23 April 2024
By Wealthovation
28 Minutes Read

Types of business entities in the USA and how to choose the right one for you?

A business entity is simply the structure an individual or a group creates to conduct business activities. It's like the framework that defines how the business operates and how it's taxed. When starting a business, one of the first decisions you'll make is choosing the type of business entity and this decision has legal and financial implications. Taxes, access to loans, and liability in case of legal issues all depend on this choice.

While there are many types of business entities recognized by states, most small business owners consider six main options: sole proprietorship, general partnership, limited partnership, limited liability company (LLC), C corporation, and S corporation.

This guide aims to help you understand each type's pros and cons, empowering you to choose the best fit for your company's needs and goals.

Types of business entities

I) Sole Proprietorship

A sole proprietorship is the most basic type of business entity, where one person (or a married couple) owns and runs the business. If you start a business on your own, you're automatically considered a sole proprietorship. You typically don't need to register it with the state, although you might require local business licenses or permits based on your industry.

Sole proprietorships are common among freelancers, consultants, and service providers, but they're also suitable for established businesses like retail stores where one individual manages operations.

Pros of Sole Proprietorship

It is easy to start as there is no legal requirement to register your business with the state.
Most business losses can be deducted on your personal tax return.
There is no need for corporate formalities such as bylaws, meeting minutes, etc.
Filing taxes is easy, you just have to fill out and attach Schedule-C Profit or Loss From Business to your personal income tax return.

Cons of Sole Proprietorship

Getting a business loan and raising money is comparatively difficult as lenders and investors prefer corporations or LLCs.
You will be personally liable for all the debts and liabilities of the business. In case someone wins a lawsuit against your business, they can take your personal assets.
Building business credit without a registered business entity is very hard.

Sole proprietorships are extremely popular in the U.S. due to their simplicity in setup. They blend personal and business finances seamlessly, simplifying both launch and tax filing processes. However, this integration also poses a risk: if your business faces legal action and loses, your personal assets can be seized. Consequently, many sole proprietors opt to convert their business to an LLC or corporation to mitigate this risk.

II) General Partnership

Partnerships resemble sole proprietorships but involve two or more owners. There are two main types: general partnerships (GPs) and limited partnerships (LPs). In a general partnership, all partners participate in managing the business and share profits and losses.

Similar to sole proprietorships, general partnerships are the default structure for multi-owner businesses, requiring no formal registration with the state.

Pros of General Partnership

Easy to start (no need to register your business with the state).
No corporate formalities or paperwork requirements.
Profits and losses are divided among partners.
Owners can deduct most business losses on personal tax returns.

Cons of General Partnership

Each owner is personally liable for business debts and liabilities.
Joint and several liability in some states.
Disputes among partners can disrupt the business.
Difficulty in obtaining business loans, big clients, and building business credit without a registered business entity.

Partnerships are often chosen to mitigate the risk associated with starting a business. Sharing both the challenges and victories with multiple individuals can provide valuable support, particularly during the initial stages.

However, selecting the appropriate partner(s) is crucial. Disagreements can significantly hinder business progress, and many state laws impose full responsibility on each partner for the actions of others. For instance, if one partner breaches a contract, any or all partners may be personally liable to third-party lawsuits.

III) Limited Partnership

In contrast to a general partnership, a limited partnership (LP) is a formally registered business entity. Establishing an LP requires filing documentation with the state. Within an LP, there are two categories of partners: general partners, who manage the business and bear liability, and limited partners, often referred to as "silent partners," who solely contribute capital and have minimal involvement in operations.

Limited partners lack control over business operations and assume fewer liabilities. They primarily function as investors in the business, resulting in reduced tax obligations due to their less active role in company affairs.

Pros of Limited Partnership

Good for raising money as investors can serve as limited partners without personal liability.
General partners maintain authority over business operations while obtaining necessary funds.
Limited partners can leave without dissolving the partnership.

Cons of Limited Partnership

General partners are personally responsible for business debts and liabilities.
More expensive to create than a general partnership and requires state filing.
Limited partners may face personal liability if they become too involved in the business.

IV) C Corporation

A C corporation is a distinct legal entity separate from its owners. Shareholders, a board of directors, and officers collectively manage the corporation, although it's feasible for one individual to assume all these roles.

Operating as a C corporation involves numerous regulations and tax laws. Incorporation procedures, fees, and necessary documentation differ across states.

Pros of C Corporation

Owners (shareholders) have limited personal liability for business debts and liabilities.
Eligible for numerous tax deductions.
Lower self-employment taxes for owners.
Ability to offer stock options for raising funds in the future.

Cons of C Corporation

More expensive to create compared to sole proprietorships and partnerships.
Subject to double taxation: corporate taxes and shareholder taxes on dividends.
Owners cannot deduct business losses on personal tax returns.
Requires adherence to formalities like board and shareholder meetings, keeping minutes, and creating bylaws.

