Business Entity Types: Which One Is Right for You?

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Introduction

Choosing the appropriate legal structure is essential to the operation of a business. Whether you’re just getting started or your company is expanding, it’s essential to understand your alternatives.

The legal structure of your business impacts tax rates, administration and administrative needs, fundraising capabilities, and much more.

The formation of sole proprietorships and partnerships is quite simple, but they provide no liability protection.

However, corporations provide liability protection and, in certain instances, more advantageous tax rates.

The legal structure of your firm has various implications. It may decide the extent of your company’s legal liability. It may erect a wall between your personal and corporate taxes, or assure that there is no such wall. It may also affect how often your board of directors must submit documents, or whether you need a board at all.

We will discuss the following business entity forms and how to choose the most appropriate structure. All illustrations are AI-generated.

 
 

Why is a company’s legal structure important?

Choosing the proper company structure at the outset is one of the most important choices you can make. It is not always simple for new enterprises that fall under two or more of these categories to pick which structure to choose. Consider the financial requirements, risk, and growth potential of your business. Changing your legal structure after establishing your firm might be difficult, so give it great consideration in the early phases of business formation.

Here are some important considerations when choosing the legal form for your firm. A CPA should also be consulted for guidance.

Liability. Limited liability companies (LLC) and corporations provide corporate shield protection of your personal assets. Sole proprietorships and general partnerships do not. As a separate legal organization, a corporation has the least level of personal liability, according to the law. This implies that creditors and consumers may file a lawsuit against the corporation, but cannot access the personal assets of the officials and shareholders. A limited liability company provides the same level of security with the tax advantages of a sole proprietorship. According to the terms of the partnership’s agreement, the partners of a partnership share liability.

 

Investment. If you need outside finance from an investor, venture capitalist, or bank, it may be advantageous to form a corporation. Sole proprietorships have a more difficult time collecting outside capital than corporations. Corporations may sell shares of stock and get extra capital for expansion, but sole owners can only obtain cash from their personal accounts, personal credit, or by acquiring partners. As a separate legal company, it is not necessarily required for the owner of an LLC to utilize his or her personal credit or assets.

Formalities. Sole proprietorships are easy to set up and maintain, whereas corporations require adherence to more formalities. LLCs are in between. Corporations are required to have a board of directors. This board must meet a specific number of times each year in some states. Corporate hierarchies also prevent the liquidation of a firm when an owner changes shares or leaves the company, or when a company’s founder dies. This closing protection is absent from other buildings.

Complexity. In terms of setup and operating complication, nothing is simpler than a sole proprietorship. Register your company name, start operations, record earnings, and pay taxes on them as personal income. However, it might be challenging to get external finance. Partnerships, on the other hand, need a written contract to clarify the duties and profit splits. State and federal governments have diverse reporting obligations for corporations and limited liability companies.

Registrations. A company’s legal structure is also a factor in registering a business in a state. Without a proper structure, you cannot apply for an employment identification number (EIN) or other required IDs, licenses and permissions.

Taxes. On their tax returns, sole proprietors, partners, and S corporation shareholders report their company revenue as personal income. C corporation revenue is distinct from a shareholder’s personal income. Given the various tax rates for company and personal revenues, your choice of business structure might greatly affect your tax liability.

Fundraising: Your organizational structure might prevent you from generating cash in certain ways. For instance, most sole proprietorships cannot provide stocks. This privilege is reserved largely for corporations.

Control. If you want sole or principal control over the firm and its operations, a sole proprietorship or an LLC may be your best option. Such power may also be negotiated in a partnership agreement. A corporation is designed to have a board of directors that makes the company’s important decisions. A single individual may govern a corporation, particularly at its birth, but as it expands, it must be managed by a board. Even for a tiny corporation, the principles designed for bigger businesses, such as documenting every key business decision, nevertheless apply.

Licenses, permits, regulations. In addition to creating your company organization, you may need additional licenses and permissions to do business. Depending on the type of company and its activity, local, state, and federal licenses may be required.

