6 Business Entity Types: The Basics of Forming a Business

Most businesses, regardless of size, operate through entities. Running a business through an entity allows owners to shield themselves from personal liability, take advantage of tax benefits, and provide an established yet flexible structure for their business. If you’re considering forming a new business entity or reorganizing an existing business entity, this article offers some basic information on why entities are important and some key points on the main types of entities. Keep in mind as you read that it is usually best to have organizational documents to govern your entity. Here, however, the entities discussed below are discussed in the broadest terms and without reference to such agreements.

Why Form a Business Entity?

Liability Protection

The owners of a business generally want to avoid personal liability for actions taken on behalf of the business.

Tax Benefits

Depending on the nature and size of the business, one can obtain meaningful tax savings by selecting the proper entity type. Such a determination should always be made with the advice and counsel of a qualified tax professional.

Establishing Structure

Especially in businesses with multiple owners, structure is key. Each owner should have clarity as to the size of their ownership interest, their rights within the company, how the company takes action, and how intra-company disputes are to be resolved.

Displaying a Professional Image

Customers who consider using your business will want to know that you take your business seriously. Someone operating a business as an individual simply does not provide the same sense of security as someone with a business entity behind them. Forming a business entity is important to demonstrating your professionalism and competence.

Types of Business Entities

There is no one-size-fits-all type of entity. However, depending on the size of your business, ownership structure, desired level of flexibility and other factors, you can choose the entity type that offers maximum benefit to your business. Below are the some of the main types of entities from which to choose. This is meant to provide general information with respect to each type of entity; the decision on which entity to choose should be the result of a discussion with an attorney and a tax professional.

Sole Proprietorship

A sole proprietorship is essentially a self-employed individual. While an individual may operate a sole proprietorship through a trade name, there are no liability shields, and the individual pays individual income tax on profits. Sole proprietorships offer the most flexibility, as there is no need to form anything with state authorities. Should the owner want to either expand or disband the sole proprietorship, it is easily done. Such entities are popular for freelancers, contractors, and other service providers. Sole proprietors are always advised to obtain adequate insurance to cover potential liability relating to the services they provide. Pros

• Flexibility
• No fees for organization/maintenance
• Pass-through tax benefits
• Easy to set up and dismantle

Cons

• Unlimited personal liability for owner
• No ability to raise capital via equity; difficult to raise capital via debt

General Partnership

A partnership is an association of two or more persons to carry on, as co-owners, a business for profit. It can be formed by written or oral agreement, and can even arise unintentionally if the statutory definition of a partnership is satisfied. Partnerships are useful in situations demanding flexibility and low costs of maintenance, as they generally do not require the filing of documents with state authorities. Generally, no state filing is necessary to form a general partnership. However, in most states, a partnership can file a certificate of authority to demonstrate its existence. This can be useful for presenting a professional image to potential customers and business partners. Concerning liability, each partner is personally liable for obligations of the partnership. With regard to tax, the partnership is a pass-through entity, meaning that the partnership itself does not pay income tax but the partners pay tax as they take distributions. Pros

• Fewer administrative requirements
• Few (or no) statutorily required formalities depending on the state
• Pass-through tax treatment

Cons

• Personal liability of partners
• Limited access to capital compared to other entity types

Limited Partnership

A limited partnership is a partnership comprised of at least one general partner and at least one limited partner. The general partner manages the business, but also risks personal liability for partnership obligations. A limited partner is protected from liability and does not participate in management. A sub-type of limited partnership is a limited liability limited partnership (LLLP). An LLLP operates mostly the same as a limited partnership, except that the general partners are generally not liable for debts of the partnership. A limited partnership offers a more flexible structure than a general partnership. For example, limited partners can be individuals or other entities. Partners may generally transfer partnership interests without causing dissolution of the partnership. Pros

• Flexible structure
• Pass-through tax treatment

Cons

• General partners can have unlimited liability (depending on type of limited partnership)
• Limited partners have fewer rights to participate in management
• More filing requirements than general partnerships

Limited Liability Company (LLC)

An LLC is an unincorporated entity offering liability protection to its owners. It is generally understood as a corporation-partnership hybrid. An LLC’s owners are called the members. Management can be vested in the members or in one or more managers. LLCs offer structural flexibility and pass-through tax treatment for members similar to a partnership, but offer liability protection for members more in line with a corporation, hence the “hybrid” designation. Pros

• Fewer formalities than a corporation
• Liability protection for members
• Pass-through tax treatment
• Easy to form

Cons

• Maintenance and annual fees more than partnerships
• Less access to outside capital than with a corporation

C-Corporation

A C corporation is a corporation which is taxed separately from its owners. The owners of a corporation are called shareholders. The notable distinction here is that a C corporation is subject to a corporate income tax—there is no passing through of income tax to the shareholders. The shareholders each bear their own tax when distributions are made, meaning there is a “double tax.” Corporations also must adhere to more stringent formalities. For example, C corporations must have annual meetings and a board of directors. With respect to liability, the assets and income of the corporation are separate from the shareholders, offering the most liability protection. Pros

• Best liability protection for both owners and management
• Access to capital

Cons

• Most legal formalities (e.g. filings, fees)
• “Double” taxation

S Corporation

An S corporation is a corporation meeting certain IRS requirements such that it may pass income taxes through directly to shareholders and avoid paying federal corporate taxes. An S corp thus provides all the benefits of a corporation with the tax benefits of a partnership. In order to qualify for treatment as an S corporation, a company must be incorporated in the United States, have no more than one class of stock, have 100 shareholders or less, and those shareholders must be individuals or certain types of trusts, estates, or tax-exempt entities.