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Types of Business Entities
A business entity is formed to conduct business activities. Learn about the different types and how to choose one.
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Nerdy takeaways
Sole proprietorships and general partnerships are good “starter” entities.
As your business grows and generates more income, you may consider registering as an LLC or corporation.
Think through the pros and cons of each business entity type. Weigh legal protection, tax treatment and government requirements for each.
Work with a business lawyer and accountant to get specific help for your business.
A business entity is an organization created to conduct business or engage in a trade. Various types of business entities exist. The most common are sole proprietorships, partnerships, corporations and limited liability companies (LLCs). The entity type determines the structure of the organization and how it’s taxed.
Choosing a business entity type is one of the first things you want to do when starting a business. This decision will have important legal and financial implications for your business. The amount of taxes you have to pay depends on your business entity choice. Your entity type can also affect how easy (or not) it is for you to get a small-business loan or raise money from investors. Plus, if someone sues your business, your business entity structure determines your risk exposure.
Which business entity is right for you? This guide is here to help you make that decision. We'll explain the types of business entities and the pros and cons of each so that you have all the information you need to determine what's best for your company.
A sole proprietorship has one person (or a married couple) as the sole owner and operator of the business. If you launch a new business and are the only owner, you are automatically a sole proprietorship under the law. There’s no need to register a sole proprietorship with the state. But you may need local business licenses or permits, depending on your industry.
Freelancers, consultants and other service professionals commonly work as sole proprietors. Sole proprietorship is also a viable option for more established businesses with one person at the helm.
Pros
No need to register your business with the state.
No corporate formalities or paperwork requirements.
You can deduct most business losses on your personal tax return.
Tax filing is simple and part of your personal income tax return.
Cons
You’re personally responsible for all of the business’s debts and liabilities.
It’s more difficult to get a business loan and raise money.
It’s harder to build business credit.
Sole proprietorships are a popular type of business structure in the U.S. because of how easy they are to set up. There’s a lot of overlap between your personal and business finances, which makes it easy to launch the business and file taxes.
The problem is that this same lack of separation can also land you in legal trouble. If a customer, employee or another third party successfully sues your business, they can take your personal assets. Due to this risk, most sole proprietors eventually convert their business to an LLC or corporation.
Partnerships share many similarities with sole proprietorships. The key difference is that a partnership has two or more owners. A general partnership (GP) is the default mode of ownership for multiple-owner businesses. This means that, like a sole proprietorship, there’s no need to register with the state. In a general partnership, all partners manage the business and share in the profits and losses.
Pros
No need to register your business with the state.
No corporate formalities or paperwork requirements.
You don’t need to absorb all the business losses on your own.
Owners can deduct most business losses on their personal tax returns.
Cons
Each owner is personally liable for the business’s debts and other liabilities.
In some states, each partner may be personally liable for another partner’s negligent actions or behavior.
Disputes among partners can unravel the business.
It’s more difficult to get a business loan, land a big client and build business credit.
Most people form partnerships to lower the risk of starting a business. Having more than one person to share the struggles and successes can be helpful, especially in the early years.
If you do choose to form a business partnership, it’s important to choose the right partner(s). Disputes can limit a business’s growth, and many state laws hold each partner fully responsible for the actions of the others. For example, if one partner enters into a contract and then violates one of the terms, the third party can sue any or all of the partners.
Limited partnership
Unlike a general partnership, a limited partnership (LP) is a registered business entity. To form one, you must file paperwork with the state. In an LP, there are two kinds of partners: general and limited. General partners own, operate and assume liability for the business. Limited, sometimes called silent, partners act only as investors.
Limited partners don’t have control over business operations and have fewer liabilities. They also pay fewer taxes because they have a more tangential role in the company.
Pros
A good option for raising money because investors can serve as limited partners without personal liability.
General partners get the money they need to operate but maintain authority over business operations.
Limited partners can leave anytime without dissolving the business partnership.
Cons
General partners are personally responsible for the business’s debts and liabilities.
More expensive to create than a general partnership and requires a state filing.
A limited partner may also face personal liability if they take too active a role in the business.
Multi-owner businesses that want to raise money from investors often do well as limited partnerships because investors can avoid liability.
You may come across yet another business entity called a limited liability partnership (LLP). In an LLP, none of the partners risk losing their personal assets due to business debts. But some states only allow law firms, doctor’s offices and other professional service firms to organize as LLPs. These types of businesses can form an LLP to avoid each partner being liable for the other’s actions. For example, if one doctor in a medical practice commits malpractice, the other doctors in the LLP can avoid liability.
