When starting a business, one of the most important decisions you’ll make is choosing the right business structure. This will dictate how you run your business, how much you and your business will owe in taxes, who manages daily operations, whether your personal assets are protected and much more.

Business entities are generally categorized as either formal entities or informal entities. Formal entities must be registered with the state to be created, while informal entities do not. In this guide, we’ll explore the advantages and disadvantages of the most common types of business entities so you can structure your business in the best way possible.

Informal entities are the simplest way to start a business since they don’t require you to register their existence with the state. As a result, they don’t provide any liability protection since it doesn’t create a separate legal entity in the eyes of the state. This means that sole proprietors and partners in a partnership can be held personally liable for any claims arising from the business.

A sole proprietorship is an unincorporated business owned and operated by only one person. In terms of taxation and liability, the sole proprietor is the same as the sole proprietorship. Meaning, the business owner can be held personally liable for activities of the business since they are not two separate legal entities.

Most small businesses that are just starting out almost always begin as sole proprietorships. However, once those startups grow, they’ll usually transition into a limited liability entity, such as an LLC.

Pros

• Autonomy over business
• State registration not required for formation
• No annual reporting requirements
• Disregarded entity tax treatment (Pass-through taxation)

Cons

• Unlimited personal liability
• Not well-suited for raising capital
• All managerial responsibilities are on the owner alone

A partnership is a business owned by two or more people that agree to share profits and losses together. A partnership shares many of the same features of a sole proprietorship, with the only difference being that a partnership allows for more than one owner.

Like a sole proprietorship, a partnership has more autonomy than incorporated entities, however you’ll be splitting this autonomy with another partner. So, to settle any disagreements between partners, it’s highly recommended that you and your partner sign a well-crafted partnership agreement before going into business together.

The standard form of a partnership, often referred to as a general partnership, consists of at least two general partners that’re involved in the daily operations of the business, and share unlimited liability for obligations of the partnership. However, there are other variations of the general partnership used for specific purposes, such as: limited partnerships (LP), limited liability partnership (LLP) or even limited liability limited partnerships (LLLP). However, these variations are considered formal entities because they must be registered with the state.

Pros

• Autonomy over business
• State registration not required for formation
• No annual reporting requirements
• Disregarded entity tax treatment (Pass-through taxation)
• Decision-making responsibilities are more manageable when shared

Cons

• Unlimited personal liability
• Not well-suited for raising capital
• Possible disagreements between partners

Formal business entities can only be created by filing formation documents with the state. This will cost you some money in filing fees and reporting fees to maintain the business in good standing with the state, so formal entities are generally more expensive than informal entities.

However, the biggest advantage of starting a formal business entity is that they provide liability protection for their owner(s). This alone will make the extra cost of formation worth it to business owners as it shields their personal assets from being vulnerable if a claim were to arise from the business.

As mentioned earlier, there are some additional variations of the standard partnership that are considered formal entities since they must be registered with the state to be created.

Limited Partnerships:

Some partnerships may be formed to include limited partners rather than just general partners. A limited partner is someone that partially owns the partnership, however they aren’t involved in managing the business at all. Since they aren’t involved in managing the business, silent partners enjoy limited liability protection — meaning they aren’t held liable for any debts of the business like a general partner would be.

You may also come across a limited liability partnership (LLP) which is a common entity type among professionals such as lawyers, accountants and physicians. Professionals use this type of entity because it protects partners from any liability arising from the negligence of other partners.

A limited liability company (LLC) is a type of formal business entity that combines the tax benefits of a sole proprietorship or partnership with the personal liability protection of a corporation. This is a popular business structure amongst small business owners since they can enjoy the benefits of being a big business without all the corporate formalities.

Each state has its own default rules governing LLCs, however a majority of the rules can be tailored to your business’s needs by the operating agreement created by the LLC’s members.

Pros

• Taxed as a disregarded entity by default
• Tax flexibility (some LLCs may elect S-corp tax status)
• Flexible management and ownership structure (via LLC operating agreement)
• Provides limited liability protection

Cons

• Must file formation documents with the state to be created
• More costly than informal entities (e.g., filing fees; publication requirement)
• More difficult to transfer ownership interests than other formal entities

S-Corp Status:

An S-corp is not a type of corporation. An S-corp is a tax status created by the IRS to allow business owners to decide how to treat taxable income.

Some LLCs have the ability to elect how they wish to be treated for tax purposes. By default, an LLC will be taxed like a sole proprietorship or partnership depending on how many members they have. Sole proprietorships and partnerships both enjoy pass-through taxation, which is when the entity itself doesn’t pay taxes and instead, the owner claims all the business income on their personal income tax returns. LLCs may instead decide to be taxed as an S-corp. The LLC will still enjoy pass-through taxation, however instead of members paying self-employment taxes on the business’ entire income, only the wage they are paid is subject to the self-employment tax rate.

A corporation, sometimes called a C-corporation or C-corp, is a type of formal business entity that is best suited for businesses looking to scale at a rapid pace because they can issue stock to fund growth.

Similar to starting an LLC, you’ll have to file formation documents (called articles of incorporation) with the appropriate state agency. However, corporations have additional requirements for formation, such as crafting bylaws, appointing officers and a board of directors, etc.

Pros

• Provides limited liability protection
• Ownership interest is freely transferable
• Corporate formalities lead to a predictable nature that investors prefer
• Some corporations may elect S-corp status to be taxed as a disregarded entity

Cons

• Must file formation documents with the state to be created
• Double-taxation (Entity pays a corporate tax and stockholders pay federal income tax on dividends)
• Rigid management structure leads to less autonomy
• Costly annual reporting and precise bookkeeping requirements

Sole proprietorships are best suited for very new businesses because of how easy they are to form. However, it’s highly recommended that you convert your sole proprietorship into an entity that offers limited liability protection once it starts to grow.

By transitioning to an entity like an LLC, you’ll receive the same tax benefits as you did with your sole proprietorship, however you won’t be subject to unlimited personal liability. Although this is more expensive than staying as a sole proprietorship, most business owners find it worthwhile.

You’ll want a partnership for the same reasons as a sole proprietorship — the ease and convenience. The only difference being that you want to start a business along with someone else, rather than just by yourself. Still, this should be a temporary structure because once your business expands, you’re going to want to protect yourself by forming an entity with liability protection.

An LLC is the most versatile form of business. If you want to be the sole owner of your business, create a single-member LLC rather than a sole proprietorship. You’ll get the same tax benefits and autonomy, but your personal assets will be safe from debtors. If you want to start a business with some friends, start a multi-member LLC rather than a partnership for the same reasons. Many states recognize different variations of LLCs that could be perfectly suited for your business needs.

You should choose a corporation if you’re looking for rapid growth because it excels at raising capital by taking on investors. Keep in mind that a corporation will usually be subject to a corporate tax unlike other types of entities. However, you can work around this if you want to start an organization with a charitable purpose. Nonprofit corporations are tax exempt, simpler to create and will be nationally recognized — making them the preferred legal structure for a nonprofit organization.

Remember, choosing the right type of entity for your business will depend on all the circumstances surrounding it. You can use one of the best LLC formation services at a fraction of the cost of getting an attorney if you want personalized professional help in choosing the best way to structure your business.

Virtually all broad “business types” can be structured using any of the four primary structures. If you’re ready to learn more about how to get the formation process started, consider using an affordable online formation option today.

Legal Disclaimer: This article contains general legal information but does not constitute professional legal advice for your particular situation and should not be interpreted as creating an attorney-client relationship. If you have legal questions, you should seek the advice of an attorney licensed in your jurisdiction.