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Different Types of Businesses & Entities - Tax Structure & Legal Basics

In a Nutshell: What are the different types of businesses and tax structures?

The 4 most common business structures are Sole-Proprietorships, Partnerships, Limited Liability Companies, and Corporations. In a nutshell, each differs in how it is treated by the IRS for tax purposes and its exposure to personal liability. There are also differences with regard to whether the business entity can be sold and the ease with which the business can raise money from outside investors.

Starting and operating a small business is hard work. Any entrepreneur can tell you that launching a startup is one of the most difficult, challenging, stressful, exhausting, rewarding and exciting things they have ever done. Just managing the day-to-day operations, like helping customers, managing social media, marketing, sorting inventory, processing sales, or managing shipping & receiving, can overwhelm anyone.

But small business owners don’t just have to run their business. They have to manage the entire financial & administrative burden of the operation themselves. Accounting, payment processing, taxes, fees, licenses, certifications, memberships in professional organizations, even paying the electric bill, there is a mountain of paperwork to get through just to keep the lights on, let alone turn a profit. So with all that to deal with already, it might seem daunting to even try and answer the question of how to choose the right small business legal structure.

The answer to that question depends on several factors, as well as your long-term goals for the business. Are you a freelancer who always works alone? Do you have a business partner or partners? Is there professional liability involved, such as in the construction or medical fields? Are there plans to raise additional business capital, now or in the future?

Choosing the right business structure can change your relationship to your small business in a number of ways, and some can be critically important for the growth and long-term viability of your operation.

What types of business structures are there?


There is a veritable rainbow of different kinds of business structures available to small business owners in the United States. The most common include:

  • Sole Proprietorships (SPs)
  • Partnerships
  • Limited-Liability Companies (LLCs)
  • Corporations (C-corp, S-corp, etc.)
  • Sole Proprietorships - A solopreneur who earns income by selling goods & services without formally setting up a separate legal entity automatically has a Sole Proprietorship (SP). SPs are federally taxed at the personal level with additional self-employment taxes. Personal assets are fully exposed to business liability claims.
 
  • Partnerships - Two or more entrepreneurs who earn income from business activities without formally setting up a separate legal entity automatically have a General Partnership (GP). Personal assets are fully exposed to business liability claims. A Limited Partnership (LP) is a legal entity that isolates business activities. General partners who run daily business operations are still exposed to personal liability while investors, known as limited partners, are not exposed. Income from both GPs & LPs "flow through" to each partner based on their % ownership and is federally taxed at the personal level with additional self-employment taxes.
 
  • Limited Liability Companies  - An LLC isolates business operations & income, thereby providing good personal liability protection. Business income "flows through" to each member based on their % ownership and is taxed at the personal level. Members must also pay self-employment taxes. An LLC is not considered a "partnership" for legal purposes.
 
  • Corporations - C-Corporations provide excellent protection against personal liability & pay a corporate-level income tax. After-tax income may be distributed to shareholders which is taxed again at the personal level. C-Corps have a high degree of flexibility in raising money, including from the public in an IPO. S-Corporations don't generally pay a corporate-level income tax. Self-employment taxes are lower than an LLC's when shareholder-owners are paid a salary. An LLC may elect to be treated as an S-Corp for tax purposes if it meets certain requirements. Distributions flow through to shareholders and are taxed at the personal level without additional self-employment taxes.

There are lots of further sub-classifications, especially in the corporation category. Here are some of the main characteristics of each business structure.

Sole Proprietorship

As a freelancer doing business under your own name, you are automatically taxed (in the U.S.) at the federal level as what is called a sole proprietor, one of the primary tax classifications for small businesses. You report all your business income on your personal taxes, using a form called Schedule C, which you attach to your 1040 tax form. The IRS sees you and your business as a singular entity, and all profit & loss is yours alone. Keep in mind that includes business liabilities, debts, and other claims too! As a sole proprietor, your personal assets are fully exposed to liabilities taken on by your business.

The main advantage of sole proprietorship is that anyone can start doing business at any time without having to apply for a business license (depending on your state or jurisdiction). You report your business income along with your personal taxes. No complicated regulations – you can start selling your product or service today.

However, before you run out the door and start selling, consider this: as a self-employed person, you will owe additional taxes. Employers are required to pay around half of their employees’ social security and Medicare taxes, which come to around 15% total. The employee only pays 7.5% of those taxes, and the employer pays the rest.

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As a self-employed sole proprietor or independent contractor, you are required to pay the full 15% of those taxes, as you are considered both employer and employee. For some entrepreneurs this is not a big deal. Depending on your income level and expenses, this might actually help with your taxes. But for most enthusiastic first-time entrepreneurs, this comes as a nasty surprise at tax time.

The good news is, you can get out there and start doing business today! Test out your new business idea and see if it flies before you commit to a more significant legal structure.

