A business entity (sometimes referred to as the business structure or legal structure) is the basic foundation of starting a business. The business entity is basically how a business is legally organized to do business.
There are four primary business entities to choose from, which include the sole proprietorship, partnership, corporation, and LLC. Each type of entity has its own pros and cons, such as liability exposure, costs, and administrative requirements.
It’s important to understand the differences of each and make your entity selection early, as many of the later steps of starting a business will depend on which one you choose.
A brief description of each entity is below.
A Sole Proprietorship is an individual or married couple that decides to go into business for themselves. This is the easiest to start, least expensive to form, and most popular of the four entities to set up, with an estimated 73% of businesses in the U.S. being sole proprietors. With this business structure, the individual and business are legally the same, so the owner is personally responsible for all debts and actions of the company. This is what’s referred to as unlimited liability and is the biggest downside to the sole proprietorship. This means if the business is sued, the owner’s personal assets are potentially at risk. The owner will also pay self-employment tax on all business profits and may pay more in taxes than other entities.
General Partnerships consist of two or more people conducting a business together. Like the sole proprietorship, there is no formal filing in most states. Also, like the sole proprietorship, the partnership has unlimited liability. If the partnership were to be sued, each of the partner’s personal assets are potentially at risk. The partnership itself does not pay tax from business income. Instead, profits and losses are passed through to the owner’s personal tax return. This income is subject to self-employment tax.
A Corporation is a legal entity that is separate from the individual. While corporations are more expensive and complicated than sole proprietorships and partnerships to form and administer, the major advantage is that the corporation shields the owner’s personal assets should the corporation be sued. In order to keep liability protection for the owners, a corporation must have a board of directors meeting, shareholders meeting and take minutes at these meetings. This all may sound absurd for a single-owner corporation but are critical to protecting the owner’s personal assets.
With no self-employment tax, income to the owner(s) will come from either a salary or dividends, which may result in a tax savings.
The Limited Liability Company (LLC) is a popular business entity choice. It provides the liability protection of a corporation with the ease of operation like a sole proprietorship. The LLC does not have the many burdens a corporation, such as holding a board of directors meeting, shareholders meeting, taking minutes, etc., but still provides the ability to protect the owner’s personal assets from lawsuits against the business.
The LLC has additional benefits, such as having the greatest tax flexibility of the four entities. Income can be taxed as a pass-through entity like the sole proprietor or partnership or as a corporation to save on self-employment taxes. Not only are there more options for how the business is taxebut the way the business is taxed can alsocan be changed later as the business grows.
To help show the differences between the sole proprietorship, partnership, corporation, and LLC, feel free to download our entity comparison PDF.