Penalties. There are negative consequences of picking the inappropriate structure. Although you may change your company’s structure in the future, your initial business structure selection is important. Changing the form of your organization, however, may be a chaotic and confusing process that may result in tax consequences and the unintended demise of your firm.

Forms of business entities 

The most prevalent forms of business entities are sole proprietorships, partnerships, limited liability companies, corporations, and cooperatives. Here is further information on each sort of legal structure.


Business structure Ownership Liability Taxes
Sole proprietorship
One person
Unlimited personal liability

Self-employment tax

Personal tax
Partnerships
Two or more people
Unlimited personal liability unless structured as a limited partnership

Self-employment tax (except for limited partners)

Personal tax
Limited liability company (LLC)
One or more people
Owners are not personally liable

Self-employment tax

Personal tax or corporate tax
Corporation – C corp
One or more people
Owners are not personally liable
Corporate tax
Corporation – S corp
One or more people, but no more than 100, and all must be U.S. citizens
Owners are not personally liable
Personal tax
Corporation – B corp
One or more people
Owners are not personally liable
Corporate tax
Corporation – Nonprofit
One or more people
Owners are not personally liable
Tax-exempt, but corporate profits can’t be distributed

 

SOLE PROPRIETORSHIP

A sole proprietorship is owned and run by one individual (although a husband and wife can qualify as sole partnership) who is personally liable for all losses and debts. It is the most common form of starting a new business because it is the simplest and least expensive type of business to establish.
Pros:
– Can be established instantly without filing any paperwork.
– Profits or losses reported on a federal Schedule C. No separate tax filing required.
– No need to pay unemployment tax on oneself.
Cons:
– Unlimited personal liability. Purchasing insurance is highly advisable.
– Investors tend to disfavor SPs and prefer a more formal entity.

 

GENERAL PARTNERSHIP

General Partners share equally in management and profits of GP. Profits are taxed as personal income for the partners.
Pros:
– Easy to set up without filing with the state or formal agreement between the General Partners. Written formal agreement, however, is advised to prevent potential misunderstandings.
– Easy to dissolve. If the GP was created for a specific task, it is dissolved automatically upon completion of that task.
– No estimated tax requirements in California.
Cons:
– Each General Partner is jointly and severally liable for the debts of the partnership and other partners. Insurance advised.
– Investors may prefer a more formal entity.
 

LIMITED PARTNERSHIP

An LP has at least one General Partner and at least one limited Partner. GP has unlimited responsibility and is primarily responsible for business affairs of the entity, while LP’s liability is limited to his/her capital contribution, unless the partners agree otherwise. To form an LP in California, a Certificate of Limited Partnership (Form LP-1) must be filed. A limited partnership formed in another state must register with the California Secretary of State prior to conducting business in California. A California LP must pay an annual tax of $800.

Pros:
– Relatively easy to set up.
– More flexible apportionment of risk and management responsibilities than GP.
– LP is not taxed as an entity. Instead, partners file their personal income tax returns and may offset losses against their income from other sources.
Cons:
– Limited Partner has limited decision-making authority within an LP.
– General Partner has unlimited personal liability.
 

LIMITED LIABILITY PARTNERSHIP (LLP)

All LLP partners enjoy limited liability protection but may participate in managing business affairs just like general partners. In California, LLPs are limited to individuals licensed to practice in the fields of public accountancy, law, architecture, engineering or land surveying. An LLP formed in another state must register with the California Secretary of State prior to conducting business in California.
Pros:
– Partners’ personal assets are shielded from liability.
– Partners may be shielded from liability for actions of other partners, although they remain liable for own wrongdoing.
– All partners may actively participate in the management affairs.
– LLPs are not taxed on their income; partners file their own individual tax returns instead. (Note: in California, LLPs still pay $800 per year for the privilege of doing business in the state).
 Cons:
– Limited to specific professional services in California.
– California, and a number of other states, require insurance.

 

LIMITED LIABILITY LIMITED PARTNERSHIP (LLLP)

An LLLP must have at least one general partner and at least one limited partner, just like a Limited Partnership. The main advantage of an LLLP is that it limits the general partners’ personal liability for obligations of an LLLP. LLLPs cannot be formed in California, but an out of state LLLP will be allowed to do business in the state upon registering with the California Secretary of State and paying an annual tax of $800. Nevada allows formation of LLLPs.