Partnership

Partnerships function the same as sole proprietorships for tax purposes. That is, income is “passed through” to each partner’s personal tax returns. In the words of the IRS, partnerships are generally treated as “disregarded entities”. Partners pay income tax on income received from the partnership. Like sole proprietors, partners also pay self-employment taxes.

A general partnership (GP) is a business arrangement where two or more individuals agree to share in all assets, profits, and financial and legal liabilities of a jointly-owned business. You can create a general partnership with a handshake – no formal legal documents are required in the eyes of the IRS or the law. That said, it would be wise to have an agreement in place to help resolve disputes should they arise. In a general partnership, partners agree to unlimited liability, meaning liabilities are not capped and can be paid through the seizure of an owner’s personal assets.

There are several types of partnership structures that provide protection against personal liability. The two main types are the limited partnership (LP) and limited liability partnership (LLP).

A limited partnership is required to have both general partners and limited partners. General partners have unlimited personal liability and have full management control of the business. Limited partners have little to no involvement in management, but also have liability that’s limited to their investment amount in the LP. 

In a limited liability partnership, the liability is spread among all members of the firm, protecting individual members from being fully liable in the event of damages or lawsuits. Their personal assets are also protected. LLP’s are popular with professional groups such as law firms, who don’t want a complicated situation at tax time, but still need protection against liability.

Limited Liability Company

A limited liability company (LLC) is the first step many small businesses take towards expanding their operations. LLCs provide substantial management flexibility. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members.

LLC’s provide personal liability protection for members, protecting personal assets from business liability claims. Additionally, most states permit “single-member” LLCs. This empowers sole business owners with personal liability protection that isn’t available in a sole proprietorship.

LLC members’ business income is taxed the same as a partnership or sole proprietorship, i.e. on your personal taxes. LLC members are also subject to self-employment taxes.

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LLC formation has specific requirements that vary from state to state. Membership requirements are also important, since depending on the state, the LLC may have to be dissolved and reformed when anyone joins or leaves the company. But forming an LLC can be useful for protecting the personal assets of its owners, as well as avoiding high corporate taxes on company earnings by passing profit & loss through to its members.

Corporation

A corporation is a legal entity that exists as fully separate from its owners. It can make profits & losses, be taxed at corporate rates, and held legally liable for damages.

C-Corporation

A C-corporation, or C-corp, is the standard form of corporate business structure. The cost and regulatory burdens of forming, keeping records, and reporting for a C-corp are much higher than an LLC or some of the simpler business structures. However, a corporation is a completely independent entity from its members, offering the strongest personal liability protection.

C-corps must pay corporate income taxes on their profits before they are distributed to shareholders. In many cases, they are taxed twice – at the corporate level and at the personal level. However, shareholders are free to sell or buy back shares, and there is no additional burden when shareholders join or leave the company. The corporation continues operation as normal.

There is a further advantage to the C-corp when it comes to fundraising, because the company can sell shares of stock. If they find they are in need of raising additional capital, the company can make a stock offering to private investors, or to the public through a public offering. They also have the advantage of being able to attract talented employees through stock offerings.

S-corporation

The S-corporation (S-corp), also known as an S-subchapter, can be the best of both worlds for a small business, combining the benefits of corporations with the tax advantages of partnerships. S-corp is a special tax-status granted by the IRS that mitigates the double taxation of a C-corp while also providing shareholders with personal liability protection. S-corps must have 100 or fewer shareholders. Shareholder requirements are much more restrictive for S-corps than they are for LLCs.

One of the main benefits of an S-Corp vs. an LLC is the potential for lower taxes. S corp status can lower the personal income tax tab for the business owners as well. By characterizing money they receive from the business as salary or dividends, S corporation owners often lower their liability for self-employment tax. The S corp status generates deductions for business expenses and wages paid their employees too.

There are special IRS requirements for forming and maintaining an S-corp, which are different from the state requirements for incorporation. Not all states treat S-corps the same way in terms of taxation and regulation. Business owners must know and understand the rules around S-corps in order to get this special status.

Alternative corporate structures

There are a number of other, less common corporate structures that provide benefits for different companies in different situations. Some of the most common include the B-corp, which must prove a social benefit for the public to its shareholders, the close corp, which is much like a B-corp but meant for smaller companies, or nonprofit corporations, which exist for educational, religious, charitable, or other beneficial purposes, not explicitly to make a profit.

All of these alternative corporate structures have strict requirements for being granted these classifications. However, they also come along with special tax benefits, meant to promote the formation and operation of socially beneficial purposes, such as little or no taxation for nonprofit income.

Should I incorporate as a freelancer or small business owner?


The answer to that is: maybe. The three most important factors to consider are:

  1. Liability
  2. Taxation
  3. Fundraising

Let’s consider each of these factors individually. Every small business operates under different circumstances, so they won’t apply to every entrepreneur in the same way.

