s no option to issue stock.

Lack of continuity: The business ceases to exist if the owner retires or passes away unless it’s sold or transferred.

Tax limitations: Sole proprietors may miss out on certain tax benefits that are available to corporations or LLCs, such as deductions for employee benefits.

Tax implications

A sole proprietorship has a simple tax structure. All business income and expenses are reported on the owner’s personal tax return using Schedule C (Form 1040). This means that the business income is subject to individual income tax rates. Sole proprietors are also responsible for paying self-employment taxes, which cover Social Security and Medicare contributions.

Unlike corporations, a sole proprietorship does not pay separate business taxes. Instead, profits pass directly to the owner, who is taxed at their individual rate. While this can simplify the tax process, it also means that you cannot take advantage of corporate tax rates or certain deductions that corporations can claim, such as employee health insurance costs or retirement benefits.

Is it right for a small business?

Sole proprietorships are ideal for small businesses with low-risk operations, especially those that don’t require significant capital investments or outside investors, including freelancers, consultants, small retail shops, and service providers like hairdressers or plumbers.

This structure works well for those who want full control and are comfortable taking on the personal liability of the business. If you expect your business to remain small, or if you plan to keep it as a side project or freelance gig, the simplicity and low cost of a sole proprietorship could be ideal.

However, as the business grows or if there’s a need to limit personal liability, other business structures like an LLC or corporation might become more suitable.

Partnership

A partnership is a business structure where two or more people share ownership of a business. Each partner contributes to the business, and profits are shared based on agreed terms.

There are different types of partnerships, each with its own set of rules and responsibilities.

Types of partnerships

General partnership (GP): In a general partnership, all partners share equal responsibility for the business’s debts and obligations. Each partner has full authority to manage the business, and all partners are personally liable for the business’s liabilities.

Limited partnership (LP): A limited partnership consists of at least one general partner and one or more limited partners. The general partner manages the business and is fully liable for its debts. Limited partners, on the other hand, contribute capital but have no management authority and are only liable up to the amount of their investment.

Limited liability partnership (LLP): In an LLP, all partners have limited liability, meaning they are protected from personal responsibility for the business’s debts. This structure is often chosen by professionals, such as lawyers or accountants, where partners need liability protection but still want to participate in managing the business.

Features and formation

The key feature of a partnership is the shared ownership and division of responsibilities. In a general partnership, all partners typically have equal say in decision-making. In limited partnerships, general partners manage the business while limited partners are more passive investors. LLPs offer liability protection to all partners while allowing them to participate in management.

To form a partnership, the owners should draft a partnership agreement outlining the roles, profit-sharing, responsibilities, and exit strategies of each partner. The partnership must also register with the state and obtain any necessary licenses or permits.

Pros: 

Ease of formation: Partnerships are relatively simple to set up, with less formal paperwork than corporations.

Shared responsibilities: Partners can share the workload and bring diverse skills to the business.

Pass-through taxation: Profits are not taxed at the partnership level but pass through to the partners, who report them on their personal tax returns.

Cons:

Personal liability: In a general partnership, partners are personally liable for the business’s debts, meaning their personal assets are at risk.

Profit-sharing conflicts: Disagreements over the division of profits or business decisions can arise between partners.

Limited continuity: The partnership may dissolve if one partner leaves or passes away, depending on the partnership agreement.

Taxation and profit-sharing

In a partnership, profits are passed through to the partners and taxed at the individual level. Each partner is responsible for reporting their share of the partnership’s income on their personal tax return, regardless of whether they actually received that income (known as pass-through taxation).

Profit-sharing is based on the terms outlined in the partnership agreement, which may distribute profits equally or according to each partner’s investment or role in the business. Clearly defining from the start how profits and losses will be shared can avoid conflicts later on.

Is it right for a small business?

A partnership is a good option if you’re starting a business with one or more people and want a flexible structure with shared decision-making. However, you should consider the risk of personal liability, especially in a general partnership. An LLP provides more protection, while an LP allows for passive investors. Make sure to have a well-defined partnership agreement in place to avoid disputes and clarify roles.

Partnerships work well in industries where collaboration is important, or where partners can bring complementary skills to the business. Make sure to first assess the level of liability you’re willing to take on and how you plan to handle profit-sharing.

Limited liability company (LLC)

An LLC is a business structure that combines the flexibility of a partnership with the liability protection of a corporation. In an LLC, the owners (called members) are not personally liable for the company’s debts or liabilities. This structure is popular with small businesses because it’s relatively easy to manage while offering strong legal protections.

Pros: 

Limited liability: LLC members are not personally responsible for business debts, meaning their personal assets are protected.

Flexible management: LLCs can be managed by the members or hire managers to run the business.

