How to Choose the Right Business Entity

What is a business entity?

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.

Pass-through entities (or flow-through entities) are business types that treat business income as the owners’ personal income. Common pass-through entities include:

• Sole Proprietorships
• Partnerships
• Limited Liability Companies (LLCs)
• S Corporations

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.

Why does your entity type matter?

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:

• Structure: Some types of businesses are structured for solo operations (sole proprietorships), while others are formatted for 2 owners (partnerships) or many more shareholders (corporations).
• Taxes: Pass-through entities pay income taxes for the business on their personal tax return, while corporations pay business taxes separately. However, corporation shareholders often face “double taxation“—first, the company must pay tax on profits distributed to shareholders, and shareholders must then pay dividend tax on their personal tax returns.
• Regulations: Government regulations at the federal, state, and local level vary based on your entity.
• Scale: Some entities are meant to be run by a single individual, while others support more owners and employees. If you plan on being the sole owner and operator of your business forever, a sole proprietorship is all you’ll likely need to consider. However, if you plan on scaling, you’ll
• need to weigh other entity types down the road.
• Financing: Your entity type impacts the way lenders consider and process your loan applications. For example, if you’re looking to sell shares (which is essentially ownership) of your business to raise capital, you’ll need to be a corporation.
• Legal risk: Different entity types limit your personal liability from business debts and lawsuits. This helps protect your personal assets.

The 6 types of business entities.

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:

• Sole Proprietorship
• General Partnership
• Limited Partnership
• Limited Liability Company 
• S Corporation
• C Corporation

Below, we’ll break down the nuances of each entity type—the good, the bad, and the ugly.

Sole proprietorship

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:

• Freelancers
• Amazon businesses
• Consultants
• Accountants
• Bakers
• Tutors
• Fitness instructors

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.”

Pros of a sole proprietorship:

• Easy to set up—you may never need to register with your state
• Complete ownership
• Simple to report your business profit and loss on your personal tax return

Cons of a sole proprietorship:

• Personally liable for business debts and lawsuits
• Can be challenging to raise capital
• Business lives and dies with you—literally

General partnership

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.

Pros of a general partnership:

• Easy to set up—you may never need to register with your state
• Partners share ownership and control
• Simple to share the business’s profits and losses and then report them on your personal tax return
• Shared liability in the case of business debt or lawsuits (this could be a pro or a con)

Cons of a general partnership:

• Can’t raise equity financing
• Personal disputes can lead to business dissolution or failure
• Shared liability in the case of business debt or lawsuits (this could be a pro or a con)

Limited partnership

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.

• General partners: General partners are the partners who own and operate the business. They also share liability for the partnership.
• Limited partners: Limited partners (also known as “passive investors” or “silent partners”) are investors in the business who typically don’t manage day-to-day tasks, responsibilities, and decision-making. Consequently, limited partners lack control of the business operations, affording them significantly fewer liabilities.

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.

Pros of a limited partnership:

• Limited partners don’t have to pay self-employment taxes
• Raising capital for your business is easier since your investors have limited liability
• Simple to share the business’s profits and/or losses and then report them on your personal tax return

Cons of a limited partnership:

• Requires more paperwork than a sole proprietorship or general partnership
• General partners still have shared personal liability in the case of business debt or lawsuits

LLC (limited liability company).

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. 

Pros of an LLC:

• Owners no longer have personal liability for business debts and lawsuits
• You can choose to be taxed as a sole proprietorship, partnership, or corporation
• Fewer regulations than corporations

Cons of an LLC:

• Must register with the state, which requires a fee
• Owners of the LLC will have to pay taxes on business profits, even if the business keeps the money as retained earnings

C corporation (C-corp)

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.

Pros of a C-corp:

• Limited liability for business owners
• More available tax deductions and lower self-employment taxes
• You can sell shares to raise capital
• No limit to the number of shareholders

Cons of a C-corp:

• Control of the business is shared among stockholders
• More expensive business registration fees
• Business losses can’t be deducted from your personal tax return
• Must comply with additional regulations (meetings, minutes, bookkeeping, etc.)
• Double taxation

S Corporation (S-Corp)

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.

Pros of an S-corp:

• Owners don’t have personal liability for business debts and lawsuits
• You can sell shares to raise capital
• No double taxation

Cons of an S-corp:

• Expensive to start
• Must comply with corporate rules (like board and shareholder meetings and bookkeeping standards)
• Limit to the number of shareholders—no more than 100

Choose the right entity type for your business.

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!