If you’re a new business owner or are preparing to start a business, you’ve likely come across the term business entity on forms or on state websites. At the most basic level, a business entity is just an organization (even a single-person organization) that engages in commerce, like any company or business.
But that’s not all. The type of business entity you operate impacts your personal liability for the business’s activities and debts and the way your business is taxed, so it pays to understand the differences between sole proprietorships, partnerships, and state-formed businesses like corporations and LLCs. We’ll cover the main types below.
Types of Business Entities
Different types of business entity have different organizational structures and tax requirements. They also receive different degrees of liability protection against debts and lawsuits.
A sole proprietorship is a business owned by one person (or in some cases, a married couple) that hasn’t been formed as a separate legal entity with the state. That means if you’re a sole proprietor, you are your business.
Because the state and federal government doesn’t distinguish between a sole proprietor and their business, the business’s revenue gets taxed as the owner’s personal income—and if the business gets sued, that’s no different from the owner getting sued. The liability protections that come with some other types of businesses (such as corporations and LLCs) just aren’t there for sole proprietorships.
Still, it’s easy to become a sole proprietor because all it takes is for you start doing business. You don’t need to file paperwork with the state, you don’t need to have a separate bank account for your business finances, and you don’t need to get an employer identification number (EIN) unless you have employees.
We won’t say that’s the wrong move. Plenty of people operate as sole proprietors and don’t suffer for it. But if you want the added legal protections that come with other business types, read on to learn more.
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Partnerships are business entities that divide their ownership between two or more partners. There are multiple types of partnership you can form: general partnerships, limited partnerships (LPs), and limited liability partnerships (LLPs).
General partnerships are the most common kind of partnership. Similar to a sole proprietorship, a general partnership is not classified as a separate entity from its owners.
Being legally the same entity as its individual owners, legal action against the partnership is the same as action against the partners as individuals, and a partner’s assets may be at risk if the business can’t cover debts. A general partnership also leaves you at risk of liability for the actions of your partners, whether you were involved or not.
Registration with a state government is usually optional for a general partnership. However Hawaii and Delaware are exceptions—you must file formation documents to start a partnership in those states.
Limited partnerships function very similarly to general partnerships but have two separate kinds of partners in the organization: general and limited partners. General partners operate the business and assume all personal liability for suits filed against the company. Meanwhile, limited partners are passive investors and not allowed to operate the business, but do have limited liability protection from any debts and lawsuits against the business.
Limited partnerships must be registered with a state and require the designation of a registered agent who can receive legal notice for the business. In these respects, limited partnerships are less like general partnerships and sole proprietorships and more like corporations and LLCs.
Limited liability partnerships are entities that are largely restricted to professional service businesses like doctors, accountants, dentists and lawyers. Limited liability partnerships provide all partners with liability protection from each other. For example, if a doctor at an LLP commits malpractice, only that doctor can be held responsible, and their partners are not at risk. Limited liability partnerships also require a registered agent, the same as a limited partnership does.
All three types of partnership are considered pass-through entities by the Internal Revenue Service. This means one’s business revenue is taxed as the individual owners’ personal income, and the partnership itself pays no income tax.
Corporations are business entities owned by shareholders with stock in the company and overseen by a board of directors. A corporation is considered a separate entity from its stockholders, directors and officers. Because of this, corporations have limited liability protection. Only assets owned by the corporation itself can be claimed during legal actions against the business or for the purpose of settling business debts. Personal assets of shareholders and officers are not at risk in a corporation.
A corporation must be registered with the government (“incorporated”) in the state where it is headquartered, usually through the office of the secretary of state. At incorporation, a registered agent must be designated to accept legal documents on its behalf.
By default, revenue is taxed both on the corporation’s income tax return and on returns of shareholders for dividends received. Some corporations choose to elect different tax classification (like s-corp status) with the IRS in order to turn their corporation into a pass-through business.
Conventional business corporations are not the only types of corporations that can be formed. Professional corporations (PCs) exist for professional services like doctors and attorneys. Nonprofit corporations benefit the public or service the interest of a group (and can apply for 501(c)(3) tax-exempt status). Benefit corporations have similar public interest goals to nonprofits but operate as for-profit companies without tax exemption.
However, one thing that all corporations share is a rigid management structure and some stiff record-keeping requirements. That’s not a problem for everyone, but if you want a business entity that offers you more control and flexibility, keep reading.
Limited Liability Companies
A limited liability company (LLC) is a business with liability protection similar to that of a corporation, but which the IRS treats as a pass-through entity when it comes to paying federal taxes. That means unless you opt to get taxed as a corporation, your LLC’s profits will be taxed as your personal income, the same way partnerships are taxed.
Like a corporation, an LLC is formed by filing paperwork at the state level and must choose a registered agent that can receive its legal documents and deliver them to the LLC.
LLCs have a flexible structure with both single-member or multi-member LLCs as options. It also allows members to decide between actively managing the company themselves or hiring managers to do the day-to-day work for them. An LLC also has fewer restrictions than a corporation about how often meetings must be held and how much record-keeping it requires.
There are several LLC types, but as LLCs are a relatively new type of business entity, not all newer LLC variations are allowed in every state at this time.