If you’re starting a small business, you’re about to embark on an exciting journey of entrepreneurship.
Of course, with any business pursuit, there are plenty of important decisions to be made along the way. One of the most crucial choices you have to make is what kind of business to form.
There are five common business structures in the United States today:
- Sole Proprietorships
- General Partnerships
- Limited Liability Companies
- Limited Partnerships
Each of these business entities has its own strengths and weaknesses, and depending on the nature of your business, one of them is probably a better fit for you than the others are.
What are the pros and cons of each entity type? How do you determine which one is the right option for your business? Over the course of this article, we’ll answer these questions and many more about which is the best business structure for you.
To begin, let’s learn a bit about each of these five business structures.
What Is a Sole Proprietorship?
A sole proprietorship is an informal business entity that operates as an unincorporated company.
The very nature of a sole proprietorship is to facilitate a simple one-person business. In fact, it isn’t even a distinct entity from its owner as an individual, and the sole proprietorship operates under the owner’s personal name.
The main reason for the sole proprietorship’s popularity is the fact that there is no setup process whatsoever, and there are no fees involved with starting or operating one. You also won’t ever need to concern yourself with ongoing maintenance requirements like annual reports or franchise taxes. All you need to do is start working on your business idea and you’re automatically a sole proprietor.
Taxes are tremendously simple for a sole proprietor as well. The business entity itself does not pay taxes. Instead, you claim all business profits on your personal return. A sole proprietor signs contracts using his or her own personal name, and their customers write checks directly to them as well.
Sole proprietors are also allowed to commingle their business and personal finances as much as they want to, because there is no separation to maintain.
What Is a General Partnership?
A general partnership is nearly identical in structure when compared with the sole proprietorship. In fact, the only significant difference is the fact that a general partnership has at least two owners, whereas the sole proprietorship only has one.
Much like the sole proprietorship, the general partnership is a good choice for informal businesses that don’t transact much business. If you own a no-risk business with at least one partner, all you need to do is make your first sale, and you are automatically a general partnership.
What Is an LLC (Limited Liability Company)?
A limited liability company (LLC) mixes elements of sole proprietorships, general partnerships, and corporations, essentially giving entrepreneurs the best of these worlds.
LLCs are typically taxed similarly to sole proprietorships and general partnerships, in that the owners include any company profits or losses into their personal returns — the LLC itself does not owe income taxes. An LLC may also elect to be taxed like a corporation, although this is not a very common option.
There are similarities to corporations too, especially when it comes to financial responsibilities. In an LLC, the owners or members are not usually personally accountable for the financial status of the business.
This means that if someone sues your LLC, your personal assets are not at risk. In this way, every owner in an LLC has the same asset protection that a limited partner has in a limited partnership.
What Is a Corporation?
The corporation is another formal business entity, and like the LLC, it provides personal asset protection to each of its owners.
Corporations generally have significantly more complex formation requirements than LLCs do, as you’ll need to designate a board of directors, as well as officers to run the company. In addition, you have to set up meetings for your directors, and also meetings for your shareholders.
The biggest difference between the corporation and the LLC is the fact that corporations are the only business entity that can issue stock. This is why the corporation is the best business structure for attracting outside investments, because the vast majority of investors prefer stock as their stake in the company.
Corporations also have rigid managerial structures, especially compared to the flexibility of the other business types we’ve discussed so far. The board of directors is responsible for handling the “big picture” items, while the corporate officers handle the day-to-day details.
Most corporations (classified as C corps for tax purposes) are also subject to what’s known as “double taxation.” This means that profits are first taxed on the corporate level, and are taxed again when those profits are paid out to shareholders as dividends.
You can avoid this double taxation if you classify your corporation as an S corp, but there are some restrictions to S corporations that prevent them from being more popular.
Specifically, an S corp cannot have more than 100 shareholders, it must only have one class of stock, it cannot be owned (in whole or in part) by any other business entities, and it cannot have any foreign shareholders. The point about having fewer than 100 shareholders is often the part that excludes many corporations, because only being allowed to sell stock to 100 people is quite the restriction.
What Is a Limited Partnership?