C CORPORATION

A corporation is a legal entity that is owned by its shareholders (owners). Since it’s an entity separate from its shareholders, the owners are shielded from personal liability for the debts and obligations of the corporation. C Corporation is the most common form. C Corp is taxed under Internal Revenue Code, Subtitle A, Chapter 1, Subchapter C, unless it chooses to be taxed under Subchapter S. C Corps are subject to double taxation: first, C Corp itself is taxed annually on its earnings; and second, the shareholders are taxed when they receive these earnings as dividends. A California C Corp is taxed on its net income at a rate of 8.84 percent; it is also subject to a minimum annual franchise tax of $800. The estimated annual tax must be paid in four installments.
C Corp. must adhere to certain formalities in order not to lose its corporate status and protections. For example, it must create bylaws that regulate shareholder meetings, define the scope of directors’ authority, etc. 
Pros:
– Generally, no personal liability.
– Ownership can be transferred easily through the sale of stock.
– Corporation survives owners’ death.
– Owners can issue and sell stock to investors to raise capital.
Cons:
– More costly to set up and maintain than a sole proprietorship or a partnership.
– Possible double taxation.
– Ongoing filing and reporting requirements.

 

S CORPORATION

An S Corp is a regular corporation or any business entity, (i.e. a partnership or LLC that chooses to be taxable as a corporation), that elects to be taxed under Subchapter S of the federal tax code. S Corp is not taxed at the entity level, and profits flow directly to the owners. California S Corp is taxed on its net income at a rate of 1.5 percent. The estimated annual tax must be paid in four installments.
Pros:
– Avoid double taxation.
– Generally, no personal liability.
– Generally, survives its owners’ death.
Cons:
– Can have no more than one class of stock.
– Ongoing filing and reporting requirements.
– One hundred shareholders max.

 

LIMITED LIABILITY COMPANY (LLC)

LLC combines the favorable tax treatment of partnership with the corporate shield from personal liability. LLC owners’ liability for debts and obligations of the LLC is limited to their financial investment, yet the members have the right to participate in management of the company like general partners.
In California, for income tax purposes, an LLC with more than one member is taxed as a partnership, and an LLC with a single individual member is taxed as a sole proprietorship. LLC may instead to choose to be taxed as a corporation by filing an election on a Form 8832 with the IRS. California taxes the LLC and its owners in the same manner the IRS does, in addition to the $800 minimum annual tax for the privilege of doing business in the state. An LLC, whether California or foreign, may not render professional services.
Pros:
– Easier and faster to form than a corporation.
– Generally, no personal liability.
– No double taxation.
– One of the least burdensome corporate filing requirements.
Cons:
– More complicated to form than other forms of partnerships and sole proprietorships.
– Ownership may be harder to transfer since the LLCs do not issue stock.

SERIES LIMITED LIABILITY COMPANY (SERIES LLLC)

Series LLC is one of the newest corporate forms for master LLCs that have subsidiaries that operate as independent LLCs, each being protected from liability for the actions of other LLCs. Series LLC cannot be formed in California, but a Series LLC formed in another state may register with the California Secretary of State and conduct business in California. Both Delaware and Nevada permit formation of Series LLCs.
Pros:
– Each unit may be managed independently of others.
– Each unit has own assets and liabilities.
– Each unit is protected from liability for the wrongdoings of other units.
– The owners enjoy personal liability protection.
– Each unit may be in the same business as a master LLC or conduct its own type of business.
– Units may be formed and dissolved by simple amendments to the Operating Agreement, without filing with the state. Therefore, reduced legal, accounting and administrative fees that would otherwise be incurred by multiple unconnected LLCs.
Cons:
– Each unit must maintain separate records.
– Since Series LLC is a new entity, its tax status is unsettled and case law underdeveloped in some states. The IRS has not stated whether each unit to be taxed as a separate entity.

