7 Entity Types for Business: Which One Is Right for You?
Choosing the right entity type for your business is one of the most important decisions you can make as an entrepreneur. Your entity type affects how you pay taxes, how you raise funds, how you protect your assets, and how you manage your operations. In this article, we will explain the pros and cons of the seven most common entity types for business in the U.S.: sole proprietorship, partnership, limited liability company (LLC), C corporation, S corporation, B corporation, and nonprofit corporation.
Sole Proprietorship
A sole proprietorship is the simplest and most common entity type for business. It is a one-person business that is not registered with the state. The owner has full control over the business and is personally liable for all debts and obligations. The owner also reports all income and expenses on their personal tax return.
Pros:
– Easy and inexpensive to start and operate
– No separate tax filing or paperwork required
– Complete flexibility and autonomy over the business
Cons:
– Unlimited personal liability for all business debts and lawsuits
– Limited ability to raise capital from investors or lenders
– No continuity of the business if the owner dies or quits
Partnership
A partnership is a business entity that is formed by two or more people who agree to share the profits and losses of the business. There are two types of partnerships: general partnership and limited partnership. In a general partnership, all partners have equal rights and responsibilities in managing the business and are personally liable for all debts and obligations. In a limited partnership, there are two classes of partners: general partners and limited partners. General partners have the same rights and liabilities as in a general partnership, while limited partners only contribute capital and have no management authority or personal liability.
Pros:
– Easy and inexpensive to form and operate
– No separate tax filing required; income and losses are passed through to the partners’ personal tax returns
– More access to capital and expertise from multiple partners
Cons:
– Unlimited personal liability for general partners; limited liability for limited partners only if they do not participate in management
– Potential conflicts and disputes among partners
– No continuity of the business if a partner dies, withdraws, or is expelled
Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid entity that combines the features of a corporation and a partnership. An LLC is formed by filing articles of organization with the state and can have one or more owners, called members. The members can choose how to manage the LLC: either by themselves (member-managed) or by appointing managers (manager-managed). The members are not personally liable for the debts and obligations of the LLC, unless they personally guarantee them. The LLC can elect how to be taxed: either as a pass-through entity like a partnership or as a separate entity like a corporation.
Pros:
– Limited liability for members
– Flexible management structure and tax options
– Ability to raise capital from various sources
Cons:
– More complex and costly to form and operate than a sole proprietorship or a partnership
– Varying state laws and regulations that may affect the LLC’s operations
– Possible self-employment taxes for members who actively participate in the business
C Corporation
A C corporation is a legal entity that is separate from its owners, called shareholders. A C corporation is formed by filing articles of incorporation with the state and can have one or more shareholders. The shareholders elect a board of directors, who appoint officers to manage the day-to-day operations of the corporation. The shareholders are not personally liable for the debts and obligations of the corporation, unless they personally guarantee them. The corporation pays taxes on its income at the corporate level, and then distributes dividends to its shareholders, who pay taxes on them at their personal level. This results in double taxation.
Pros:
– Limited liability for shareholders
– Ability to raise large amounts of capital from various sources
– Continuity of the business regardless of changes in ownership or management
Cons:
– Double taxation of income at the corporate and shareholder levels
– Complex and costly to form and operate than other entity types
– Extensive regulation and compliance requirements at the federal, state, and local levels
S Corporation
An S corporation is a special type of corporation that elects to be taxed as a pass-through entity like a partnership or an LLC. An S corporation is formed by filing articles of incorporation with the state and then filing Form 2553 with the IRS. An S corporation can have up to 100 shareholders, who must be U.S. citizens or residents. The shareholders elect a board of directors, who appoint officers to manage the day-to-day operations of the corporation. The shareholders are not personally liable for the debts and obligations of the corporation, unless they personally guarantee them. The corporation does not pay taxes on its income; instead, it passes through its income and losses to its shareholders, who report them on their personal tax returns.
Pros:
– Limited liability for shareholders
– Pass-through taxation of income and losses, avoiding double taxation
– Continuity of the business regardless of changes in ownership or management
Cons:
– Restrictions on the number and type of shareholders
– Complex and costly to form and operate than other entity types
– Extensive regulation and compliance requirements at the federal, state, and local levels
B Corporation
A B corporation is a for-profit corporation that meets certain social and environmental standards, as certified by a third-party organization called B Lab. A B corporation is formed by filing articles of incorporation with the state and then applying for certification with B Lab. A B corporation can have any number of shareholders, who elect a board of directors, who appoint officers to manage the day-to-day operations of the corporation. The shareholders are not personally liable for the debts and obligations of the corporation, unless they personally guarantee them. The corporation pays taxes on its income at the corporate level, and then distributes dividends to its shareholders, who pay taxes on them at their personal level. This results in double taxation. However, a B corporation can also elect to be taxed as an S corporation or an LLC, if it meets the eligibility criteria.
