7 Types of Business Entities (+ Pros and Cons)
Your choice of business entity can hinder or boost your company. You can’t pick the most suitable one without knowing the pros and cons of different business structures.
Do you want full or partial control over your business? How do you want to pay your taxes? Are you planning to finance the company from your pocket? Do you want to leverage the contributions of external investors?
Read on to learn more about the common business entity types and how to choose the perfect one that offers your company the best legal protection and benefits.
Compare Different Types of Business Entities (Winners & Losers)
|Business Control||Sole Proprietorship||C Corporation|
|Capital Investment||C Corporation||Sole Proprietorship|
|Taxation||S Corporation||C Corporation|
|Limited Liability||All Types of Corporations and Limited Liability Companies (LLCs)||Sole Proprietorship and General Partnership|
|Simplicity||Sole Proprietorship||C Corporation|
|Business Privacy||Sole Proprietorship||C Corporation and S Corporation|
1. Sole Proprietorship Entity. Perfect for Low-Risk Small Businesses.
A sole proprietorship is a type of business ownership run, owned, and controlled by a person for his or her own benefit. The simplest business entity to set up. In many countries, any unregistered business automatically falls into this category.
There is no distinction between personal and business assets in a sole proprietorship because the law doesn’t recognize it as a separate legal entity. The owner bears personal liabilities for the business actions.
A sole proprietor doesn’t pay corporate taxes. Instead, owners report the business profits and losses on their individual income tax returns and pay personal income tax.
This business entity is perfect if you want absolute control over your company without external interference.
A sole proprietorship entity is best for the following businesses:
- Retail traders.
- Freelancing businesses.
- Laundry service businesses.
- Maintenance and repair services.
- Independent contractors.
- House cleaning services.
- Plumbing services.
- Tutoring services.
Pros of Sole Proprietorship
- You Can Start with Low Capital: Lack of funds is why many people don’t start businesses. The cost of starting a sole proprietorship is low compared to other business entities. You can launch a sole proprietorship with little capital investment and expand the business as it grows.
- Easy Tax Filing: In the US, you file a Schedule C (Form 1040) to report profit or loss from your business annually to the Internal Revenue Service (IRS). Owners record business profits and losses on their personal tax returns.
- Full Business Control: The best benefit of this business entity is how much control it provides to owners. They can make business decisions without answering to co-owners or a board of directors.
- Less Legal Requirements: You enjoy the freedom other business entities struggle to get because of state and federal government interference and regulations on their business activities. There are no shareholders' meetings to attend. In many countries, the only legal requirement is to register your business name.
Cons of Sole Proprietorship
- Unlimited Personal Liability: Having to cover your business debts and losses that put your personal assets at risk is a disadvantage. You have no legal protection and can be sued for your business actions. Your personal assets can form part of the settlement for debts and liquidations.
- Difficult to Raise Money: Raising money or obtaining loans from banks and external investors is difficult. Foreign and local investors prefer to find other business structures more attractive for funding. Luckily, some small business loans without credit checks are available to sole proprietors.
2. General Partnership Entity. Suitable for Business Partners.
A general partnership is a business entity involving two or more persons actively running the business. General partners contribute resources, time, skills, knowledge, and ideas. They share business profits, debts, and losses in a written partnership agreement.
Like sole proprietorship business entities, general partnership businesses are easy to set up and require no formal registration. The cost of setting up general partnerships is low compared to corporations.
A general partnership is not a separate legal entity from its owners. Partners share unlimited personal liability. They have no legal protection over business actions. Creditors can sue partners and seize their assets if the partnership fails to meet its financial obligations.
Pros of General Partnership
- Enough Capital to Startup: Partners’ contributions make it easy to start and run business operations without seeking external investment.
- Expertise & Collaboration: Partners actively contribute their time, capital, intelligence, diverse experience, skills, and knowledge to the business. During meetings, they collectively and carefully analyze business strategies. Individual partners take up specific business roles that best suit their expertise.
