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Types of Business Entities: Pros, Cons, and How to Choose

Priyanka Prakash

Senior Staff Writer at Fundera
Priyanka is a senior staff writer at Fundera, reporting on business financing, law, and news. Previously managing editor at Fit Small Business, she's also a licensed attorney who served as general counsel at a Y Combinator tech startup. She loves helping entrepreneurs launch, run, and grow their businesses.

When launching a business, there are a million and one things to do—raise money, hire staff, develop a marketing strategy, and the list goes on. Choosing among the types of business entities is probably not at the top of your list, but it should be.

This decision has very real legal and financial implications. The amount of taxes you have to pay depends on what you choose from the types of business entities, as does the ease with which you can get a small business loan or raise money from investors. And if someone successfully sues your business—not something any business owner wants to think about, but it could happen—your business entity structure determines what assets they can collect on.

There are six different types of business entities: sole proprietorship, general partnership, limited partnership (LP), limited liability company (LLC), C-corporation, and S-corporation. Don’t believe anyone who claims that one of these is the “best” choice for all small businesses. There are pros and cons of each, and your decision ultimately depends on what’s important to you now and in the future as your business evolves.

Find out the advantages and disadvantages of each business entity type and how to decide what’s best for you.

Entity #1: Sole Proprietorship Pros and Cons

A sole proprietorship is the simplest business entity, with one person as the sole owner and operator of the business. If you launch a new business and are the only owner, you are automatically a sole proprietorship under the law. There’s no need to register a sole proprietorship with the state, though you might need local business permits or licenses depending on your industry.

Freelancers, consultants, and other service professionals commonly work as sole proprietors, but it’s also a viable option for more established businesses, such as retail stores, with one person at the helm.

Pros of a Sole Proprietorship

  • Easy to start up (no need to register your business with the state).
  • No corporate formalities or paperwork requirements, such as meeting minutes, bylaws, etc.
  • You can deduct most business losses on your personal tax return.
  • Tax filing is easy—simply fill out and attach Schedule C-Profit or Loss From Business to your personal income tax return.

Cons of a Sole Proprietorship

  • As the only owner, you’re personally liable for all of the business’s debts and liabilities—someone who wins a lawsuit against your business can take your personal assets (your car, personal bank accounts, even your home in some situations).
  • There’s no real separation between you and the business, so it’s more difficult to get a business loan and raise money (lenders and investors prefer LLCs or corps).
  • It’s harder to build business credit without a registered business entity.

Sole proprietorships are by far the most popular type of business structure in the US because of how easy they are to set up. There’s a lot of overlap between your personal and business finances, which makes it easy to launch and file taxes. The problem is that this same lack of separation can also land you in legal trouble. If a customer, employee, or other third party successfully sues your business, they can take your personal assets. Due to this risk, most sole proprietors eventually convert their business to an LLC or corporation.

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Entity #2: General Partnership (GP) Pros and Cons

Partnerships share a lot of similarities with sole proprietorships—the key difference is that the business has two or more owners. There are two kinds of partnerships: general partnerships (GPs) and limited partnerships (LPs). In a general partnership, all partners actively manage the business and share in the profits and losses.

Like a sole proprietorship, a general partnership is the default mode of ownership for multiple-owner businesses—there’s no need to register a general partnership with the state.

Pros of a General Partnership

  • Easy to start up (no need to register your business with the state).
  • No corporate formalities or paperwork requirements, such as meeting minutes, bylaws, etc.
  • You don’t need to absorb all the business losses on your own because the partners divide the profits and losses.
  • Owners can deduct most business losses on their personal tax returns.

Cons of a General Partnership

  • Each owner is personally liable for the business’s debts and other liabilities.
  • In some states, each partner may be personally liable for another partner’s negligent actions or behavior (this is called joint and several liability).
  • Disputes among partners can unravel the business (though drafting a solid partnership agreement can help you avoid this).
  • It’s more difficult to get a business loan, land a big client, and build business credit without a registered business entity.