Pros:
– Limited liability for shareholders
– Ability to pursue a social or environmental mission while generating profits
– Access to a network of like-minded businesses and consumers
Cons:
– Double taxation of income at the corporate and shareholder levels, unless electing a different tax status
– Complex and costly to form and operate than other entity types
– Additional certification and reporting requirements to maintain the B corporation status
Nonprofit Corporation
A nonprofit corporation is a legal entity that is formed for a charitable, educational, religious, scientific, or other public benefit purpose. A nonprofit corporation is formed by filing articles of incorporation with the state and then applying for tax-exempt status with the IRS. A nonprofit corporation can have any number of members, who elect a board of directors, who appoint officers to manage the day-to-day operations of the corporation. The members are not personally liable for the debts and obligations of the corporation, unless they personally guarantee them. The corporation does not pay taxes on its income, as long as it uses its income for its exempt purpose. The corporation can also receive tax-deductible donations from individuals and organizations.
Pros:
– Limited liability for members
– Tax-exempt status for income and donations
– Ability to serve a public benefit purpose
Cons:
– Complex and costly to form and operate than other entity types
– Extensive regulation and compliance requirements at the federal, state, and local levels
– Restrictions on political activities and lobbying
Choosing the right entity type for your business depends on several factors, such as your goals, preferences, risks, resources, and tax situation. Each entity type has its own advantages and disadvantages that you should weigh carefully before making a decision. You should also consult with a lawyer, an accountant, or a business advisor to help you choose the best option for your specific case.
Entity Types Business: A Statistical Overview
Global Demand for Different Business Entities
According to a report by the World Bank, there were about 115 million formal businesses registered worldwide in 2010, with an average annual growth rate of 9.5% from 2004 to 2010 . The most common type of business entity was the limited liability company (LLC), accounting for 38% of all registered businesses, followed by the sole proprietorship (24%), the corporation (18%), the partnership (12%), and other types (8%) .
The global demand for different business entities varies by region, income level, and sector. For example, in high-income countries, corporations are more prevalent than in low-income countries, where sole proprietorships dominate . Similarly, in the service sector, LLCs and sole proprietorships are more common than in the manufacturing sector, where corporations and partnerships are more popular .
Trends and Challenges in Business Entity Formation
The global trend in business entity formation shows an increase in the share of LLCs and a decrease in the share of sole proprietorships and corporations . This reflects the growing preference for flexible and simple legal forms that offer limited liability protection and tax advantages to business owners . However, there are also challenges and barriers that affect the choice and formation of business entities, such as:
– Legal complexity and costs: Different business entities have different legal requirements and implications, such as registration fees, reporting obligations, governance structures, liability exposure, and tax treatment. These factors can influence the ease and cost of starting and operating a business .
– Access to finance: Different business entities have different access to finance options, such as loans, grants, equity, or crowdfunding. Some types of entities, such as corporations, may have more opportunities to raise capital from external sources than others, such as sole proprietorships or partnerships .
– Cultural and social norms: Different business entities may have different cultural and social connotations, such as prestige, trustworthiness, or legitimacy. Some types of entities, such as corporations or LLCs, may be more accepted or respected than others, such as sole proprietorships or partnerships .
These challenges and barriers may affect the decision-making process and outcomes of entrepreneurs who want to start or grow their businesses. Therefore, it is important to understand the advantages and disadvantages of each type of business entity and choose the one that best suits the needs and goals of the business.
References:
https://www.sbif.cl/sbifweb/internet/archivos/DISCURSOS_5983.pdf
http://www.elclubdelemprenedor.org/sccl.pdf
https://openknowledge.worldbank.org/handle/10986/11843
https://doi.org/10.1787/entrepreneur_aag-2017-en
https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
https://www.nerdwallet.com/article/small-business/business-entity
https://en.wikipedia.org/wiki/List_of_legal_entity_types_by_country
https://bench.co/blog/starting-a-business/business-entity-types/
https://www.nerdwallet.com/article/small-business/business-entity
