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.

Sole Proprietorship

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.

LLC

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

Corporation

C Corporation

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.

S Corporation

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.