Types of Business Entities
U.S. state governments recognize many different legal entity types, but most small businesses incorporate under one of five entity types: sole proprietorship, partnership, C corporation, S corporation, or limited liability company (LLC).
Sole proprietorships are the simplest form of a business entity in which the business has a single owner: you. As the sole owner and operator, you personally take on all financial responsibility and legal liability for the business. Forming a sole proprietorship happens automatically when you begin selling goods or services; it requires no formal paperwork or registration. You record profits and losses for the company in your personal tax documents at the end of the year.
Example: If you run an auto repair business on your own, with no employees or shared responsibility, you’re a sole proprietor.
Of course, this entity type has its highs and lows. On the plus side, you don’t have to file a wide variety of reports with the government, and you call all the shots—from keeping all profits to shuttering the business at your discretion. But it’s also harder to raise capital, and you assume 100 percent liability.
Partnerships are a separate entity type and fall under one of two groups: general partnerships (GP) or limited partnerships (LP).
GPs are similar to proprietorships in that they start automatically alongside business operations and typically don’t require formal registration with your state government. With a partnership, all founders are personally liable for legal action against the partnership, and you report profits on personal tax forms.
Example: You and your long-time friend start a catering business with equal stakes and liability for successes, failures, and legal needs.
LPs are different in that some founders have personal liability, while limited partners have little to no liability. This makes it easier for business founders to bring on investors without giving over control of their business. Unlike GP entities, you must formally register LPs and file with your state government.
Example: You, your brother, and a former colleague open a new law firm together. You and your brother hold majority ownership, and consequently, all liability for successes, failures, and legal needs. Your former colleague and new partner is a partner in name only and does not share in any liability.
What’s appealing about partnerships is that you get decision-making and creative support and more capital. But it’s also challenging because of the liability burden and because you share authority with someone and won’t always agree.
C corporations are legal entities independent from their founder(s). This means the business itself is liable for legal action, while the founder(s) and owner(s) are legally separate from the organization. Filing as a C corporation requires that you adhere to additional governance, such as holding board meetings and creating company bylaws. Taxation occurs twice for C corporation owners: The business is taxed and so are personal earnings from company dividends.
The plus side to operating as a C corporation is that the business is perpetual and can be passed on to heirs—not to mention that individual liability is limited to however much each person invested. But you do face double taxation and must obtain a corporate charter from your state.
S corporations take advantage of reduced personal liability afforded to C corporation owners minus the double taxation. But there’s a catch. S corporations can only have 100 shareholders, reducing your ability to grow compared to C corporations.
What’s nice about operating as an S corporation is that it’s simple for stockholders to sell off their shares of the business or even go all in and raise capital to expand the company. But S corporations are limited. They’re only legally allowed to operate in the state specified by the corporate charter unless you otherwise obtain permission.
Limited liability company
Limited liability companies (LLCs) provide owners the flexibility to choose how their business is taxed. LLCs are separate legal entities from the owner, and profits flow through to the owners who recognize that income on their personal tax returns. Regulations concerning bylaws and board meetings don’t apply to LLCs, making LLCs appealing to most small-business owners.
LLCs are among the most appealing entity types because they provide freedom and flexibility. For one thing, the world is your oyster when it comes to customizing the structure of the business, plus you can’t be held fully liable if things somehow go wrong. But LLCs are also strict, needing 360-degree operating agreements because of how flexible other aspects of the business are.