- Shared Business Responsibility: In a general partnership, partners share job roles, duties, and responsibilities, which clearly are stated and outlined in the partnership agreement. You don’t need to work tirelessly as a sole trader does because of workload distribution among partners.
- Pass-Through Taxation: The tax treatment in a general partnership is similar to a sole proprietorship. Earnings from the partnership pass directly to the partners who pay personal income tax. They report their income, deductions, and credits to the IRS by filing Schedule K-1 (Form 1065).
Cons of General Partnership
- Complicated Decision-Making Process: Emergencies may arise that require a quick decision. The time it takes to consult other partners can result in losses.
- Conflict among Partners: Disputes of interests among partners can affect business operations. Imagine partners constantly disapproving of each other’s opinions and can’t reach a mutual agreement during crucial business meetings! Conflicts among partners can lead to the folding of the partnership if not managed effectively.
3. Limited Partnership Entity. Suitable for Partners Needing More or Less Business Control.
A limited partnership has at least one general partner and one limited partner. General partners contribute their money, labor, time, and skills. They are responsible for the day-to-day business management.
In contrast, the limited partner(s) only contribute capital and take no active role in running the business. Limited partners receive a share of business profit based on the amount invested.
For example, Billy and Sharon agree to start a coffee business. According to the partnership agreement, Billy is a general partner responsible for keeping their coffee business records and making business decisions.
Meanwhile, Sharon is a limited partner that invests $1,000 in the partnership but does not partake in daily business management. She receives a portion of the business profit based on her investment.
This business partnership is profitable for investors that want to enjoy legal protection for their personal assets. General partners seeking to raise enough capital for their company through investors' contributions benefit from this structure.
Taxation in a limited partnership varies for general and limited partners. General partners pay self-employment taxes on their profits. On the other hand, limited partners pay personal income taxes on their partnership income.
Examples of limited partnerships include:
- Manufacturing firms.
- Distribution companies.
- Real estate firms.
- Law firms.
Pros of Limited Partnership
- Pass-Through Taxation for Limited Partners: Limited partners enjoy pass-through taxation on their partnership income. They don’t pay taxes at the partnership level but report their earnings and pay personal income taxes. General partners, on the other hand, pay self-employment taxes.
- Limited Liability Protection: This partnership provides protection for limited partners’ personal assets. Limited partners are silent players in the business who contribute capital resources. They are liable to the extent of their contributions. Creditors can’t come after their personal assets.
- Good Source of Raising Business Capital: General partners set up this business structure as it is a great way to raise business capital. They invite limited partners to contribute to the partnership without giving them much control over the business.
- More Control for General Partners: The structure of a limited partnership gives the general partner as much control as the sole proprietor has. General partners run the company's affairs and make business decisions on behalf of limited partners.
Cons of Limited Partnership
- Limited Partners only Contribute Financially: Limited partners don’t contribute to the day-to-day running of the business. Unlike a general partnership, the company does not profit from the ideas, skills, and knowledge of limited partners.
- Unlimited Personal Liabilities for General Partners: While limited partners enjoy liability protection, general partners don’t. They are responsible for the business actions because of their managerial duties. Creditors can sue general partners, and the court can use their personal assets to pay off business debts.
4. Limited Liability Partnership (LLP) Entity. Best Liability Protection for Partners.
A limited liability partnership combines the features of a general partnership and a corporation. This business legal structure enjoys easy formation as a general partnership and the separate legal entity status and limited liability of a corporation.
There is no limit to the number of partners in an LLP. Partners enjoy limited liability. If the company owes debts beyond what it can pay, partners’ assets and belongings don’t form part of any settlement.
Unlike a general partnership, partners in an LLP are not responsible for the negligence of another partner.
Some common business types that fit as an LLP entity include:
- Real estate companies.
- Physician offices.
- Dental offices.
- Accounting firms.
- Marketing firms.
- Law firms.
Pros of Limited Liability Partnership
- Limited Liability Protection: Unlike general and limited partnerships, the law recognizes the LLP as a stand-alone legal entity from partners. Partners in an LLP enjoy protection on their personal assets. They are not liable for business actions.
