Understanding the Different Types of Business Entities
There are several types of business entities recognized by the United States. Each type offers certain benefits to companies and industries. Some offer tax benefits, while others offer liability protection, but each entity serves a specific purpose in the business world.
Listed below are the most common business entities in the United States. Linked within the sections are articles outlining the steps needed to form those entities. Follow along to see which one best fits your business.
1. Sole Proprietorship
The simplest form of a business entity, a sole proprietorship is owned and run by a single person. While the owner is able to receive all profits, he/she is also fully liable for all debts and obligations of the business. A sole proprietorship is the typical form most businesses take before evolving into a more complex entity.
The benefits of a sole proprietorship lie in its simplicity. It’s relatively simple to set up, and taxes are levied only on income. But its simplicity is also a source of a sole proprietorship’s disadvantages. A sole proprietor cannot sell interest in the business, making the raising of capital a difficult proposition. On top of that, proprietorships enjoy no liability protection, making their personal finances susceptible to business-related debt collection and lawsuits.
Click here for a guide on forming a sole proprietorship.
Often called a “C corporation,” a standard corporation is a legal entity separate from its owners. The term “corporate personhood” refers to a corporation’s recognition as an individual by law. They hold and exercise certain individual rights, including the right to enter into contracts and the right to sue. Corporations can be for-profit or nonprofit entities.
All U.S. corporations must issue stock to shareholders and elect a board of directors. Even if a corporation is formed by a single person, that person must issue stock to him/herself and elect themselves as the sole board member.
Corporations enjoy liability protection; shareholders are only liable for their investment, and their personal finances are protected from debts and damages of the corporation. A disadvantage of a corporation is its potential for double taxation, which forces the corporation to pay taxes on annual earnings and the shareholders to pay taxes on dividends.
For a guide to forming a corporation, click here.
3. S Corporation
S corporations enjoy the liability protection afforded to standard corporations, but they avoid double taxation. To be eligible for subchapter S status, the business must have no more than 100 individual shareholders.
While the advantages lie in its “pass-through” taxation, the disadvantages of an S corporation lie in its restrictions. In addition to the limit on shareholders, S corporations are only allowed to issue common stock, and the issuance is limited to U.S. citizens; these restrictions make raising capital more difficult than a standard corporation. On top of that, the process of subchapter S incorporation is time-consuming, complicated and could prove expensive.
For a step-by-step guide on S corporation formation, click here.
4. Limited Liability Company
Like an S corporation, limited liability companies (LLCs) enjoy liability protection and avoid double taxation. However, unlike an S corporation, LLCs can issue different forms of ownership to an unlimited amount of members, who can be individual persons, corporations or partnerships.
A major disadvantage of an LLC is its restrictions on the transfer of ownership. For large-cap entities, the flexibility of stock transference makes incorporation a better choice. On top of that, LLC regulations vary greatly from state to state, and the process of LLC formation can be complicated and expensive.
For a look at the process of forming an LLC, click here.
5. General Partnership
A general partnership (GP) is a group of individuals who own and operate a business and are liable for all its debts and obligations. While GPs are strapped with personal liability, they’re a “pass-through” entity that avoids double taxation.
The major disadvantage of GPs is their liability. The partners share joint and several responsibility for all debt. If the business is unable to settle its debts, the personal assets of the owners can be seized. On top of that, the legal and accounting services needed to run a GP make it a more expensive entity than that of a sole proprietorship.
Click here for a guide to forming a general partnership.
6. Limited Partnership
A limited partnership (LP) is an entity consisting of both general and limited partners. General partners have management obligations and unlimited liability, but limited partners (often called “silent partners”) sacrifice management rights in exchange for liability protection.
Limited partnerships are advantageous in their “pass-through” taxation and liability protections. These liability and tax benefits make generating capital easier for LPs, as investors are more willing to invest while their personal assets are protected. A disadvantage of LPs is the formalities involved in fulfilling state requirements.
For the full step-by-step guide to LP formation, click here.
7. Limited Liability Partnership
Limited liability partnerships (LLPs) are groups of individuals that manage a company and share some liability protection. LLPs are particularly well-suited for professional partnerships (i.e.: medical practices, law firms, accounting firms, etc.). LLPs offer asset protection from debts issued in malpractice lawsuits against other partners. They also avoid double taxation.
Depending on the state, LLPs have many restrictions. For example, California only allows certain professions to qualify for LLP status, and some states limit liability protection. As such, forming and maintaining an LLP can be complex and expensive.
For a guide on forming an LLP, click here.
Nonprofits are organizations that conduct business intended to benefit the public. Unlike for-profit entities that allot profits to owners and shareholders, nonprofits must reinvest its profits back into the organization.
Some nonprofits enjoy sales, property and/or income tax exemptions. Keeping a nonprofit afloat is one of its biggest challenges, but the pride gained through public service is a great reward. Keep in mind, however, that fraudulent practices or failure to maintain nonprofit status cold result in very hefty fines.
Finding the ideal entity for your business is a difficult proposition. While this and the linked articles are designed to aid you in your search for the perfect entity, in some cases, a business-formation attorney can help you decide which is best for you and can help expedite the formation process.
The IRS website and your local Secretary of State Office can also be a useful resource to help with your business formation. And sites like License123® can provide a list of required licenses for your business and state.