 

Liability

If your business is graphic design, selling t-shirts, or publishing content online, professional liability probably isn’t anything you will have to worry about, other than the occasional threat of copyright infringement. However, for doctors, lawyers, building contractors, cosmetologists, anyone whose profession could potentially impact the health or safety of others, the liability picture changes.

Licensed professionals are often required to buy special insurance, such as medical malpractice insurance, or be bonded with the local government or trade organization, which helps cover any unexpected eventuality where someone might be injured or bring a lawsuit against you, for any reason. Especially in the highly litigious United States, it’s important for these licensed professionals to be personally protected against claims of damage. One of the key benefits of forming a partnership, LLC, or corporation is that it limits the personal liability of owners and members of the organization. Partnerships can be structured so that one partner has the bulk of the liability, or such that the liability is shared among all members equally. When you reach the point of establishing an LLC or an S-corp, you have a functionally separate business entity against which any damages are levied, leaving your personal assets protected from most claims.

Taxation

One of the main benefits of incorporation, whether you choose to do so under an LLC or a more standard corporate structure like a C-corp or S-corp, is the tax benefit. Under a corporate tax regimen, your business is taxed differently than your personal income. Business income can be reinvested, and you pay yourself a salary, both of which are taxed separately.

The picture is a bit more complicated than the simplified version above, but the most important thing to remember is that, as a corporation, business income is taxed differently than personal income. How you distribute that income is where different corporate structures come into play.

Fundraising

Having capital to invest into your business to open, maintain, and grow is one of the most important parts of entrepreneurship. Most businesses are not profitable for at least the first year, and it can be critical to have other sources of capital to make it through those crucial early days. Small business owners often fund their business out of their own pocket in the beginning. Others might be lucky enough to have family or friends help support their dreams of entrepreneurship.

Still others go looking for outside investment, startup capital from professional investors, incubator programs, or crowdfunding platforms to get their business off the ground. One of the most common ways to raise capital is to sell stock in your company, with the promise of growth in the price as well as future dividends for shareholders.

A sole proprietor or partnership cannot sell stock in their company. However, a corporation like a C-corp or S-corp can. Besides just fundraising from investors, stock offerings can also be used to attract employees or choice talent to your company. Selling stock comes along with a whole universe of regulatory and taxation concerns, but for many companies it can be very worthwhile.

Corporations can also be bought and sold, so if you’re planning on selling the company some day, incorporating is the clear choice.

Table: Consider the pros and cons of incorporating your small business


All this might seem complicated, but it doesn’t have to be. Stay motivated and work with an advisor to help you sort through the various options. You can also get input from other entrepreneurs and small business forums on how they sorted through finding the right structure for their business. If you’re just starting your business, you’re probably quite safe from any undue liability or tax burdens until much further down the road. It’s only when other people get involved with the business, as partners or employees, when the business becomes more profitable, or you want to raise additional capital, that you should consider opting for a more formal business legal structure. Also if you are someone who operates with special liability concerns, such as an attorney, doctor, or as a licensed & bonded professional.

To help weigh your options, we’ve prepared this handy table to compare and contrast some of the most common business structures for small businesses, entrepreneurs, and startups:

Business TypeLiabilityTaxationFundraising
Sole Proprietorship (SP)Unlimited100% personalNo stock sales, business cannot be sold
Limited Partnership (LP)1 or more general partners, 1 or more limited partners100% personal for each partnerNo stock sales, business cannot be sold
Limited Liability Partnership (LLP)Limited/shared for all partners100% personal for all partnersNo stock sales, business cannot be sold
Limited Liability Company (LLC)Personal assets protected for ownersX% corporate / Y% personal for owners’ incomeNo stock sales, business CAN be sold in whole
C-Corporation (C-corp)Only corporate entity is liable for damagesCorporate + shareholders taxed on dividendsStock sales allowed, corporation can be sold
S-Corporation (S-corp)Only corporate entity is liable for damagesX% corporate, owner(s) determine % of personal income that is taxedStock sales allowed, corporation can be sold

When your business has grown, the profits are flowing in, and you’re thinking about expanding, then the time might be right to consider one of the more formal business structures, such as an LLC, C-corp or S-corp. As your business expands, you will open yourself up to more potential liability concerns. Not to mention that if the business is doing well, the IRS will come looking for its share of the profits.

By forming a partnership, LLC, or corporation, you can reap the dual benefits of diffusing the liability for any damage claims, as well as controlling how your profits & losses get taxed. Beyond that, new tools for raising capital become available at your disposal. Know your business situation, and know how your business structure choice affects liability, taxation, and fundraising, so that you are able to leverage the greatest available advantages to help you achieve success.

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A special high five to Miles Burke for his outstanding research and contributions to this article. We love working with and supporting like-minded entrepreneurs. Thank you Miles! ❤️

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