How to Choose the Right Entity Type for Your Business

By Amanda Smith on August 29, 2018

There are sharp twists and turns on every business owner’s journey to success . Some are out of your control, but some are the direct result of key decisions you make early on. Choosing the right entity type is one of those decisions—it defines how your business is legally structured, taxed and your capacity to grow.

Weighing the options can be confusing and overwhelming. We’re here to walk you through the key business entity types and help you land on the one most applicable to you.

Why it’s important to establish your entity type early on

There are five main entity types for small businesses:

Before we break down the defining features of each option, let’s look at why it’s important to determine the best long-term structure for your business sooner rather than later.

The entity type 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 narrow the playing field

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?

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Find your match

Keep your answers in mind as you read through the small business entity types described below. See where there’s alignment to determine what business structure will best suit your long term plans and any existing constraints.

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.

There are pros and cons to sole proprietorship. On the upside: 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.

On the downside: 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

Criteria Sole Proprietorship
Ownership structure Total ownership by the sole proprietor
Taxation rules Business earnings and losses are reported on owner’s personal income tax return
Your cut of the profit 100% goes to the owner
Accountability and legal liability Business and owner are considered as one—as a sole proprietor, you are fully responsible for all debts incurred by the business and law suits filed against it
Sources of capital Owner can use their own income and savings or apply for loans

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.

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:

  1. If you and your collaborators plan on equally splitting all your contributions, profits and losses, then you’re looking at a general partnership.

  2. 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.

  3. 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

Criteria Partnership
Ownership structure Two or more individuals share ownership of a business.
Taxation rules Each owner files their share of profits in their personal tax returns

The partnership also needs to file an annual information return (Form 1065).
Your cut of the profit Shared equally by all partners in a general partnership, otherwise, determined by the partners’ investment percentage or alternative agreement.
Accountability and legal liability The partners equally share all costs, debts, and losses—except in limited partnerships.
Sources of capital Combined resources of partners, plus loans.

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.

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 downside? Establishing a corporation is complex and expensive—regulations on the state, federal, and local levels can result in hefty legal bills. 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.

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

Criteria C Corporation
Ownership structure One or more owners, and the corporation is supervised by shareholders, board of directors, and management

Corporation continues to exist even if a shareholder or owner leaves
Taxation rules The business as a separate entity pays tax at a special corporate rate

Shareholders declare their share of the profits (paid in salaries, bonuses and dividends) in their individual returns
Your cut of the profit Profits can potentially come to you three ways:
1. Salaries or bonuses paid to shareholders
2. Dividends paid to shareholders
3. Sale of shares
Accountability and legal liability The corporation is treated as a separate legal entity
Sources of capital Gain capital by selling equity to investors
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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

Criteria S Corporation
Ownership structure One or more owners, and the corporation is supervised by shareholders, board of directors, and management

Corporation continues to exist even if a shareholder or owner leaves
Taxation rules Shareholders report the company’s income, losses, deductions, and credits on their individual tax returns—the S corp doesn’t pay federal tax
Your cut of the profit Owners and shareholders receive distributions based on the percentage of their investment
Accountability and legal liability The corporation is treated as a separate legal entity

If shareholders do not report their salaries properly on their annual tax returns, they may be financially penalized
Sources of capital Gain capital by selling equity to investors (restricted to up to 100 shareholders who are US citizens or residents)

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

CRITERIA Limited Liability Company
Ownership structure Can be a sole owner or involve partners, investors, and shareholders
Taxation rules Can be taxed as a corporation or through owners’ individual tax returns
Your cut of the profit Directly proportional to the investment percentage of each owner, or through an agreement
Accountability and legal liability An LLC is treated as a separate legal entity
Sources of capital Gain capital through owners’ and shareholders’ investments and loans

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.

Read this next: How to Find, Hire, and Work With an Accountant

Cartoon illustration of an income statement

Do Your Own Bookkeeping with an Excel Income Statement Template

Enter your transactions into this Excel template, and voila! You get a ready-made Income Statement. Perfect for entrepreneurs who aren't ready for full-fledged accounting software.


This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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