- Easy Registration: Registering an LLP is easier compared to LLCs and corporations. The requirements include creating a partnership agreement and registering with the state in which the business is located. There is no need to create an article of incorporation and form a board of directors.
- Raise Funds from Partners and External Sources: There is no limit to the number of partners a limited liability partnership can have after registration. Because an LLP is a separate legal entity from partners, it can easily raise funds from banks and non-banking financial institutions.
- Tax Flexibility: An LLP doesn’t pay corporate taxes like corporations. It can pay taxes on partners’ income or pass the business income and losses directly to partners’ personal returns.
- Flexible Management and Contributions: Partners can determine their contribution levels to the LLP. Some partners can contribute financially, while others can share managerial responsibilities based on their qualifications. A partner can decide to stop playing an active role in the day-to-day running of the company and switch to a purely financial contribution.
Cons of Limited Liability Partnership
- Abuse of Partnership Flexibility: Some partners may abuse the flexibility provided by the LLP for their own personal interests.
- Public Disclosure of Earnings: LLPs don’t enjoy the privacy other partnership types have. They must publicly disclose their financial statements and records of partners’ earnings.
- Not Recognized Everywhere: Some states don’t recognize LLPs, while some only allow specific professions to form them, such as lawyers, doctors, dentists, and accountants.
- Not Entitled to Sell Public Shares: Limited liability partnerships can’t raise funds through selling shares like C-corporations.
5. Limited Liability Company (LLC) Entity. Perfect for High-Risk Small Businesses.
A limited liability company is a business legal structure that combines the features of a sole proprietorship and a corporation. It may have one or more members.
This business entity has the pass-through taxation benefit of a sole proprietorship and the limited liability protection of a corporation.
Limited liability companies (LLCs) are best for high-risk small businesses because of the limited liability protection they offer. There is no limit to the number of members an LLC can have. Business entities can hold shares in an LLC except for insurance companies and banks.
An LLC doesn’t have shareholders. Instead, they have members that share the company’s profit. The profit shared with LLC members is taxable as personal income tax.
They are two main types of LLC entities.
- Single-Member LLC: This LLC type has one owner. It is best for solo entrepreneurs because of its low startup costs and minimal document requirements. Similar to sole proprietorship, the owner is responsible for running the company, taxes, and debts. Unlike a sole proprietor, the owner of a single-member LLC has limited liability.
- Multiple-Member LLC: An LLC with multiple owners. Similar to general partnerships, owners share responsibilities for the company’s transactions, debts, and taxes. However, they enjoy limited liability protection on their personal assets.
When forming a limited liability company, draft an LLC operating agreement providing details on ownership and business operations. Members may collectively agree to manage the company or hire an external management team.
An LLC allows members to choose how they want to pay taxes. The default tax status for an LLC is pass-through taxation, where owners pay the tax directly from their earnings. Members can decide to pay corporate taxes like a corporation.
Examples of businesses that an LLC best serves include:
- Manufacturing companies.
- Professional services.
- Boutique stores.
- Family-run grocery stores.
Pros of Limited Liability Company
- Limited Liability Protection: The law recognizes an LLC as a separate legal entity from its owners. An LLC provides personal liability protection for members. If the company owes debts or gets sued for its actions, members' assets don’t form part of the settlement.
- More Credibility and Better Access to Business Loans: Setting up an LLC increases your market credibility in the eyes of investors. You can access business loans and attract investors better than with a sole proprietorship or partnership.
- Tax Flexibility: Operating an LLC structure allows you to choose how you want to pay taxes. You can record your company’s earnings on your personal tax returns like a sole proprietorship or a partnership or pay corporate taxes like a C-corporation.
- Less Paperwork Compared to a Corporation: The paperwork required for an LLC is minimal compared to a corporation. You don’t have to create a board of directors to run the business. However, some paperwork is still needed, like articles of organization and operating agreements.
