In some regards, the decision to start a small business is easy—when compared to the work it takes to actually do it. The path of an entrepreneur has many twists, turns, and branches. The first fork in the road? Selecting how to structure your small business, from a legal and tax perspective. Will you opt for a certain business entity designation (the legal, structural format of your company), and/or a certain tax status? Small businesses with the same structuring will be treated in different ways by tax authorities, depending on the work they do.
What types of businesses are there?
There are four main categories of business entities: sole proprietorships, partnerships, limited liability companies, and corporations. Within those types, there are subtypes—general and limited partnerships, limited liability partnerships, and S and C corporations. Lastly, there are joint ventures, which can be formed by temporarily merging the efforts of one or more of the above.
Business entities vs. tax statuses
The entity types outlined above can qualify for different tax treatment by the US Internal Revenue Service (IRS) and a company’s state and local tax authorities. The main difference between an entity type and a tax status is that business entities can engage in any legal line of business, whereas certain tax statuses are only available to organizations that pursue certain kinds of work.
Tax status types include:
- Pass-through entities. These businesses are taxed once, at the owner’s personal income levels.
- Corporations. Corporations (specifically C corporations) are taxed twice—once on corporate income and again at shareholders’ personal income levels (so-called “double taxation”).
- Nonprofits. Nonprofits are exempt from some taxes (mainly on income) at the federal and state levels, so long as they meet certain eligibility requirements as defined by the IRS and state tax authorities.
9 types of businesses
The way you organize your business depends on whether you are acting alone or with partners, how much personal liability you are willing to accept, and whether you need to issue shares to investors in order to get your business started.
A sole proprietorship is an unincorporated business entity owned and operated by a single individual. Its main advantage lies in its simplicity. It is the default business entity designation for anyone selling a service or product themselves and requires no special filing. But the ease of setting up a sole proprietorship is a double-edged sword—it enjoys the least amount of protection for the owner among the available entity types. Sole proprietors are fully liable for debts and legal liabilities incurred by the company. Other advantages enjoyed by the sole proprietor are unfettered control over the company and a single round of taxation at the owner’s personal income level.
General partnership (GP)
General partnerships are the default form of partnership—a business owned by two or more people. Like sole proprietorships, general partnerships are subject to pass-through taxation, meaning they are only taxed once at the partners’ personal income levels. Likewise, general partners are equal participants in the firm, meaning everyone has a say. General partnerships are also vulnerable to some of the same drawbacks as sole proprietorships—there is no legal distinction between the general partners and the partnership itself, meaning all owners are subject to unlimited liability for the company’s debts and damages. Creditors and lawsuit plaintiffs can reach the personal assets of partners. Additionally, general partners are liable for the business conduct of all other partners.
Limited partnership (LP)
Limited partnerships, like general partnerships, are businesses owned by two or more people. They also enjoy pass-through taxation. The key difference between LPs and GPs is the existence of limited partners, who enjoy limited liability, only up to the amount of capital they’ve invested in the business. Each limited partnership must have at least one general partner, however, who is subject to unlimited liability. A possible downside of limited partnership is that limited partners generally don’t have much say in the day-to-day running of the firm—a tough spot for the liability-conscious partner with lots of ideas about how to manage things.
Limited liability partnership (LLP)
LLPs are also owned by two or more partners and enjoy pass-through taxation. While partners in an LLP are liable for their own conduct, they are not personally liable for the conduct of other partners or the debts and damages of the business. The main disadvantage of the LLP entity is that it is not available to all businesses. They are usually exclusive to certain licensed professions, such as law or accounting.
C corporations, or C corps, are the most common type of corporation. The main advantage of forming your small business as a C corp is the relative ease of fundraising. C corps can be funded through the issuance of shares—as many as you like. The associated drawback is that the C corps is a complex business organization requiring attentive oversight and an intensive filing and registration process with your state’s secretary of state, the drafting of bylaws, the appointing of a board of directors, etc. Above all, the main downside of forming a C corp is that you will not enjoy pass-through taxation status. Your company will, in effect, be taxed twice, once on corporate income, and again at the personal levels of owners and shareholders.
S corporations, or S corps, sidestep the main drawback faced by C corp owners—double taxation. S corps are pass-through entities, meaning they are taxed only once, at the owner's and shareholders’ personal income levels. That advantage is offset, however, by limits on fundraising. S corps may only issue stock to a maximum of 100 shareholders, and those shareholders must be individuals who are citizens or permanent residents of the United States.
Limited liability company (LLC)
LLCs meld many of the characteristics of a partnership with those of a traditional corporate legal entity. LLCs exist as distinct legal entities from ownership, which can consist of one or more owners. This protects owners from personal liability for the debts and damages of the firm. An additional advantage of forming your small business as an LLC is the tax flexibility it affords—LLCs can opt to be taxed as corporations (twice), or as pass-through entities, like sole proprietorships or S corps. The downside of forming an LLC is that the process is far more complex than that of a sole proprietorship or partnership, like writing and filing of articles of incorporation, and appointing a registered agent.
A joint venture is like a partnership between one or more separate business entities. In the arrangement, firms agree to pool resources toward the achievement of a specific task, often on a temporary basis. This can be a specific project, or the purchase and joint operation of a piece of real estate, for example. The upside of joint ventures is that they allow participants to benefit from the resources of other participating firms without forfeiting independence by merging them into one organization. The main disadvantage is that each participant is responsible for all the costs and losses of the joint venture.
A nonprofit is a business that has been granted tax-exempt status by the IRS on the basis that it advances a social cause benefiting the public in some way. In that sense, a nonprofit is a tax status rather than an entity type. The main advantage of forming your small business as a nonprofit is the tax benefits—if your organization qualifies as a 501(c)(3) tax-exempt organization under the Internal Revenue Code, for example, it won’t have to pay federal income taxes. The main disadvantage of nonprofits is that they are extremely limited in the line of business they can pursue and that profits may not be used for anything other than continuing to operate the business.
Determining what business type is right for you
Determining what business type is right for your small business is one of the most important decisions you will make on your entrepreneurial journey. There are a number of questions you and any partners you have should consider before making a selection, such as:
- How important is the ability to fundraise to your business’s financial future?
- Do you prefer solo control over your company, or do you want partners?
- Are you willing to accept unlimited, personal liability for the business and conduct of any partners, or would you prefer a level of protection?
- Are you able to pay two rounds of federal taxation?
- Is your business’s mission oriented toward the advancement of some social good for the public benefit?