Types of Business Entities
It can be tricky to grasp how each business entity affects you. Your chosen entity type will impact your business taxes and whether your personal assets are on the hook for business debts and lawsuits.
Businesses come in all shapes and sizes, so it’s impossible to recommend one entity type to all business owners. The best entity for you largely depends on your specific business needs and goals.
We’ll explain the most common types of business entities and dive into their individual pros and cons so you can confidently choose the entity type that makes the most sense for your business.
Many businesses start as a sole proprietorship. This is the most common type of business entity because it allows you to do business under your own name without going through the legal process of creating a separate entity.
Common sole proprietorship businesses include freelance hustles like writing and programming and individual-run services like lawn care and music lessons. Sole proprietorships generally don’t have any employees, but there are no restrictions on employee hiring. In fact, you can hire as many employees as you want.
Becoming a sole proprietor is as easy as deciding to be your own boss. You don’t have to file anything with the state or come up with a business name—you can just get to work. There aren’t a lot of regulations surrounding this type of business entity, so you only have to worry about filing your taxes properly.
Luckily, sole proprietorship taxes are as simple as filling out a few extra forms. Once that’s done, you’re officially a small business.
Unlimited personal liability is the biggest drawback of being a sole proprietorship. All debts, lawsuits, and other financial obligations fall squarely on your shoulders. That means your house, fridge, and rare books collection are all on the line should you or any of your employees run into financial or legal troubles.
It’s also much harder to find small-business financing as a sole proprietor. When you form a separate legal entity, you have a business credit score and an easily tracked business record—two important factors in obtaining most small-business loans.
You can leverage your personal credit for loans, but then you are personally on the hook for the payments.
A partnership is when two or more parties formally agree to do business together. The terms of the partnership are usually laid out in a legal document, but two people can start doing business together with just a handshake. Partners typically share in profits, liabilities, and business responsibilities.
Partnerships are incredibly easy to form because you don’t have to file them with the state. In a way, a partnership is a lot like a sole proprietorship if it were run by multiple people.
The main benefit of having another person running your company is not having to go it alone. Businesses can be a nightmare to manage and often get bigger and more complicated over time, so having another entrepreneur on hand to keep things running smoothly can be a godsend.
Partnerships also allow you to bring new networks and expertise into your business mix. For example, you could find someone skilled in building and managing profitable sales teams. Understanding your weaknesses as an entrepreneur will help you find someone who can fill in your gaps.
Lastly, partnerships don’t pay business income tax. The taxes and liabilities pass through the business, and the partners pay sole-proprietorship taxes based on their share of the income.
Sharing liability is a bit of a double-edged sword because, on the one hand, it means you don’t have to shoulder the burden all by yourself, but on the other, you are personally responsible for the actions of your partner.
Because partners also share in all the profits according to their ownership percentage in the company, you can’t unilaterally make decisions about reinvesting profits—each partner will get to decide how to invest their profits.
So, if your partner’s bad business decisions lead to a lawsuit, and that partner has spent all their profits, you may have to pay any fees assessed.
This brings us to one of the main problems with partnerships: relationship pains. It may sound like a fun idea to go into business with your best friend, but what happens if that friend starts wasting company money and becomes lazy in shouldering their work? You’ll have to deal with that, and trust us, it’s a real pain.
Businesses are hard enough to build and maintain without a partner sabotaging them from the inside, so you should find a seasoned partner who you can see yourself running a successful business with in 10 years.
Also, while there are some tax benefits in being a partnership as compared to a corporation, partnership tax filing is a bit more complicated than sole proprietor taxes because there are a few extra forms that must be filled out detailing the income of the partnership.
Common partnership types
There are a few different kinds of partnership agreements common in the small-business space.
A general partnership is a simple partnership between two or more people who agree to share profits and tax responsibility. Usually each partner has unlimited liability.
Your businesses must have both general and limited partners to be legally considered part of a limited partnership. Your general partners are the ones who share in unlimited liability. Limited partners may take the form of equity investors who solely share your profits and business equity in exchange for financing assets. You spell out the liability of limited partners in the partnership agreement.
