Your small business is a legal entity, and there are significant implications to the type of legal entity you opt to form when starting a business. The type of corporation you choose affects everything from tax status to the myriad ways you can be brought into court.
For example, while forming a sole proprietorship may allow you to avoid some of the fees associated with formally incorporating your online business, it does not offer the same level of liability protection one might get from a limited liability company (LLC) or C corp.
Types of corporations
The 6 types of corporations are:
- Sole proprietorship
- S Corp
- C Corp
There are many different ways to legally structure a business, depending on the type, scale, and scope of the business (for-profits and nonprofits are structured differently, for example). There are S corporations, C corporations, and nonprofits, which are all corporations. Sole proprietorships, partnerships, and LLCs, on the other hand, are not considered corporations (though an LLC can elect to be taxed as a corporation).
At a high level, the primary difference between corporate and non-corporate entities is the legal separation of the ownership class from the business itself. Shareholders, or members in LLCs (even non-corporate ones), are legally separate from the company; sole proprietors or partners are not.
1. Sole proprietorship
A sole proprietorship encompasses the business and the person behind the business, with no legal distinctions between the two. This means the person behind the business—the sole proprietor—is personally and financially liable for any debts or damages incurred by the business.
You don’t have to file any special paperwork to become a sole proprietor. In fact, for tax purposes, the IRS recognizes sole proprietors by default for all new businesses with a single owner (i.e., the self-employed). You could be a sole proprietor without even realizing it if you engage in any freelance work. However, if your sole proprietorship operates under a name that is different from your own legal name, you will need to file a “doing business as” (DBA) form.
And don’t let the name confuse you—a sole proprietorship need not be solitary. A sole proprietor may hire employees or contractors. But any work done by an employee of a sole proprietorship is still legally bound to the proprietor—the proprietor assumes all liability for business functions, including those performed by an employee or contractor.
Sole proprietorships are arguably the easiest form of business entity to start. No formal action is needed to form one and the designation automatically applies when you commence business activities.
Partnerships come in three primary subtypes: general partnerships, joint ventures, and limited liability partnerships (LLPs).
- General partnership. General partnerships are like sole proprietorships in that the partners assume personal liability for business operations. Even if you elect to form another kind of business entity, such as an LLC or S corporation, if you (and your partners) do not comply with the regulations upon which such designations depend, your business will revert to a default partnership. This may eliminate any liability shield that comes with forming an LLC.
- Joint venture. A joint venture is similar in most ways to a general partnership, but the two differ in terms of scope and duration. While a general partnership is often intended to operate indefinitely, a joint venture is generally formed to operate on a temporary basis. In both a joint venture and a general partnership, all partners assume full personal liability for all business operations and the conduct of all other partners and employees.
- Limited liability partnership. An LLP is a business entity where the partners are protected from personal liability. Unlike a general partnership or joint venture, a partner in an LLP does not assume liability for the torts (illegal activities) of other partners, employees, or the partnership itself. The exception to this rule occurs when a partner is offering certain “professional services,” such as legal advice or medical consultation, in which case the partner assumes liability for both his own actions and anyone he is supervising or working with.
3. Limited liability company (LLC)
A limited liability company is a business entity that offers some separation of the people owning the business from the business itself. An LLC protects its owners (known as “members”) from being financially liable for most debts and damages and protects their personal assets in the event a business fails.
Forming an LLC requires that the business owner(s) file articles of incorporation. These articles outline the structure of the business. This is where LLCs rise above the other business entity types available to US small businesspeople—an LLC can opt for many different operating models: a 50/50 partnership, or even maintain a board of directors, like a C corporation.
The main advantage to forming and operating as an LLC lies in its simplicity. Income is taxed at the personal level one time, as opposed to at the corporate level, or both the corporate and personal levels (“double taxation”). LLCs can also choose what tax treatment works best for them—they can opt for pass-through taxation, like an S corp, or double taxation, like a C corp.
4. S corporation
S corporations, or S corps, are business entities that pass through corporate income, losses, credit, and deductions to shareholders—which are limited to 100 or less. Shareholders report those financials on their personal income tax returns, which is how distributions are ultimately taxed. The S corp pays federal corporate taxes only if it has passive income (income from sources beyond business activities the company actively participates in, such as investment in a C corp) in excess of 25% of gross receipts.