Most people form partnerships to lower the risk of starting a business. Instead of going all in on your own, having multiple people sharing the struggles and successes can be very helpful, especially in the early years.

That being said, if you do go this route, it’s very important to choose the right partner or partners. Disputes can seriously limit a business’s growth, and many state laws hold each partner fully responsible for the actions of the others. For example, if one partner enters into a contract and then violates one of the terms, the party on the other side can personally sue any or all of the partners.

Entity #3: Limited Partnership (LP) Pros and Cons

Unlike a general partnership, a limited partnership is a registered business entity. To form an LP, you must file paperwork with the state. In an LP, there are two kinds of partners: those who own, operate, and assume liability for the business (general partners), and those who act only as investors (limited partners, sometimes called “silent partners”).

Limited partners don’t have control over business operations and have fewer liabilities. They typically act as investors in the business and also pay fewer taxes because they have a more tangential role in the company.

Pros of a Limited Partnership

  • An LP is a good option for raising money because investors can serve as limited partners without personal liability.
  • General partners get the money they need to operate but maintain authority over business operations.
  • Limited partners can leave anytime without dissolving the business partnership.

Cons of a Limited Partnership

  • General partners are personally responsible for the business’s debts and liabilities.
  • More expensive to create than a general partnership and requires a state filing.
  • A limited partner may also face personal liability if they inadvertently take too active a role in the business.

Multi-owner businesses that want to raise money from investors often do well as LPs because investors can avoid liability.

You might come across yet another business entity structure called a limited liability partnership (LLP). In an LLP, none of the partners have personal liability for the business, but most states only allow law firms, accounting firms, doctor’s offices, and other professional service firms to organize as LLPs. These types of businesses can organize as an LLP to avoid each partner from having liability for the other’s actions. For example, if one doctor in a medical practice commits malpractice, having an LLP lets the other doctors avoid liability.

Entity #4: C-Corporation Pros and Cons

A C-corporation is an independent legal entity that exists separately from the company’s owners. Shareholders (the owners), a board of directors, and officers have control over the corporation, though one person in a C-corp can fulfill all of these roles, so it’s possible to create a corporation with you in charge of everything.

With this type of business entity, there are many more regulations and tax laws that the company must comply with. Methods for incorporating, fees, and required forms vary by state.

Pros of a C-corporation

  • Owners (shareholders) don’t have personal liability for the business’s debts and liabilities.
  • C-corporations are eligible for more tax deductions than any other type of business.
  • C-corporation owners pay lower self-employment taxes.
  • You have the ability to offer stock options, which can help you raise money in the future.

Cons of a C-corporation

  • More expensive to create than sole proprietorships and partnerships (filing fees range from $100 to $500 based on which state you’re in).
  • C-corporations face double taxation: The company pays taxes on the corporate tax return, and then shareholders pay taxes on dividends on their personal tax returns.
  • Owners cannot deduct business losses on their personal tax return.
  • There are a lot of formalities that corporations have to meet, such as holding board meetings and shareholder meetings, keeping meeting minutes, and creating bylaws.

Most small businesses pass over C-corps when deciding how to structure their business, but they can be a good choice as your business grows and you find yourself needing more legal protections. The biggest benefit of a C-corp is limited liability. If someone sues the business, they are limited to taking business assets to cover the judgment—they can’t come after your home, car, or other personal assets. 

Corporations are a mixed bag from a tax perspective—there are more tax deductions and fewer self-employment taxes, but there’s the possibility of double taxation if you plan to offer dividends. Owners who invest profits back into the business as opposed to taking dividends are more likely to benefit under a corporate structure. Corporation formation and maintenance can be complicated, but online legal services like LegalZoom, Avvo, and IncFile can help with these things.

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Entity #5: S-Corporation Pros and Cons

An S-corporation preserves the limited liability that comes with a C-corporation but is a pass-through entity for tax purposes. This means that, similar to a sole prop or partnership, an S-corp’s profits and losses pass through to the owners’ personal tax returns. There’s no corporate-level taxation for an S-corp.

