Types of Business Entities
A business entity is an organization that engages in business activity. Types of business entities include sole proprietorships, partnerships, corporations, and limited liability companies.
A sole proprietorship is not a separate legal entity and is not required to register with any government agency to conduct business. There are no formalities to maintain, and the owner's personal finances are not separate from those of the business.
All profit and loss of the business are tax-deductible for the individual. However, the IRS states that it is possible for an individual to lose their personal assets when a business is sued for negligence or causing loss to others.
A sole proprietorship does not offer limited liability protection since all income is reported on the owner’s personal tax return. C corporations and LLCs are formal legal structures, unlike sole proprietorships.
An LLC is a hybrid business structure that combines the formality of a corporation with the simplicity of a sole proprietorship or partnership. The owner of an LLC can be a person or a group of people known as members.
LLCs are taxed like sole proprietorships (single-member LLCs) or partnerships (multi-member LLCs) by default, although they can choose to be taxed as a C corporation or S corporation.
An LLC is typically used by small businesses because it protects their personal assets from being used to pay off debts or other financial obligations of the company.
The pros of starting an LLC include:
- Easy and inexpensive to form
- Offers personal liability protection
- Management flexibility
- Flexible tax structure options
- Simple compliance requirements
The cons of starting an LLC include:
- Less appealing to investors
- Can be hard to transfer ownership
A C corporation is a corporation that is taxed as a separate entity. C corps pay corporate income tax, and the shareholders pay taxes on dividends. The C corporation is the most common type of corporation and is often used for larger companies.
C corps experience double taxation, meaning the corporation pays corporate income tax on its profits, and the shareholders pay personal income tax on their dividends from those distributed profits. This form of taxation may be unfavorable to small business owners.
An S corporation is a tax status set by the IRS. S corps are pass-through entities and, thus, do not pay federal income tax at the corporate level. Instead, the income and losses of the corporation "pass through" to its shareholders and are reported on their individual income tax returns. This is how S corps avoid double taxation.
There are some strict requirements for qualifying as an S corporation, including:
- 75% of shareholders must be US citizens
- No more than 100 shareholders
- Must file Form 2553 with IRS
- Have only one class of stock
Choosing the Best Business Structure
Selecting which business entity is best for your business comes down to the type of business you’re starting, how many employees and partners you will have, and which entity is most advantageous regarding taxation and liability protection.
For most businesses a limited liability company is the best way to go because you’re under less IRS regulation and restrictions, personal liability is greatly reduced, and you have greater control over your business.
Frequently Asked Questions
How do I start a limited liability company LLC?
There are two ways to start a limited liability company LLC. The easiest way is to outsource the work to a company like ZenBusiness or Incfile. These business formation services firms specialize in helping startups incorporate without making timely and costly mistakes. The second option is to learn how to start an LLC and set it up yourself.
What does limited liability mean?
Limited liability protection is the legal principle that states that a company's shareholders cannot be held liable for the company's debts beyond their initial investment. If a company is sued for negligence or loss, then the owner's personal assets remain protected.
What type of tax entity is an LLC?
By default, LLCs are treated as disregarded entities (for single-member LLCs) or partnerships (for multi-member LLCs) by the IRS.
Is my LLC an S corp or C corp?
LLCs are a hybrid entity, meaning that they are not any type of corporation. However, they can choose to be taxed as either a C corp or S corp.
Is an LLC its own entity?
An LLC is its own entity, meaning that technically it is different from its members. In an LLC, the members are the owners of the business. In this case, the LLC is liable for its own debts and can sue or be sued in its own name.
How do I file taxes as a single-member LLC?
As a single-member LLC, you file as a disregarded entity on your personal tax returns using Schedule C on your 1040. Single-member LLCs who need to report income from rental properties or other investments will use Schedule E. An LLC owner that earned more than $400 in a year must also file Schedule SE for self-employment taxes.
Is an LLC a pass-through entity?
An LLC is considered to be a pass-through entity or flow-through entity because it does not pay taxes on company earnings. Instead, the owners of the company report the company's earnings on their personal tax returns and pay personal income tax on those earnings.
What is an operating agreement?
An operating agreement is a written agreement entered into by a group of people to set out the rules of a corporate entity. The agreement spells out how the corporation will be governed, its management structure, and the rights, responsibilities, and obligations of each of its members.