Breaking Down Business Entity Types

One of the most important steps you’ll need to make when starting your business is reviewing business entity types and deciding which one you should choose for your company. The structure you pick will affect your business from legal and tax obligation standpoints. That’s why it pays to understand the various business entity types—and the potential advantages and downsides of each.

I recommend talking with a business attorney and accounting professional for guidance. In the meantime, I’m going to share some information about the most commonly used business structures to give you a head start in furthering your knowledge.

The Low Down On Business Entity Types

How you operate your business and the ongoing compliance obligations you need to fulfill will depend on which legal entity you pick. Realize that rules and regulations might vary from state to state, so make sure you research what your state requires.

Sole Proprietorship and General Partnerships

By default, your company will be considered one of these if you don’t register your business as a different type of business entity. A sole proprietorship has just one owner (or a husband and wife) while a partnership has two or more owners. All assets and liabilities are tied to the individual owners.

If you choose to operate your business in a name other than that of the owner—for example, “Café Metro” rather than “Jane Smith’s Coffee Shop”—you can do so by filing a DBA (Doing Business As). A DBA gives you permission from the state to conduct business under a “fictitious name.” Because all business profits and losses flow through to the individual owner(s), business income tax is reported through the owners’ personal income tax returns.

Advantages of operating as a sole proprietorship or partnership include:

  • Inexpensive to establish – To operate as a sole proprietorship or partnership, the only fees you’ll typically incur will be for filing your DBA and obtaining any required licenses and permits.
  • Simplicity – Operating as a sole proprietorship or partnership requires no legal formation paperwork or corporate compliance. Tax filing is relatively simple, too, since all business income and expenses are passed through to owners’ personal tax returns (on Schedule C of IRS Form 1040).

For the above reasons, many home-based businesses choose to operate as sole proprietorships or general partnerships.

Disadvantages of operating as a sole proprietorship or partnership include:

  • Unlimited personal liability – Your company and your personal self are legally considered one in the same. If someone sues your company or your business goes bankrupt, your personal assets will be at risk.
  • Limited growth potential – Operating as a sole proprietorship or partnership might hamper your chances of raising external capital to grow your business. You cannot sell company stock. And you may have difficulty finding outside investors. They typically favor funding businesses that are legally formed as business entities (such as LLCs and corporations).
  • Self-employment tax burden – Because all business income is subject to FICA (Social Security and Medicare) tax, you might find yourself paying a lofty amount to Uncle Sam.

Limited Liability Company (LLC)

I often refer to the LLC as “the best of both worlds.” This business structure offers the personal liability protection of a corporation with the formation, tax treatment, and compliance simplicity of a sole proprietorship or partnership. As an LLC, you get personal liability protection but don’t have the extensive formation paperwork and complicated compliance requirements as when registering as a corporation. Taxes are filed as they would be for a sole proprietorship or partnership, with the LLC’s income and expenses reported on the Schedule C of IRS Form 1040.

An LLC can be either a Single Member LLC (SLLC) with just one owner or a Multi-Member LLC with multiple owners. In most states, you must file Articles of Organization to form an LLC. Although not mandatory, you should consider creating an Operating Agreement, as well, to spell how the LLC should be managed and to identify the rights and responsibilities of its owners.

Advantages of operating as an LLC include:

  • Legal protection – Your business is a separate and distinct legal entity. If someone sues your business or your company cannot meet its debt obligations, your personal assets aren’t at risk. (Please note that you remain personally liable if you do something that personally endangers or causes injury to someone else.)
  • Simplicity – With an LLC, your company’s profits and losses flow through to your individual tax return. You don’t need to file a corporate tax form, and you avoid the double taxation that corporations face. (More on that later!) Also, your LLC will have less ongoing compliance requirements than you would if you were set up as a corporation.
  • Ownership flexibility – The LLC structure allows you the freedom to allocate percentages of your business’s profits and losses among owners as you see fit. For example, if one owner will be investing more time and effort into the business, you can give them a higher percentage of ownership.  Few restrictions exist regarding who can own an LLC. In many states, individuals (including non-residents of the U.S.), groups, corporations, and even other LLCs are eligible to form an LLC.
  • Management flexibility – If you have a multi-member LLC you can run it as either a member-managed LLC or manager-managed LLC. In a member-managed LLC, the owners of the company have the authority to act on behalf of the company and manage other operational and administrative tasks. In a manager-managed LLC, LLC owners elect a manager or managers to run the business operations. Most states will consider your LLC to be member-managed if you specify a management structure in your formation documents.
  • Tax flexibility – Your LLC may elect to be treated as an S Corporation. That election enables you to take some money out of your business without paying self-employment tax on it. I’ll explain this in more detail later in this article.
  • Credibility – Potential customers, investors, and project partners might perceive your business as more legitimate if you have “LLC” behind its name.

Disadvantages of operating as an LLC include:

  • Limited growth potential – As an LLC, you may not issue shares of stock. And although our business may be thought of as more legit than a sole proprietorship, some investors might be hesitant to offer you funding.
  • Self-employment tax burden – Generally, all of your business earnings will be subject to self-employment taxes. That means you’ll pay Social Security tax and Medicare tax on the money your business makes rather than just the amount you personally draw from that income.