Pros of an S-corporation

  • Owners (shareholders) don’t have personal liability for the business’s debts and liabilities.
  • No corporate taxation and no double taxation: An S-corp is a pass-through entity, so the government taxes it much like a sole proprietorship or partnership.

Cons of an S-corporation

  • Like C-corporations, S-corporations are more expensive to create than both sole proprietorships and partnerships (requires registration with the state).
  • There are more limits on issuing stock in S-corps vs C-corps.
  • You still need to comply with corporate formalities, like creating bylaws and holding board and shareholder meetings.

In order to organize as an S-corporation or convert your business to an S-corporation, you have to file IRS form 2553. S-corporations can be a good choice for businesses that want a corporate structure but like the tax flexibility of a sole proprietorship or partnership.

Entity #6: Limited Liability Company (LLC)

A limited liability company takes positive features from each of the other business entity types. Like corporations, LLCs offer limited liability protections. But they have few paperwork and ongoing requirements, and in that sense, they are more like sole proprietorships and partnerships.

Another big benefit is that you can choose how you want the IRS to tax your LLC. You can elect to have the IRS treat you as a corporation or as a pass-through entity on your taxes.

Pros of an LLC

  • Owners don’t have personal liability for the business’s debts or liabilities.
  • You can choose whether you want your LLC to be taxed as a partnership or as a corporation.
  • Not as many corporate formalities compared to an S-corp or C-corp.

Cons of an LLC

  • It’s more expensive to create an LLC than a sole proprietorship or partnership (requires registration with the state).

LLCs are popular among small business owners, including freelancers, because they combine the best of many worlds: the ease of a sole proprietorship or partnership with the legal protections of a corporation.

→TL;DR (Too Long; Didn’t Read): Sole proprietorships and partnerships are the easiest business entities to form because you don’t have to file anything with the state. But if you want more legal protections and tax advantages, it’s best to opt for an LP, LLC, or corporation.

Business Entity Types: How to Choose the Best One for Your Business

With a better understanding of how the common business entity types work and their respective pros and cons, you can now determine which of the different types of business entities works best for your small business. The best course of action, if you can afford it, is to consult a business lawyer and tax professional on which structure is optimal for you, given where your business is currently and where you hope to take it.

As a starting point, though, there are three general factors to consider when choosing among business entity types: legal protection, tax treatment, and paperwork requirements. In the table below, see how the entities stack up on each of these factors.

Business Entity Summarytypes-of-business-entities

Sole props and GPs are light on liability protections, so they expose you to greater legal risk if someone sues your business. But taxation is simple when you have a sole prop or GP, and you don’t have nearly as many government requirements to comply with. That means more time to do what you love—running your business.

The simplicity of a sole prop or a partnership makes it a good starting point for freelancers and consultants, particularly if the industry you’re in brings little legal risk with it. For example, fashion and beauty influencer Joanna Faith Williams thinks that a sole prop is right for her at the moment. She says, ”Being a sole proprietor now seems most appropriate as there is not much that I am liable for at this time. I keep well-written contracts to protect myself, but as I begin to dive more into creating content such as eBooks… or things that my audience will have to pay for, I will definitely consider registering as an LLC.”

If your business is in a more litigious industry, such as food service, child care, or professional services, that’s a strong reason to create an LLC or corporation right off the bat. And regardless of industry, as your business grows and more dollars are at stake, that can be the ideal time to “graduate” to an LLC or corporation. What works for a freelancer or hobbyist likely won’t work for someone who is trying to hire employees, bring on additional owners, or expand.

Brett Helling, owner of ridesharing blog Ridester.com, found this to be true. “Initially,” Helling says, “I started this blog as a part-time thing. However, once the site began to experience growth at a very rapid pace and began making money, I realized it was turning into an actual business. I quickly realized that I should register an LLC… to shield myself from liability in case something went wrong.”

