When you’re starting your business, there are all kinds of fun things to think about. What’s your passion? How will you turn that into a business? What’s your business name going to be? How much money will you be able to make? There are also some less fun things to think about (but equally important, if not more so!). One of those is which of the 5 legal business types you will use. These are called business structures or business entities.
There are 5 main legal business types to choose from. These are sole proprietorship, partnership, limited liability company (LLC), S-corporation, and C-corporation. Whether you actively choose one or not, when you start your business you will fall within one of these types. This quick guide will teach you the basics of each type and the benefits/drawbacks of each so you can choose what’s right for you.
5 Legal Types of Businesses
A sole proprietor is where you run your business without a formal structure. This is the simplest business structure, because your business is merely an extension of yourself. There are no filing requirements and no ongoing obligations to keep the business going. When they’re just starting out a lot of people operate as sole proprietors.
A sole proprietorship does not offer any liability protection and you are liable for all debts and claims of the business. A sole proprietor is taxed at the individual level, meaning all income of the business will be reported on the owner’s individual tax return.
Depending on the type of business you have and your state’s laws, you may be required to obtain licenses and/or permits to legally run your business.
If you are operating the business in any name other than your personal name, you are required to file for an assumed name, or doing business as (DBA). This is usually a simple process and the filing fees are generally modest. While you don’t have to keep up with annual filings to operate your sole proprietorship, if you have DBAs, licenses, and/or permits, you are required to keep these current.
This post has more information on being a sole proprietor.
Partnerships are a well-known type of business. A partnership requires more than one person (or business). Partnerships can be created automatically when two or more persons come together to earn a profit (even if they don’t intend to form a partnership) and can even be formed without officially writing anything down. You can also proactively choose to form a partnership. Some states require registering your partnership. Like sole proprietors, partners in a partnership are taxed on their individual tax returns.
A partnership does not offer any liability protection, and in most cases, all partners will be jointly & severally liable for all business debts and/or liabilities. “Joint and several liability” is a legal term meaning every party involved is responsible for 100% of whatever is owed. So, if the partnership gets sued, the person suing can collect 100% from just one partner. The partner who has to pay can recover from the other partner, but will still be liable for the full amount to the injured party. This is most often a problem when the partners have unequal assets.
Partnership names are generally the names of the partners, but can file for an assumed name as well if they want to be called something different. If licenses and/or permits are required for your type of business or your state, the partnership will need to obtain those as well.
Your state will have default rules for a partnership in the absence of a Partnership Agreement. The default is usually for each partner to own an equal part of the business. If you’re going to have a partnership, it is very important to have a written Partnership Agreement. A Partnership Agreement is the contract that will govern the terms of your partnership.
You may also have the option to form a Limited Liability Partnership. This will require formal filings with your state, but it does offer some liability protection to the partners, though not as much as limited liability companies or corporations.
I always advise to enter into a partnership with caution. You are putting a lot of faith on your partner to run the business well. Out of all the business types, I have seen the most disputes within partnerships. This is usually caused by a failure to have a Partnership Agreement, but sometimes one partner is a really bad business owner and causes a huge loss to the partnership.
Limited Liability Company
Limited Liability Companies (LLCs) are one of the most common types of business. Owners of an LLC are called members and can have one member or multiple members. LLCs can either be managed by its members or managers. LLCs are formed at the state level, usually by filing Articles of Organization with the Secretary of State.
Though it’s fairly easy to create an LLC, there are formal filing requirements and fees (that vary by state) and there are things you have to do each year to keep your business in good standing and to maintain your liability protection. The LLC also has flexible taxation options—you can choose to be taxed as a sole proprietor/partnership or as a corporation.
As the name suggests, this type of business offers liability protection, and this is the biggest reason I see businesses form an LLC. So, if your business gets sued, the LLC is liable for the debts & claims and not you individually. This is a great benefit for business owners. You don’t want to risk losing your savings or house because of your business debts or liabilities.
However, you can lose your liability protection if “piercing the corporate veil” takes place. Piercing the corporate veil means, if you get sued (or have some other liability), then the injured party can go after your personal assets. The idea is that the LLC was only formed for liability protection and was not really operated in such a way that it could be considered separate from the individual members so the members should be liable. There are many factors the court will consider if asked to pierce the corporate veil. Some things you can do to preserve your liability protection are to keeping personal & business accounts completely separate and maintaining business formalities like regular meetings and having a written Operating Agreement.
The biggest mistake I see LLC members make is not having a written Operating Agreement. An Operating Agreement is the contract that governs your LLC. This is important, even for single-member LLCs. Having a written Operating Agreement is further proof that you intend your business to operate as separately from you and can help protect your liability protection.
S-corporations are a type of corporation. They have shareholders (not members or partners), but they aren’t taxed at the corporate level like C-corporations are. Income & expenses are passed down to the shareholders. There are strict requirements to qualify as an S-corporation, although most small businesses will have no problem meeting the requirements.
To qualify as an S-Corporation the company must: (1) be a domestic corporation; (2) have only allowable shareholders (individuals, some trusts/estates; may not be partnerships, corporations or non-resident alien shareholders); (3) have no more than 100 shareholders; (4) have only one class of stock; and (5) not be an ineligible corporation (as defined by the IRS and state statutes).
S-corps are formed at the state level, just like a C-corp, by filing Articles of Incorporation. The S-corp then elects S-corp tax status from the IRS.
S-corps offer liability protection to their shareholders and are a great choice for businesses that will need to seek investments. S-corps require more formalities than the other types of business, but the benefits to the shareholders often outweigh the burden of keeping up with the formalities.
A C-corporation is formed by “incorporating” which is generally filing forms (usually called Articles of Incorporation, but also called Certificates of Incorporation or Charter) in an individual state and has very formal requirements. For many small business owners, a corporation is possibly more than they need. A C-corporation is seen as an entity entirely separate from its owners, called shareholders. A corporation offers maximum liability protection.
C-corporations are taxed on the corporate level as well as at the individual level. This is usually called double-taxation. However, corporations are generally taxed at a lower rate than individuals, so there can be tax advantages. Also, profits can stay in a corporation, so are not automatically deemed income like they are with sole proprietors, LLCs, and partnerships.
Corporations are required to have directors, corporate bylaws, and shareholders’ agreement. An initial board of directors meeting should be held, and all business activity should be well documented. Stock certificates should be issued to the shareholders.
Which legal type of business is right for you?
There are 5 main legal types of businesses structures you can use to operate your business. Many businesses will do just fine as sole proprietors or LLCs, but for some other types you may need the protection or the tax benefits of using a corporation. If you’re still not sure, you can talk with an attorney licensed to practice in your jurisdiction or speak with a CPA about the tax consequences of your business entity choice.
This site, and all information contained herein or through communication with me, is intended as legal information only. I am an attorney, but I am not your attorney, so nothing on this site, nor any communication with me, shall create an attorney-client relationship. I am not liable for damages or losses based on any action taken, or inaction, based on the information contained on this site. All areas of the law are fact specific and there is no substitute for legal advice from an attorney licensed in your jurisdiction who is familiar with the specific facts and circumstances of your situation.