Business Entity Types - How to choose the right one?

author avatar by Capbase Staff • 7 min

Choose Your Business Structure Waisly

When starting a business, one of the first things you want to do is choose the structure of your company—in other words, choose a business entity type.

This decision will have important legal and financial implications for your business. The amount of taxes you have to pay depends on your business entity choice, as does the ease with which you can get a small business loan or raise money from investors. Plus, if someone sues your business, your business entity structure determines your risk exposure.

State governments in the U.S. recognize more than a dozen different types of business entities. Still, the average small business owner chooses between these six: sole proprietorship, general partnership, limited partnership (LP), limited liability company (LLC), C-corporation, and S-corporation.

Which business entity is right for you? This guide is here to help you make that decision. We’ll explain the types of business entities and the pros and cons of each so that you have all of the information you need to determine what’s best for your company.

There’s no one best choice for the type of business entity you legally choose, just the best choice for your particular company based on your goals.

What Exactly Is a Business Entity?

In simplest terms, a business entity is an organization created by an individual or individuals to conduct business, engage in a trade, or partake in similar activities. There are various types of business entities—sole proprietorship, partnership, LLC, corporation, etc. A business entity type dictates both the structure of that organization and how that company is taxed.

Business Entity Types

1. Sole Proprietorship. This essentially means you are your business. The company is started in your name, and all company payables come from your personal expenses. The advantages of this arrangement are that you have no one else to report to and the arrangement is a simple one. But there are many disadvantages to mingling your personal expenses with your professional ones, and with a sole proprietorship, you are personally responsible for financial issues related to your business. This kind of arrangement can quickly become messy, especially come tax-time or in the case of a lawsuit against your business.

Some sole proprietors choose to file for a DBA, which just means “doing business as.” There are no specific business reasons why you should file for a DBA. However, the DBA is an alias that puts a more professional facade on your sole proprietorship. Your DBA is an alias that puts a more professional facade on your sole proprietorship.

Pros of Sole Proprietorship

Easy to start (no need to register your business with the state).

There are 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 Sole Proprietorship

As the only owner, you’re personally responsible for all of the business’s debts and liabilities—someone who wins a lawsuit against your business can take your personal assets (your car, 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 corporations).

It’s harder to build business credit without a registered business entity.

2. Partnership. If you decide to bring in partners, you will need to set up a general partnership that usually includes a formal partnership agreement signed by all partners (usually not requiring a state filing). This kind of business structure is also simple and easy to operate, and forming a partnership will enable you to raise money by selling partnership interests.

But with a general partnership, there is still a fuzzy line between personal and business finances, so all partners could find themselves in financial trouble due to a business issue. There’s also some potential confusion around partner roles, responsibilities, and liabilities.

Pros of General Partnership

Easy to start (no need to register your business with the state).

There are 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 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.



3. Limited partnership. Limited partnerships are just a variation on the theme of general partnerships. In the case of a limited partnership, you will still have general partners responsible for the actual business, but investors can purchase a limited partnership interest.

Limited partners aren’t embedded within a business in the same way that general partners are—the worst that can happen from a financial perspective is that they lose their original investment. As a founder, a limited partnership means that the involvement of such partners is minimal so you don’t lose any authority over your business. That said, entrepreneurs aren’t generally big fans of this kind of entity because there’s no built-in protection for entrepreneurs.

Pros of 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 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 business role.

4. Limited liability companies (LLC). These companies provide a more formalized legal structure sthat offers some protection from liability. Here, finally, is a structure that separates your personal assets from your company’s debts. Also, with an LLC, while there is an agreement that governs operations, there’s no buy-sell, which can lead to issues if all members aren’t contributing equally to the business. LLCs don’t have to have boards, hold annual meetings, or record minutes.

In an LLC, there is no limit to the number of members (as opposed to “partners”) and ownership can be broken down into different classes, giving entrepreneurs some flexibility when raising equity financing. An LLC makes sense if your company is only at the stage in your development process where you will have the ability to attract angel investors, but not VCs (i.e., you are expecting that your business will generate losses). Angels will be motivated by the potential tax losses; VCs will not. VCs still prefer purchasing stock in a corporation over purchasing membership interests.

Pros of 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 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.

5. C Corporation. If you’re in your early stage (particularly pre-revenue) and have your sights set on venture capital, opting for a C corp makes good sense. VCs are comfortable investing in this type of company. And there are other advantages to this kind of entity outside of funding, including a separation between debts, tax, and legal structure from your personal assets.