Although it’s certainly possible to change business structures at any point of your business’s journey, some changes are easier to make than others. For instance, it’s relatively simple to convert from a sole prop or partnership to an LLC by filing the right paperwork with your state. But converting to a corp is more difficult, particularly if you plan to issue stock. Converting from a C-corp to an S-corp can bring unexpected taxes. So, before changing your business structure, make sure you’ve thought it through and spoken to a lawyer.

Also keep in mind that the IRS places certain limits and deadlines on how often you can change your business’s entity type.

→TL;DR: Sole proprietorships and partnerships are a good option for business owners in low-risk industries or who are just starting out. For more mature businesses or higher-risk industries, it’s wise to protect your assets by establishing an LLC or corporation.

New Tax Plan’s Impact on Business Entity Choices

The Tax Cuts and Jobs Act—which you might know as the Trump Tax Plan—took effect this year and impacts some of the tax considerations around your business entity choice.

Congress made two main changes that impact small businesses:

  1. C-corporations are subject to a flat 21% corporate tax rate, a significant cut from the previous 35% corporate tax rate.
  2. Owners of pass-through entities can deduct 20% of business income on their personal income tax returns. These include owners of sole proprietorships, S-corps, LLCs that have elected pass-through tax status, and general partners in a partnership. There are some limitations on the deduction based on business type and income level.

Right after Congress passed this law, many business owners began wondering if they should convert their businesses to C-corporations to enjoy the new flat tax rate. The 21% flat tax rate may be lower than your personal tax rate, but you also lose the 20% deduction if you convert your company to a C-corp.

Lee Reams, an Enrolled Agent at Accountant Marketing firm ClientWhys, says that the corporate tax cut and the new pass-through deduction sort of cancel each other out, putting all types of a businesses on a more even ground. “The tax reform,” says Reams, “reduced the corporate tax to a flat 21%, and to provide a similar tax break for pass-through businesses, Congress came up with the 20% pass-through income tax deduction. Thus, for the most part, the new tax law will not necessarily motivate a business owner’s decision on business entity type.”

The main situation where it might make sense to convert to a C-corp is if you are ineligible for the 20% pass-through deduction. Under the new law, businesses with income over $315,000 (married joint filers) or $157,500 (single filers) can’t take the full pass-through deduction. The deduction slowly phases out at that time, with the most restrictions being on professional service firms like doctors and lawyers.

Apart from the new tax reform, the other potential pitfall with a C-corporation is double taxation. If you are planning to take distributions from your business, then you’ll pay the 21% corporate tax rate plus personal taxes on the distributions. A C-corp makes more sense when a business is in total growth mode and the owners reinvest all the profits back into the company (instead of taking distributions).

→TL;DR: The new tax law cuts the corporate tax rate to 21% and gives pass-through entities a 20% deduction. The reforms won’t impact entity choice in a big way, but converting to a C-corp might make sense if your business income or industry make you ineligible for the 20% deduction.

What You Should Know When Choosing Among the Types of Business Entities

Your choice of business entity is a very important one. It can affect how people perceive your business and has a big impact on your legal exposure and finances.

Keep the following in mind when deciding among the different types of business entities:

  • Sole props and general partnerships are good “starter” entities.
  • As your business grows and generates more income, consider registering as an LLC or corp.
  • Think through the pros and cons of each business entity in terms of legal protection, tax treatment, and government requirements.
  • Consult a business lawyer and accountant to get specific help for your business.

There’s no one best business entity choice for all small businesses, but there is a best option for your small business right now. Use the tips above to figure out what that is.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.

Priyanka Prakash

Senior Staff Writer at Fundera
Priyanka is a senior staff writer at Fundera, reporting on business financing, law, and news. Previously managing editor at Fit Small Business, she's also a licensed attorney who served as general counsel at a Y Combinator tech startup. She loves helping entrepreneurs launch, run, and grow their businesses.

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