Joint ventures are weird because not all joint ventures are partnerships but all partnerships are a type of joint venture. What makes a joint venture different from a partnership is its flexibility. Anything you can write into a contract between you and any other entity can be considered a joint venture.
Even large corporations can enter into joint ventures with other groups or individuals. A business, for example, could set up a joint venture with a manufacturer to pay much less for manufactured goods in exchange for a cut of sales profits.
Joint ventures are a great way to do business with others without having to enter into a full partnership agreement.
Corporation (C corporation)
Converting your business into a C corporation separates your personal assets from company assets. It also means your company can issue stock in exchange for financing, so get ready for new stockholders with big ideas on how to run your business.
Becoming a corporation is a serious legal endeavor, and you shouldn’t undertake it without the help of an attorney or CPA because of increasingly sophisticated tax and legal requirements.
Separation of personal and company assets is a good thing. It prevents you from being personally responsible for any liabilities your business incurs.
As a corporation, you’ll be able to issue stock, making it easier to generate financing for the growth of your company. At first, you may choose to issue this stock to those you trust to own shares in your business, but over time, other businesses and individuals may try to buy shares from your stockholders. You can also offer this stock to your employees as part of their compensation.
C corporations are heavily regulated, making them a bit of an administrative nightmare. Generally, businesses only become a C corporation when they can afford the administrative costs.
Because your income will now be separate from the income of the business, you’ll have to deal with double taxation. Double taxation means the profits of your business are taxed, and then the personal income paid to you and your shareholders is also taxed.
You’ll be mandated by your state to hold yearly meetings with your board of directors, which your shareholders will elect. And remember, you may or may not have personally issued stock to these shareholders. Hostile business takeovers can happen when an interested party obtains access to a sizeable amount of stock
This is a special type of corporation that you can create only after your business is already an approved C corporation. To qualify as an S corporation, your business must have 100 shareholders or fewer.
S corporations enjoy all the same benefits of a C corporation, with one key difference: there’s no corporate tax. This effectively avoids the double taxation problem. Instead of the corporation being taxed and then shareholder dividends being taxed, the shareholders shoulder the full tax burden, leaving them with more money overall.
The administrative complexity of running a C corp still applies here. Also, with fewer stockholders, there’s less chance of a hostile takeover, but also less flexibility in issuing stock whenever you want to obtain extra financing.
Limited liability company (LLC)
An LLC provides many of the same benefits of a C corporation without a lot of the hassle. That said, LLCs are regulated differently depending on the state, so you may want to consult a CPA to learn the specific LLC regulations for your state before you change your business entity.
An LLC separates personal and business liability in the same way that a C corporation does, so you won’t be personally accountable for any incurred business liabilities. Only the assets of your company will be at stake.
The federal government doesn’t tax LLCs, but some states do. Instead, owners, partners, and employees are each taxed according to their income. This prevents the double taxation problem of a C corporation.
Another C corporation problem that an LLC avoids is administrative complexity. While you do have to officially file an LLC with the state, there’s little red tape added beyond that.
Your LLC will have a business credit score that it can leverage to obtain financing, even if your personal credit score isn’t great.
Each individual person has to pay self-employment taxes, including employees. Self-employment taxes are simpler than corporate taxes but will be more complicated for your employees if they’ve never done them before. Self-employment taxes may or may not be more expensive for your employees depending on what they can write off for their job.
It’s worth remembering that if you want an easier time securing financing for your business, you’ll want to separate your personal assets from your company assets. That way you’ll be able to borrow against your business credit score instead of your personal credit score.
Now that you have a better understanding of the different types of business entities, it’s up to you to decide what’s best for your business. For the more complicated entities, it’s imperative that you consult a lawyer or CPA to help you properly navigate the process. It’s always better to be safe than sorry.
Once you’ve organized your business into a legal entity, it may be time to get on top of your business credit. Be sure to check out our guide on How to Build Business Credit for all the information you need to get started. Also see what essential hardware products you need to start your business.
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