Cons of Limited Liability Company
- Expensive to Run: The cost of setting up and running an LLC is costlier than a sole proprietorship and partnership. You have to pay a filing fee. There are additional fees and paperwork requirements, such as annual filing and state licensing fees.
- Limit to Personal Liability Protection: There is a limit to the liability protection offered by an LLC. Members do not enjoy protection from the effect of their actions.
- Weak Investment Pull: Compared to corporations, limited liability companies don’t have the same appeal for attracting investors. Since it cannot issue shares, many investors would prefer to invest funds in a corporation.
6. C Corporation Entity. Best for Multinational Organizations and Complex Business Operations.
A C corporation is a large legal entity owned by shareholders. It is a separate legal entity that can own assets, incur debt, borrow and loan money, and sue and be sued.
There are many benefits of choosing a C corp. Owners can trade shares publicly to attract investors and raise business capital. There is no limit to the number of shareholders this business structure can accommodate.
A C corporation is a legal entity responsible for its own actions. Shareholders enjoy personal liability protection from business lawsuits and debts.
The tax structure in a C corporation involves double taxation. The company pays taxes on its corporate profits, and shareholders pay personal income tax (PIT) on dividends.
C corps enjoy the best tax deductions among business entities because of double taxation. Some states lower self-employment and corporate taxes for C corps.
Companies like Microsoft, Google, Toyota, and Walmart are C corporations.
Forming a C corporation involves:
- Filing an article of incorporation with the state.
- Document an LLC operating statement containing the rules and regulations guiding the business and its owners.
- Electing representatives (the board of directors) for day-to-day business operations.
A C corporation is by law required to fulfill the following obligations:
- Trade publicly different types of shares, both local and foreign.
- Pay federal, state, and local tasks allocated to them.
- Regularly update and make financial records public.
Pros of C Corporation
- Limited Liability Protection: A C corporation offers the best limited liability protection of all business entities. Shareholders are not liable for business actions.
- Reduction in Corporate Tax: Some states reduce corporate taxes for C corps because of their double taxation status. C corps qualify for many tax deductions, including health insurance and retirement benefits.
- Guaranteed Business Continuity: A C corp does not struggle to continue in the demise of a shareholder like a sole proprietor, partnership, or LLC.
Cons of C Corporation
- Double Taxation Burden: C corporations pay federal and state income taxes on their profits. Shareholders who receive dividends from the corporation pay personal income tax on it. The only way around this double taxation is for owners to reinvest profits into the company.
- High Startup and Running Cost: The cost of forming and running a C corporation is expensive compared to other business entities. You need to amass huge capital to start, pay filing charges, ongoing fees, and state and federal income taxes.
- Heavy Paperwork Requirements: Setting up a C corp requires you to file different documents such as Articles of Incorporation, financial statements, and annual tax returns.
7. S Corporation Entity. Ideal for Small Businesses with Complex Operations.
An S corporation is a business entity combining the limited liability protection of a corporation and the pass-through taxation of a sole proprietorship and partnership. Another name for S corp is a small business corporation.
Unlike the C-corporation, it is not subject to double taxation. S corps do not pay corporate taxes. Shareholders include their dividends in their tax returns and pay personal income tax on them.
According to the Internal Revenue Code Subchapter S, S corporations are small domestic businesses that can’t have more than 100 shareholders. Not every entity can become an S corporation owner. Corporations and partnerships can’t buy shares in an S Corp.
Setting up an S corporation requires you to file an article of incorporation and elect the board of directors. Examples of S-corp businesses include family businesses, self-employed consultants, and closed or privately held companies operating as an S-Corp.
Pros of S Corporation
- No Double Taxation: S corporations don’t pay federal and state income taxes on their profit like C corporations. Shareholders pay personal income tax on their earnings. However, the IRS mandates an S corp to pay shareholders a salary even if it records a loss.
- Limited Liability Protection: Shareholders’ liability is limited to the value of their shares. Creditors can’t pursue shareholders’ assets to cover debts the business incurred in the event of bankruptcy.