PROFESSIONAL CORPORATION (PC)

PCs are organized by licensed professionals, such as accountants, lawyers and doctors. In California, a PC pay taxes on its net income, either at a rate of a corporation or an S Corp., with a minimum annual $800 franchise tax. PC must pay the estimated tax in four installments.
 Pro:
– Owners are not liable for malpractice of other owners. However, each owner is personally liable for own malpractice.
Con:
– Many states require significant capitalization or insurance policies.


 

NON-PROFIT

Non-profit must be formed for a charitable, educational, religious, literary and similar public interest purposes. A non-profit can be registered on two levels: state and federal. When you hear “501(c)(3),” that refers to the section of the federal tax code and, thus, a federal level of registration. A federal level of registration is what you need in order to be eligible for federal tax exemptions and to attract donors by being able to tell them that their contributions will be tax deductible.
State level registration is a relatively quick, straightforward process, and usually only requires a simple filing of the articles of incorporation, stating the purpose of the organization, with the Secretary of State. Federal 501(c)(3) level registration requires filing a more complicated Form 1023, and takes longer to approve. In order to be eligible for federal tax exemptions, a nonprofit must first be registered at the state level. In California, most charities and non-profits must apply for and receive a letter of acknowledgment in order to receive a tax-exempt status. Small non-profits with ordinary gross receipts of less than $25,000 must electronically file an annual informational notice with the Secretary of State.
Pros:
–  Tax exemptions.
–  Donations to 501(c)(3) are tax-deductible.
– Eligibility for grants.
–  Directors are shielded from personal liability.
Cons:
– May not be eligible to engage in certain business activities.
– Ongoing filing and reporting requirements.

 

B CORPORATION

“B” stands for “benefit,” as in “public benefit.” B Corps may harness the power of business and pursue public interest purposes at the same time. In discharging their duties, B Corp directors are not required by law to only pursue shareholder profit maximization; they may consider various socially important purposes and interests of stakeholders other than B Corp’s shareholders.
Pros:
– May simultaneously pursue business and socially important purposes.
– Directors are shielded from personal liability.
Cons:
– A new and unknown to the public at large corporate form.
– Only available in a handful of states.

 

– Potential for abuse, if directors try to hide own business incompetence and try to justify losses with the pretense of pursuing social interests rather than profit.
 

COOPERATIVE


A cooperative (co-op) is owned by the same individuals it serves. Members, sometimes known as user-owners, who vote on the organization’s goal and direction and share earnings benefit from the company’s products.

Cooperatives provide many significant benefits:

Federal funds may be available to cooperatives to help them get started.

Cooperatives may utilize their corporate scale to secure discounts on goods and services for their members, as well as superior service. State-by-state variation in the co-op agreement filing fee.

DOING BUSINESS AS (DBA)

A widespread misunderstanding is that a DBA is a kind of company structure or legal organization. A DBA is not a business structure and does not provide the same protection for personal assets as an LLC or corporation. DBA is simply utilizing a new name for your company operations. A DBA is not a legal entity; it is merely another name under which your firm is registered.
 

Doing Business As (DBA), also known as fictitious business names, trade names, or an assumed name, is a name that the legal owners of a business register with the state. Owners are only required to establish a DBA if they use a different name on goods such as company signs, letterheads, and advertising.

 
This DBA name is anything different than the legal owners’ names (for sole proprietorships and partnerships) or the business name specified on the formation documents (for LLCs and corporations).
 
DBAs are not necessary or required to operate a company, however they are occasionally required. For branding reasons, partnerships, sole proprietorships, LLCs, and corporations often utilize DBAs.
 
After deciding on a business entity type, you will often be required to register your firm in the state where it is headquartered.
 
 

Conclusion

In the end, there is no one-size-fits-all method to selecting a company organization since your decision will affect your finances as well as your responsibility and risk. 
 
The majority of entrepreneurs and small company owners form an LLC because it provides limited liability protection and pass-through taxation advantages.
 
As your firm grows, becomes more sophisticated and the investors are interested, you may decide to incorporate. 
 
A general partnership or limited partnership may be a useful starting point if you have several partners. 
 
If you are still uncertain about which choice is ideal for your firm, you can always consult a legal and/or tax/financial expert for guidance.

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