While many small businesses initially overlook C corporations, they can become appealing as the business expands and requires increased legal protection. The primary advantage of a C corp is limited liability. In the event of a lawsuit against the business, personal assets like homes or cars are shielded, and only business assets can be targeted to cover any judgements.

From a tax standpoint, C corporations present a mixed scenario. Although they offer more tax deductions and lower self-employment taxes, the potential for double taxation arises, particularly if dividends are distributed. Owners who reinvest profits back into the business, rather than taking dividends, are typically better under the corporate structure. While corporation formation and upkeep can be complex, taking legal services can assist in dealing with these processes.

V) S Corporation

An S corporation maintains the limited liability protection of a C corporation but operates as a pass-through entity for tax purposes. In essence, like a sole proprietorship or partnership, the profits and losses of an S corp are reported on the owners' personal tax returns. Notably, there is no corporate-level taxation for an S corp.

Pros of S Corporation

Owners (shareholders) have limited personal liability for business debts and liabilities.
No corporate taxation or double taxation; S corp is a pass-through entity.

Cons of S Corporation

More expensive to create compared to sole proprietorships and partnerships; requires state registration.
More limits on issuing stock compared to C corporations.
Still requires compliance with corporate formalities such as creating bylaws and holding meetings.

To establish or convert your business to an S corporation, you must submit IRS Form 2553. S corporations offer an appealing option for businesses seeking the structure of a corporation with tax advantages similar to a sole proprietorship or partnership.

VI) Limited Liability Company (LLC)

A limited liability company (LLC) combines advantageous aspects from various business entity types. Similar to corporations, LLCs provide limited liability protection. However, they require less paperwork and ongoing obligations, resembling sole proprietorships and partnerships in this regard.

Another significant advantage is the flexibility in tax treatment. LLC owners can elect how the IRS taxes their business, either as a corporation or as a pass-through entity on their personal tax returns.

Pros of Limited Liability Company (LLC)

Owners have limited personal liability for business debts and liabilities.
Flexibility to choose taxation as a partnership or corporation.
Fewer corporate formalities compared to S corp or C corp.

Cons of Limited Liability Company (LLC)

More expensive to create than sole proprietorships or partnerships; requires state registration.

LLCs are favored by small-business owners, including freelancers, for their ability to blend the simplicity of a sole proprietorship or partnership with the legal safeguards offered by a corporation.

How can you choose the best business entity type for you?

Now you know the basic structure of each business entity and want to decide which business entity will suit you the most. The 3 important points you need to consider before starting a business are- level of government requirements, tax treatment, and limited liability protections.

Here is the summary of each business entity concerning these 3 factors. These will hopefully help you in making a decision.

Business entity	Level of government requirements	Tax treatment	Limited liability protection
Sole proprietorship	Low	Personal tax rate	No
General partnership	Low	Personal tax rate	No
Limited partnership	Medium	General partners are taxed at the personal tax rate	For limited partners only
S Corporation	High	Personal tax rate	Yes
C Corporation	High	Corporate taxes (but need to be aware of double taxation on dividends)	Yes
Limited Liability Company (LLC)	Medium	Can choose how you want to be taxed	Yes

Sole proprietorships and general partnerships expose you to greater legal risk in case somebody sues your business as they do not provide liability protections. But, taxation is quite simple as you do not have many government regulations to comply with. This gives you the liberty to invest more time in running your business. These are great for freelancers, consultants, and those running businesses in industries with fewer regulations and little legal risk.

If your business is in an industry that is very regulated such as child care, food services, professional services, health and wellness, etc. then you need to consider either a corporation or LLC because of the liability protection they provide.

It is possible to change business structure at any point in time but some changes are easier to make than others. For example- converting a sole proprietorship or a partnership to an LLC is easy.

Converting to a corporation on the other hand is complex especially if you plan to issue stock. Converting to a corporation also brings in unexpected taxes so this is a decision you need to take very carefully and should consult a business attorney for professional advice.

Additionally, note that the IRS has restrictions and deadlines for changing your business entity type. Tax laws can also affect how different business structures are taxed, influencing your decision.

Which is great for whom?

Sole Proprietorship: Ideal for freelancers, consultants, or small-scale service providers operating individually. Examples include freelance writers, graphic designers, or independent contractors.

Partnership: Well-suited for small businesses with multiple owners who want to share profits and responsibilities. Examples include law firms, accounting firms, or small family-owned businesses like local cafes or shops.

LLC (Limited Liability Company): Suitable for businesses looking for liability protection and flexibility in management. Examples include real estate investment firms, small creative agencies, online retail stores, etc.

S Corporation: Beneficial for small to medium-sized businesses seeking tax advantages and pass-through taxation. Examples include medical practices, engineering firms, technology startups, etc.

C Corporation: Ideal for businesses planning rapid growth, seeking venture capital, or intending to go public. Examples include tech companies, pharmaceutical firms, multinational corporations, etc.