Tax flexibility: LLCs can choose how they want to be taxed (as a sole proprietorship, partnership, or corporation).

Pass-through taxation: Profits can pass through to members without being taxed at the business level, avoiding double taxation.

Fewer formalities: LLCs are easier to manage and have fewer compliance requirements compared to corporations.

Cons:

Self-employment taxes: In most cases, LLC members must pay self-employment taxes on their share of the profits unless they opt to be taxed as a corporation.

Costs: Formation fees and annual fees for LLCs can be higher than for sole proprietorships or partnerships.

Limited growth: An LLC cannot issue stock, which may limit its ability to raise capital.

Formation and management

Forming an LLC is relatively simple. You need to choose a name, file Articles of Organization with your state, and pay a filing fee. Most states also require LLCs to have an Operating Agreement, which outlines the ownership and management structure, though it’s not always mandatory.

LLCs can be member-managed, where the owners handle the day-to-day operations, or manager-managed, where outside managers are hired to run the business. Members can choose to play an active or passive role in running the company, which makes LLCs flexible.

Tax treatment and flexibility

LLCs offer several options for taxation. By default, a single-member LLC is taxed as a sole proprietorship, and a multi-member LLC is taxed as a partnership. This means profits pass through to the members, and they report the income on their personal tax returns.

However, LLCs can also elect to be taxed as an S corporation or a C corporation. Choosing to be taxed as an S corp allows owners to potentially reduce their self-employment taxes, while opting for C corporation status can offer other tax benefits.

This tax flexibility makes LLCs attractive, letting business owners choose the best tax treatment for their financial situation.

Is it right for a small business?

An LLC is an excellent option for small businesses looking for liability protection without the complexities of a corporation. It’s a great choice if you want to protect your personal assets from business debts, have flexibility in how you manage the company, and want options for how your business is taxed.

Small businesses that don’t need to raise large amounts of capital often prefer the LLC structure because it requires fewer formalities than a corporation. It’s also ideal if you’re planning to keep the business relatively small or family-owned.

Corporation

A corporation is a legal entity separate from its owners (shareholders), meaning it can own assets, enter contracts, and be sued. Corporations offer the highest level of liability protection, but they also come with more regulations and requirements.

Corporations can be divided into two main types: C corporations and S corporations, each with its own structure and tax implications.

C corporation (C corp): The most common type of corporation. It operates as a separate entity from its owners and is subject to corporate tax rates.

S corporation (S corp): A special tax status for corporations that allows profits and losses to pass through to shareholders, avoiding double taxation. To qualify as an S corp, the business must meet specific criteria, such as having 100 or fewer shareholders who are U.S. citizens or residents.

Formation and legal requirements

To form a corporation, you must file Articles of Incorporation with your state and pay a filing fee. The corporation also needs to create bylaws, which outline how the business will be governed, and appoint a board of directors. In addition to these legal steps, corporations must hold annual meetings, keep detailed records, and issue stock.

Both C corporations and S corporations require compliance with federal, state, and local regulations. Additionally, S corps must meet specific criteria, such as maintaining no more than 100 shareholders and ensuring all shareholders are individuals or certain types of trusts and estates.

Pros:

Limited liability: Shareholders are not personally responsible for the company’s debts or legal issues.

Perpetual existence: Corporations can continue to exist even if the original owners sell their shares or pass away.

Easier to raise capital: Corporations can issue stock to raise funds, so it’s easier to attract investors.

Tax flexibility (S corp): S corporations allow profits to pass through to shareholders, avoiding double taxation.

Cons:

Double taxation (C corp): C corporation profits are taxed at both the corporate level and again when distributed to shareholders as dividends.

Cost and complexity: Corporations require more paperwork, fees, and regulatory compliance than other business structures.

Ownership restrictions (S corp): S corporations are limited to 100 shareholders and cannot have foreign investors or other corporations as shareholders.

Taxation differences between C corp and S corp

One of the most significant differences between C corporations and S corporations is how they are taxed.

C corporation: C corps are subject to double taxation. First, the company’s profits are taxed at the corporate level. Then, when those profits are distributed to shareholders as dividends, they are taxed again on the individual level. This double taxation can be a drawback for small businesses.

S corporation: S corps avoid double taxation by allowing profits to pass through directly to shareholders. The company itself is not taxed at the corporate level. Instead, the income is reported on each shareholder’s personal tax return, and the shareholders pay taxes on their share of the profits, a potential tax savings for small business owners.

Is it right for a small business?

When choosing between a C corporation and an S corporation, you should consider your growth goals, taxation preferences, and the number of shareholders you expect to have.

If you plan to reinvest profits back into the business and potentially seek out investors, a C corporation may be the best fit as it can issue multiple classes of stock and raise capital.