S corps differ from other pass-through entities like general partnerships and sole proprietorships in that S corps can pay salaries to shareholders who are active employees of the company. An S corp will pay payroll taxes on such distributions, rather than passing that credit onto shareholders for personal income taxation.
While the tax benefits of operating as an S corp are clear, it’s worth noting that tax authorities like the IRS tend to scrutinize them—mainly because of the many tax loopholes associated with S corps.
5. C corporation
A C corporation, or C corp, is similar to an S corp in that it may distribute profits to shareholders. Unlike an S corp, a C corp can have an unlimited number of shareholders. But a C corp is required to maintain a board of directors, who are the core decision-makers behind the company.
C corporations are subject to double taxation—corporate income is taxed and distributions to shareholders are taxed once again.
A C corporation is an excellent business entity type if you plan to grow your small business and eventually sell it. The ability to issue shares to an unlimited number of shareholders allows the C corp unparalleled growth potential. The cost of that potential, of course, comes on tax day.
Nonprofit corporations are quite similar to for-profit corporations in structure. They are generally run by boards of directors, and donors help fund the nonprofit and might oversee some company operations, similar to how shareholders fund corporations and have some control over the company (though shareholders have ownership while donors do not). But a nonprofit (as the name suggests) generates no profit.
Because of their public-service missions, nonprofits are tax exempt. They are also permitted to receive donations from a wide variety of funding sources, including private donors, for-profit corporations, and government grants.
Other considerations when choosing a corporation type
Naming and DBA
All entity types need to register a business name (try our business name generator). For most sole proprietors, this might be their legal name. In fact, for sole proprietorships and partnerships, unless a DBA is filed, the company name is, by default, the name of the owner or owners. For other kinds of small businesses, a name might reflect the product or service offered, its location, or other identifying details.
A name you initially choose for your small business may not always be the name most fitting for the long term. Filing a “doing business as” allows a company to do business under a name different from its legal or “true” name. For example, a law firm LLP originally incorporated as Jones & Associates could file a DBA to indicate its field of specialty: Jones & Associates Personal Injury Attorneys.
To file a DBA, you must complete and file the appropriate forms and pay a filing fee to the office of your state’s secretary of state.
State of incorporation
Small business owners in the US may incorporate their company in any of the 50 states. The state in which you incorporate your small business determines a variety of important factors, not just which laws your company is subject to. It will dictate how your business is taxed and even where you can sue or be sued.
Variables to consider when choosing where to incorporate your small business include:
- Geographical convenience. Is the state of incorporation easy to get to?
- Minimum owners. Certain states require a certain number of people to establish a business.
- Tax structure. How much does the state levy annually in corporate franchise tax? Will income your business earns elsewhere be subject to taxes in the state of incorporation?
- Records. Some states require that you keep records within state lines.
- Banking. Some states require that a corporate bank account exist, and oftentimes within the boundaries of the state of incorporation.
Special requirements for special fields
Certain fields requiring special certification or licenses—such as medical or legal practice—are limited in terms of what types of business entity practitioners can elect to form. Depending on the state of incorporation, groups of such professionals may have to come together in the form of a professional corporation or professional services corporation.
Professional services corporations allow licensed professionals to benefit from the liability protections embedded in traditional corporate structures, excluding malpractice claims against licensed practitioners themselves. Professional services corporations are taxed like C corps. They are subject to corporate tax, as well as tax on shareholder distributions.
In some states, such as California or Virginia, professionals may organize into LLPs or LLCs. The main difference between an LLP/LLC model and a professional services corporation is that the latter must pay income taxes on the corporation itself, like a C corp, whereas with LLPs and LLCs, members pay personal income taxes on income received.
Occupations covered by these state mandates may include:
- Lawyers (lawyers are barred from forming LLCs in some states)
- Health care professionals
- Engineers and architects
Selecting a legal designation and corporation type for your small business may seem like a complex choice, given the six distinct options before you. You should consider all aspects of your business’ goals and present operations before making your ultimate selection—from year-to-year tax obligations to growth projections, even seemingly small things like employee benefits.
Business Structures FAQ
What are the five 5 most common business structures?
- Sole Proprietorship
- Limited Liability Company (LLC)
What is structure in business?
What are the 4 types of LLC?
- Single-Member LLCs
- Multi-Member LLCs
- Series LLCs
- Professional LLCs