The five main entity types
Almost every business falls into one of these categories:
The business structure that you choose will directly impact:
- The size of your business and operations
- How you’re taxed
- Your share of profits
- Your degree of ownership and accountability
- Your legal liability
- Funding options
Questions to ask when choosing between types of business entities
Start by asking yourself a few questions to get a clearer picture of your short-term and long-term goals, financial responsibilities, and leadership style.
- Will you be a solo leader with a few employees? Or will you be taking on partners and collaborating with investors?
- Do you want to be the sole decision-maker in your business? Or would you rather collaborate with partners, board members, or investors?
- How large do you want your business to grow?
- How will you raise capital for your venture?
- Will you be bringing in shareholders and issuing stock to them? If not, is that something you’re open to in the future?
- Do you plan on running your business for the long haul?
Sole proprietorship
If you want to run your business solo, and don’t have grand plans to be the next Uber or Apple, this is the place to start. In fact, the minute you start running a business solo, you’re automatically a sole proprietor in the eyes of the government. As a sole proprietor you could operate alone indefinitely or bring on contractors or staff—but if your income passes a certain threshold, you’ll want to incorporate.
Pros
Sole proprietorships are the easiest and most affordable to set up. There’s no legal paperwork involved, apart from local licenses and permits, so you can hit the ground running. Many small businesses start out as sole proprietorships—from mom and pop grocery stores, to art studios, to clothing boutiques.
Cons
As a sole proprietor, you’re taxed as an individual—which means letting go of a significantly larger percentage of profits than you’d pay as a corporation. You’re also 100% liable for the company’s finances. If your business hits hard times, you are personally responsible for any debts and you could lose your personal assets. It’s also much harder to get financing or raise capital as a sole proprietor—banks and investors see it as a riskier endeavour, so if you plan to grow, this might not be the route for you.
Who it’s best for
If you want to run a small-ish operation, with few employees, the sole prop route is probably best for you.
People who are successful in this role are comfortable making 100 percent of the business decisions, while also being accountable for any costs, debts, and legal responsibilities.
Sole proprietorships in a nutshell
Further reading: Sole Proprietorship vs LLC (Main Differences)
Partnerships
It’s nice to have someone to share the workload—a partnership lets two or more individuals do exactly that. This type of organization relies on the collective resources, talents, and efforts of each partner. Common examples of partnerships include law firms, bars and restaurants, creative agencies, and family businesses. There are two subtypes of partnership: General partnerships and limited liability partnerships.
Who it’s best for
Being a strong collaborator and having complete trust in your partners is essential to success in this form of business. There are three types of partnerships to look at:
- If you and your collaborators plan on equally splitting all your contributions, profits and losses, then you’re looking at a general partnership.
- If one or two partners will be doing most of the heavy lifting, but one or more partners will have limited management say and limited liability, then you should be considering a limited partnership.
- Finally, if you want test out a new business idea with some friends or family for a set period of time, you’ll be looking at a joint venture. If you decide to keep the train going after its expiration date, you must then commit to a general partnership.
Partnerships in a nutshell
C corporation
C corporations are the most common form of corporation in the U.S. It takes the liability off individuals because, unlike partnerships and sole proprietorships, the C corp is its own legal entity. As a result, the corporation itself can retain profits and incur losses, and is taxed separately from its owners.
Pros
The main upside is liability protection for owners—you don’t need to worry about your personal assets being affected by debts, losses, or lawsuits against the company. You also have the option to sell stock or bring on investors to propel growth. The Trump Tax Reform also made C corps a more attractive option, by introducing a flat tax rate of 21%.
Cons
Establishing a corporation is complex and expensive—state law, federal regulations, and local bylaws can result in hefty legal bills; be prepared to deal with both your Secretary of State and the IRS. Ongoing maintenance fees are also much higher for C corporations. Finally, the corporation is taxed twice—once as a separate legal entity, then shareholders must file their cut of the profits on their personal tax returns. This is often referred to as “double taxation.”
Who it’s best for
C corps are run by shareholders, a board of directors, and management—owners of the business usually hold one or more of these positions. It’s a great option for companies expecting high growth and expansion.
C corps in a nutshell
S corporation
An S corporation must always start as a C corp first. When a business applies to become an S corp, it remains a separate legal entity, provides limited liability protection to its owners, and is supervised by a board of directors, shareholders, and management. So why should you even bother becoming an S Corp? Major tax savings.
Unlike C corps, S corps opt for the business’ income, losses, deductions, and credits to be passed onto its shareholders who file this in their personal income tax. The company is not subject to federal income tax because it is not claiming any profit.
Because of this major tax advantage, there are certain limits put on S corporations. For instance, they can only have a maximum of 100 shareholders (all of whom must be US citizens or residents) and only one class of stock—these conditions are highly restrictive, especially when you’re at a point in your business where you really want to catapult your growth.
Also, the IRS will be keeping close tabs on you—or at least on your payroll. Because of the tax advantages of an S corp, the IRS constantly monitors the wages of shareholders who are employees to make sure they are being compensated according to market and industry standards, and paying the fair amount of taxes.
Who it’s best for
Only U.S. citizens can form an S corp. And if you’re thinking of massive growth, this isn’t for you—remember that 100-shareholder cap. But if you want a business that can live beyond your tenure and you’re willing to be scrupulous about meeting strict filing requirements, forming an S corp is a good way to save on taxes.
S corps in a nutshell
Limited liability company (LLC)
A limited liability company (LLC) can be best described as a hybrid business entity. Owners can choose how they are taxed—if they prefer to be taxed as a corporation, then that’s on the table. But if it’s more advantageous to owners and shareholders, they can opt for the business’s profits, losses, credits, or deductions to be processed in their individual tax returns, just like in sole proprietorships, partnerships, and S corporations.
Who it’s best for
An LLC is the frontrunner if you’re looking for a legal structure that’s relatively easy to set up and you want to give your venture some flexibility. Like a C or S corporation, an LLC gives owners and shareholders limited liability protection, so their personal assets are never at stake if the company is faced with any losses, debts, or lawsuits.
Unless you have a clear exit strategy in mind, make sure you choose partners or shareholders who are in it for the long run when starting an LLC. Unfortunately, you’ll have to dissolve the LLC if one of the partners leaves.
LLCs in a nutshell
Changing your business entity
Just like human beings, businesses evolve. C corporations can become S corporations, sole proprietorships can become LLCs, and so forth. It’s important to know that while you initially chose a legal structure to suit your business at the time, you still have the freedom to change your entity type in the future. Make sure you check in with federal, state, and local regulations to fill out the correct paperwork to make that transition.
When setting up or changing your entity, you’ll want to consult a lawyer. But once your business is established, a good accountant can help ensure all your accounts fall in line with regulations for that entity.