- Long Business Lifespan: A S corporation ensures the company continues in the event of shareholders' demise or selling their shares. This structure is best for family businesses or privately owned companies that seek continuity that an LLC can’t provide.
Cons of S Corporation
- Restricted Share Ownership: An S corporation has many restrictions that can discourage prospective business owners, especially foreign investors. The maximum number of shareholders allowed is 100, and it can only issue common stocks. Corporations and partnerships can’t buy shares in an S corp.
- Strict Monitoring by the IRS: The IRS mandates that an S corp pays shareholders a reasonable salary even if it does not make a profit.
- Unplanned Termination: If a shareholder transfers share ownership to an entity prohibited from owning S corp shares, the company will immediately lose S corp status.
How to Choose the Best Business Entity Type
Choosing the right business entity is essential. Your choice will affect how much investment you can attract, your legal exposure, the level of control over business decisions, and your growth potential.
Although you can switch from one entity to another, it can lead to tax consequences and other complications.
Note: Before picking a business entity structure, consult with legal professionals, business counselors, and accountants. Luckily, you can book free consultations on many online legal services for advice on the right business entity for your plans.
Here are some questions you should answer before picking a business entity.
1. Business Funding. How Much Investment Do You Need?
Do you have the funds to start and effectively run your business? If you want to source funds from external sources like banks and venture capitalists, your best bet is the C corporation. You can sell shares to raise extra business finance.
2. Startup Cost. What is the Cost of Setting Up a Business Entity?
The cost of setting up a business entity varies by type. A sole proprietorship is the cheapest business entity to set up. In many countries, one only needs to register their business name to start operating legally.
LLCs and corporations have high startup and maintenance costs because of their paperwork and strict requirements.
3. Taxation. Which Business Entity Offers You the Best Tax Status?
How do you want to pay your business tax? Sole proprietorships, partnerships, and LLCs enjoy pass-through taxation benefits. They don’t pay corporate tax, but owners pay income tax on business profits.
A C corporation suffers double taxation: corporate taxes on the company’s profits and personal income taxes for shareholders on their dividends. An S corp can use the double taxation system of the C corp or the pass-through taxation of a sole proprietorship.
4. Business Control and Ownership. How Much Control and Ownership Do You Want to Manage?
Do you want to retain full ownership of your business? If yes, choose the sole proprietorship and single-member LLC entity. Do you want to share ownership with other partners and shareholders? If yes, choose the corporation and partnership entity.
Who should be in charge of running the business? If you want a structure that allows owners self-manage the business, choose sole proprietorships, LLCs, and partnerships.
But if you want to employ a more competent management style, choose corporations that elect a board of directors to run their affairs.
5. Growth Potential. Which Business Entity Helps Your Company Reach its Full Potential?
How big do you want your company to grow? Sole proprietorships and partnerships are simple to set up and run but have limited growth potential because of many restrictions.
However, if you want to choose a business entity that can help your company reach its full potential without limitations, choose a corporation.
6. Business Structure. A Simple or Complex Structure?
Do you prefer a simple or complex business structure? The simplest business entity to run is the sole proprietorship. You have full control over the business. The only requirements are registering your business name and paying your income tax.
A partnership doesn’t have the same simple structure as a sole proprietorship because of the involvement of multiple partners. However, it is not as complex as an LLC and a corporation. The major requirement is the partnership agreement.
LLCs and corporations have complex structures. Registering them requires extensive paperwork and higher registration fees. For example, a corporation requires you to elect a board of directors to run the company.
7. Business Liability. How Much Personal Liability Protection Do You Need?
Do you want to set up a low or high-risk business? If you want to start a high-risk business, you can risk choosing sole proprietorship and general partnership business entities.
Why? They don’t provide liability protection for their owners for bad business decisions. Owners are personally liable for the business’s debts and liabilities. If creditors sue these business entities and win in court, owners’ personal assets can form part of the settlement.
The business entities that provide the best business liability cover are corporations and limited liability companies (LLCs). Owners’ personal assets are free from the consequences of bad business decisions.