C corporation
A C corporation is an independent legal entity that exists separately from the company’s owners. Shareholders (the owners), a board of directors and officers have control over the corporation. It is also possible for one person (you) to fulfill all of these roles.
With this type of business entity, there are many more regulations and tax laws that the company must follow. Methods for incorporating, fees and required forms vary by state.
Pros
Owners (shareholders) don’t have personal liability for the business’s debts and liabilities.
C corporations are eligible for more tax deductions than any other type of business.
C corporation owners pay lower self-employment taxes.
You have the ability to offer stock options, which can help you raise money in the future.
Cons
More expensive to create than sole proprietorships and partnerships.
C corporations face double taxation.
Owners cannot deduct business losses on their personal tax returns.
Corporations involve a lot of business formalities.
C corps can be a good choice as your business grows and you find yourself needing more legal protections. The biggest benefit of a C corp is limited liability. If someone sues the business, they are limited to taking business assets to cover the judgment. They can’t come after your home, car or other personal assets.
Corporations are a mixed bag from a tax perspective. They come with more tax deduction opportunities, but there’s the possibility of double taxation if you plan to offer dividends. Owners who invest profits back into the business instead of taking dividends are more likely to benefit under a corporate structure. Forming and maintaining a corporation can be complex, but online legal services can help.
An S corporation preserves the limited liability that comes with a C corporation but is a pass-through entity for tax purposes. This means that, like a sole prop or partnership, an S corp’s profits and losses pass through to the owners’ personal tax returns. There’s no corporate-level taxation for an S corp.
Pros
Owners (shareholders) don’t have personal liability for the business’s debts and liabilities.
No corporate taxation and no double taxation.
Cons
S corporations are more expensive to create than sole proprietorships and partnerships.
There are more limits on issuing stock with S corps than C corps.
You still need to comply with corporate formalities.
To organize as an S corporation or convert your business to an S corporation, you have to file IRS form 2553. S corporations can be a good choice for businesses that want a corporate structure along with tax flexibility.
Limited liability company
A limited liability company takes positive features from each of the other business entity types. Like corporations, LLCs offer limited liability protections. LLCs also have less paperwork and ongoing requirements. In that sense, they’re more like sole proprietorships and partnerships.
Another big benefit is that you can choose how you want the IRS to tax your LLC. You can elect to have the IRS treat it as a corporation or as a pass-through entity on your taxes.
Pros
Owners don’t have personal liability for the business’s debts or liabilities.
You can choose to be taxed as a partnership or a corporation.
Not as many corporate formalities compared with an S corp or C corp.
Cons
It’s more expensive to create an LLC than a sole proprietorship or partnership.
LLCs are popular among small-business owners because they combine the best of many worlds. They offer the ease of a sole proprietorship or partnership with the legal protections of a corporation.
Now to determine which entity type works best for your small business. The best course of action, if you can afford it, is to consult a business lawyer and tax professional. They can advise on which structure is optimal for you.
As a starting point, however, there are three general factors to consider when choosing among business entity types: legal protection, tax treatment and paperwork requirements. In the table below, you can compare entity types across each of these factors.
Business entity type
Limited liability protections
Tax treatment
Level of government requirements
Sole proprietorship
No.
Taxed at personal tax rate.
Low.
General partnership
No.
Taxed at personal tax rate.
Low.
Limited partnership
For limited partners only.
General partners taxed at personal tax rate.
Medium.
S corporation
Yes.
Taxed at personal tax rate.
High.
C corporation
Yes.
Must pay corporate taxes (but beware of double taxation on dividends).
High.
LLC
Yes.
Can choose how you want to be taxed.
Medium.
Sole proprietorships and GPs are light on liability protections, so they expose you to greater legal risk if someone sues your business. But taxation is simpler with these entities, and you don’t have as many government regulations to comply with. That means more time to do what you love — running your business.
The simplicity of a sole proprietorship or a partnership makes either a good option for freelancers and consultants. The less legal risk inherent in your business industry, the better suited it is to these entity types.
If your business is in a more litigious industry, such as food service or child care, that’s a strong reason to create an LLC or corporation. Regardless of industry, as your business grows it may be beneficial to “graduate” to an LLC or corporation. What works for a freelancer or hobbyist likely won’t work for someone who is trying to hire employees, bring on additional owners or expand.
Although it’s certainly possible to change business structures at any point, some changes are easier to make than others. For instance, it’s relatively simple to convert from a sole prop or partnership to an LLC by filing the right paperwork with your state.
Converting to a corporation, however, is more difficult, particularly if you plan to issue stock. Additionally, converting from a C corp to an S corp can bring unexpected taxes. So before changing your business structure, you'll want to think through the pros and cons of doing so. And it’s always worth consulting a business attorney for professional advice.
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