There is an added level of structure that goes along with a C corp, such as starting holding annual meetings and record minutes. The potential downside is that the C corp is taxed on its corporate profits, but when you’re just starting out, you likely don’t have any profits to be taxed on so this isn’t really a problem.

Pros of 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 can offer stock options, which can help you raise money in the future.

Cons of C-corporation

More expensive to create than sole proprietorships and partnerships (the filing fees required to incorporate a business 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 returns.

Corporations have to meet a lot of formalities, such as holding board and shareholder meetings, keeping meeting minutes, and creating bylaws.

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6. S Corporation.

This is a great option for you if you are fine limiting the number of shareholders and needing liability protection. An S corporation separates your personal assets from your company’s debts and offers some tax benefits (which may not be that big of a deal if you’re in the early stage and not making any money anyway). S corps are not so great if you’re seeking venture capital because you’re limited to one class of stock which eliminates your ability to do multiple financings.

Pros of 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 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 with S-corps vs. C-corps.

You still need to comply with corporate formalities, like creating bylaws and holding board and shareholder meetings.

Most Founders wonder what entity is best for allocating equity to employees

Typically, an aspiring venture-backed startup's early hires will receive (and expect) equity as a reward for betting on an unproven company. Depending on the startup's hiring expectations, selecting a structure that allows for easy issuance of equity may be an important consideration. Both C corporations and S corporations (subject to the above-referenced ownership limitations) are well-suited for allocating equity to employees because they can adopt a traditional stock option plan as well as grant "incentive stock options."

In contrast, structuring an equity incentive plan for an LLC is more complex. LLCs are similar in many ways to S corporations, but ownership is evidenced by membership interests rather than stock. As a result, LLCs cannot issue incentive stock options or adopt traditional stock option plans.Structuring equity incentives such as profits interests is complex and requires careful valuation and tax analysis.

Why Should I incorporate in Delaware?

Many companies choose to incorporate in Delaware either by default or are persuaded by the widely recognized benefits of being a Delaware corporation. These benefits include its flexible, business-friendly corporate statute, its well-developed and widely understood body of corporate law and sophisticated Court of Chancery (a special court that hears only Delaware business entity cases).

There are quite a few reasons why so many big brands are incorporated in Delaware but do not actually have physical headquarters in that location. In fact, almost half of the Fortune 500 and publicly traded companies in the United States are incorporated in Delaware. What makes Delaware so popular for businesses?

Benefits of Incorporating in Delaware

  • Unsurpassed flexibility – The State of Delaware offers businesses lots of flexibility when it comes to corporate and board structure, which makes it easier to set up your organization. Your officers and directors do not have to live in the state to serve your business. You can also run your business solo in Delaware whereas other states may require at least three individuals to be directors and officers.
  • Enhanced privacy – In Delaware, you do not need to disclose key details about your officers and directors when you form your business. If privacy is a concern, Delaware could be a good option for incorporation.
  • An established and savvy court system – When it comes to corporate issues, Delaware uses judges instead of juries. When your case is heard, it will be before a judge with expertise in corporate law, not a jury made up of laypeople. With savvy judges and attorneys, if you do need to head to court in Delaware, you are more likely to experience a fair, impartial, and streamlined process.
  • Attractive to investors – Many investors and banks show strong preferences for Delaware corporations. If you are looking for venture capital or are going public, then incorporating in Delaware could give you an edge.
  • Tax advantages – With business-friendly tax laws, there are clear financial reasons to incorporate in the state. If you incorporate in Delaware but have your headquarters elsewhere, you will not have to pay state income tax.
  • The Court of Chancery focuses solely on business law and uses judges instead of juries.
  • For corporations, there is no state corporate income tax for companies that are formed in Delaware but do not transact business there (but there is a franchise tax).
  • Taxation requirements are often favorable to companies with complex capitalization structures and/or a large number of authorized shares of stock.
  • There is no personal income tax for non-residents.
  • Shareholders, directors and officers of a corporation or members or managers of an LLC don’t need to be residents of Delaware.
  • Stock shares owned by persons outside Delaware are not subject to Delaware taxes.

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DISCLOSURE: This article is intended for informational purposes only. It is not intended as nor should be taken as legal advice. If you need legal advice, you should consult an attorney in your geographic area. Capbase's Terms of Service apply to this and all articles posted on this website.