But if you want to avoid double taxation and run a smaller, closely held business, the S corporation structure might be a better choice.

Consider also the administrative requirements of a corporation. While corporations offer strong liability protection, they need more effort to maintain in terms of paperwork, record-keeping, and compliance with regulations.

Nonprofit organization

A nonprofit organization (NPO) is a business entity formed for a charitable, educational, religious, or scientific purpose. Unlike traditional businesses, nonprofits do not aim to generate profits for their owners. Instead, any surplus revenue is reinvested into the organization to further its mission.

Nonprofits are eligible for tax-exempt status, and pay no federal income tax.

Nonprofit organizations exist to serve the public interest and may focus on causes like education, healthcare, environmental protection, or community development. Instead of distributing profits to shareholders or owners, nonprofits use their income to advance their mission, a structure that’s appealing if you want to run a business while making a positive impact on society.

Formation and regulatory requirements

To form a nonprofit, you first establish the organization as a corporation in your state. This involves filing articles of incorporation with the relevant state agency, typically the Secretary of State’s office. The articles of incorporation should specify the nonprofit’s purpose, its structure, and its method of operation.

Once incorporated, the next step is to apply for tax-exempt status with the IRS by filing Form 1023 or Form 1023-EZ (for smaller organizations). This process confirms that your nonprofit meets the criteria under IRS Section 501(c)(3) or another appropriate section.

Nonprofits need to also comply with state-level regulations, which may include registering with the state’s charitable organizations bureau, filing annual reports, and maintaining good standing with the state by keeping up with filing and tax requirements.

Pros:

Tax-exempt status: Nonprofits are exempt from federal and state income taxes, so more resources can be directed toward achieving the organization’s mission.

Eligibility for grants: Many foundations and government entities offer grants exclusively to nonprofit organizations, providing important funding for projects and operations.

Public trust: As a nonprofit, your organization may gain credibility and trust from the community, making it easier to attract donors, volunteers, and support from the public.

Cons:

Limited revenue potential: Nonprofits cannot distribute profits to individuals. This limits the ability to raise capital through investors, as no equity can be offered.

Regulatory oversight: Nonprofits must meet strict regulatory requirements, both at the federal and state levels, including annual reporting and transparency measures.

Resource constraints: Many nonprofits struggle with limited resources, relying heavily on donations, grants, and volunteers. This can make it challenging to scale operations.

Tax-exempt status and compliance

To get tax-exempt status, a nonprofit must apply to the IRS and meet specific criteria, such as operating exclusively for a charitable purpose and refraining from engaging in political campaigns. Once approved, the nonprofit becomes a 501(c)(3) organization and is exempt from paying federal income taxes on activities related to its mission.

Tax-exempt status does come with strict compliance requirements. Nonprofits must file annual information returns (Form 990) with the IRS, detailing their income, expenses, and activities. Noncompliance can lead to fines, penalties, or even loss of tax-exempt status. Nonprofits are also prohibited from distributing profits to individuals, meaning any income must be reinvested in the organization’s mission.

Is it right for a small business with charitable goals?

Nonprofits can be an excellent choice for entrepreneurs who are focused on charitable goals rather than generating personal profit. If your business model is centered on giving back to the community, providing educational services, or promoting social good, forming a nonprofit could align with your goals.

Do consider, though, the limitations of operating as a nonprofit. You can’t issue shares or or provide financial returns to investors, and this can limit your fundraising options. And the administrative burden of maintaining tax-exempt status and complying with government regulations can be a lot.

But if you’re committed to a cause and plan to reinvest earnings into your mission, a nonprofit might be the right fit for your business goals.

Conclusion

Choosing the right business entity is the first, and in some ways the most important decision you’ll make as a small business owner. We’ve discussed the key features of various entities: sole proprietorships, partnerships, LLCs, C corporations, S corporations, and nonprofits. Each comes with its own advantages, disadvantages, and tax implications, all of which affect how your business operates and grows.

Sole proprietorships offer simplicity but expose you to personal liability. Partnerships provide shared responsibility, but each partner is liable for business debts. LLCs combine flexibility with limited liability, a win-win for small businesses. Corporations, particularly C corps and S corps, are more structured and have different tax treatments, which affect how profits are distributed. Nonprofits serve charitable purposes but come with strict regulatory requirements.

Consult legal and financial advisors when making the decision. They can help you navigate tax laws, liability risks, and compliance requirements, and select the best entity type for your needs.

Ultimately, the right entity depends on your business goals, liability concerns, and how you plan to manage taxes.

Next, check out our articles on understanding debts and credits, understanding accounts receivable, and the 13 best tax books to read in 2024.

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