S Corporation

An S Corporation isn’t formally a business entity structure on its own. It is a special election made with the IRS to give a business pass-through tax treatment on federal income taxes. With S Corporation election, a business does not pay federal taxes at the corporate level. Profits or losses flow through to the shareholders (owners), who then report them on their personal income tax returns.

LLCs and C Corporations may elect to be considered S Corporations for tax purposes. All other aspects of operating the LLC or C Corporation business entity types stay true to their structures.

Advantages of operating as an S Corporation include:

  • Legal protection – Because the underlying structure is either an LLC or corporation, your business is its own legal entity. So, your personal assets have protection against lawsuits and debts of your company.
  • Flexibility in accounting methods – While C Corporations must use the accrual method of accounting; S Corps can typically use the cash method (unless they have inventory).
  • Elimination of double taxation – When a C Corporation elects S Corporation tax treatment, its owners avoid double taxation. Normally, a C Corporation pays tax on its profits at the corporate level and then again at the individual (shareholder) level. With S Corp election, the corporation won’t be taxed on its profits; only federal tax at the individual level will apply.
  • Less self-employment tax – If your business is an LLC that elects S Corp tax treatment, owners won’t pay Social Security tax and Medicare tax on all business income—only on wages and salaries (not income paid as dividends) are subject to those self-employment taxes.

Disadvantages of operating as an S Corporation include:

  • Shareholder limitations – An S Corporation may have no more than 100 shareholders, which could impact growth potential. Shareholders must be individuals who are either United States citizens or permanent residents.
  • More formation costs and ongoing compliance requirements – With the advantages of S Corp election may also come some additional upfront costs, along with reports and other formalities, to stay compliant.

C Corporation

A C Corporation, a more complicated legal structure, offers the highest degree of personal liability protection for owners. It is considered by the IRS as a separate taxpayer, with income and expenses tied to the business, not its owners (shareholders). Ownership of a C Corp is through the issuance of stock (held privately or publicly) in the company.

You must file “Articles of Incorporation” with the state to register your business as a C Corporation. A C Corp must follow internal and external corporate rules to operate legally and stay in good standing with the state. The possible requirements include holding shareholder and board of director meetings, adopting bylaws, filing annual reports, and other paperwork and tasks.

Advantages of operating as a C Corporation include:

  • Legal protection – Because a C Corporation is a separate legal entity, shareholders have protection from creditors of the corporation and not held responsible in lawsuits against the business.
  • Ability to sell stock – C Corporations may have an unlimited number of shareholders and can issue multiple classes of stock. This freedom can enable you to raise substantial capital to grow your business.
  • Potential tax savings – In some situations, the federal corporate income tax rate is lower for corporations than for individuals. And a C Corp may be eligible for tax deductions not available to an LLC, partnership, or sole proprietorship.
  • Credibility – With “Inc.” at the end of your business name, you may more easily gain the attention and trust of potential customers, vendors, and investors. Incorporating projects a degree of commitment and seriousness about succeeding for the long-term.
  • Perpetual life – With a sole proprietorship (and sometimes even with an LLC), the business dies when the owner dies. A C Corp, however, can survive beyond its owners. A C Corporation’s ownership interests can be transferred via selling, gifting, or bequeathing shares of stock to others. This business entity type can continue to operate until it is dissolved.

Disadvantages of operating as a C Corporation include:

  • Double taxation – A C Corp pays taxes on its profits at the corporate tax rate. If the company then distributes profits to its shareholders as dividends, that income is taxed again at the individual income tax rate. For this reason, many small businesses do not opt to form their businesses as C Corporations.
  • Higher business formation costs – Your business will pay more to incorporate than it would if it were to form an LLC.
  • More compliance requirements and government oversight – Because of the complex tax rules, compliance responsibilities, and a higher degree of personal liability protection, a C Corp may fall under more scrutiny than other business entity types.

Which Business Entity Type is the Right Fit?

As you can see, there’s a lot to consider when reviewing business entity types for your company. Before deciding which formal business structure will offer the most favorable environment legally and from a tax perspective, I encourage you to talk with an attorney knowledgeable in business law and an accountant who can advise on how the different entities will impact your tax obligations. While it’s possible to change your business entity down the road, you’ll save time and money by getting it right from the start.

After you determine the business structure you want to use, you can minimize your costs by turning to CorpNet to handle preparing and filing the formation documents for you.

No matter where you’re located within the 50 states of the U.S., we can assist by filing DBA requests or submitting your paperwork to incorporate or form your LLC. We will also help you stay on top of critical tax and compliance deadlines.

Contact us today for all of your business document filing needs. We’re here to help you get your business off on the right foot—and stay there!

About the Author:

Nellie Akalp
Nellie Akalp is an entrepreneur, small business expert, speaker, and mother of four amazing kids. As CEO of CorpNet.com, she has helped more than half a million entrepreneurs launch their businesses. Akalp is nationally recognized as one of the most prominent experts on small business legal matters, contributing frequently to outlets like Entrepreneur, Forbes, Huffington Post, Mashable, and Fox Small Business. A passionate entrepreneur herself, Akalp is committed to helping others take the reigns and dive into small business ownership. Through her public speaking, media appearances, and frequent blogging, she has developed a strong following within the small business community and has been honored as a Small Business Influencer Champion three years in a row.

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