Another popular type of formal partnership is a limited partnership. The limited partnership is differentiated from the general partnership by several aspects, first of which is the fact that a limited partnership has a formal business formation process.
While the general partnership is automatically formed when you start doing business, the limited partnership requires registration with your state government.
As for the details, a limited partnership has one general partner, and there is no limit to that partner’s liability. In addition, there are also limited partners, who live up to their title by having limited liability. The other big difference between limited partners and the general partner is the fact that the general partner has a far greater degree of control over the company.
The limited partnership is also a pass-through tax entity, but there’s another difference between the general and limited partners in this regard, which is that the general partner is subject to self-employment tax. This is a 15.3% tax which includes both the employer and employee portions of Medicare and Social Security.
Limited partnerships are a good fit for businesses with multiple owners that have an uneven split in responsibilities.
What Are the Major Advantages of Each Business Structure?
Sole Proprietorships and General Partnerships
For the purposes of this section, we’ll group these two business types together, because they’re nearly identical in structure. The biggest advantages of these informal business types are based around the fact that they don’t require any effort or money to start or maintain.
The sole proprietorship and general partnership are acceptable business entities if your business pursuits have very little liability attached to them. If your business is essentially risk-free, one of these structures might make sense for you. In addition, companies that don’t transact much business could also succeed as a sole proprietorship or general partnership.
The big appeal of the limited partnership is how it allows for an uneven split in ownership and managerial responsibilities. This business structure is often used for real estate investment, or for professional firms (like law offices) that want to be managed by a more experienced general partner, with less experienced limited partners working alongside them.
The limited partnership is also an interesting option for family-owned businesses. Sometimes, when a business is passed down from generation to generation, it will use a limited partnership structure to enable the older generation to remain in control, while easing the younger generation into their ownership roles.
Limited Liability Company
The advantages of an LLC are quite numerous, which is why this is such an overwhelmingly popular option for such a wide variety of businesses. As we mentioned earlier, the LLC is often viewed as a “best of both worlds” option that exists somewhere in between the rigid formality of the corporation and the casual nature of the sole proprietorship or general partnership.
One major advantage of the LLC is the fact that you can choose from three different taxation options. The default method is also by far the most popular, which is a pass-through method that is very similar to the taxation of a sole proprietorship or general partnership. If you want to, you can also elect the C corporation’s “double taxation” style, or the S corp method.
Overall, we like the LLC structure so much because it provides personal asset protection, but without many of the hassles that come with operating a corporation. There’s far less paperwork required of an LLC, and there are also not nearly as many record-keeping requirements.
The corporation’s potential for growth far exceeds that of any other American business structure. This is due to the corporation’s ability to sell stock, which makes the sky the limit when it comes to expanding and developing your business.
Another major advantage of corporations that isn’t discussed as often is the fact that it is a stable and predictable business entity. Corporations as a business structure have been around for hundreds of years, and as such there is plenty of precedent for these entities in the court system. Furthermore, the corporation doesn’t have the same problem the LLC has regarding inconsistent legality. Each state has its own version of the LLC, but corporations are uniform across the country.
Finally, it’s important to remind you that the corporation also has the same limited liability protection enjoyed by LLC owners and limited partners in LPs.
What Are the Major Disadvantages of Each Business Structure?
Sole Proprietorships and General Partnerships
The reason we very rarely recommend these informal business structures to our readers is the lack of personal asset protection. Because of this, if your sole proprietorship or general partnership is sued, your creditors can pursue both your business assets and your personal assets. Therefore, there is no protection for your personal bank accounts, house, car, etc.
In addition, these entity types have very little growth potential. No investor would ever invest money into a sole proprietorship or general partnership, so they’re really only useful for extremely small-scale business endeavors.
The major drawback of the LP is the unlimited liability of the general partner. For this individual, there’s a tremendous amount of risk involved in owning a limited partnership. And on the other side of the equation, the limited partners don’t have much control over the business practices and operations of the company.
If you would like to learn more about how the LP compares to an LLC, take a look at our comprehensive comparison guide.
Limited Liability Company
We tend to recommend LLCs more than any other business structure, but that doesn’t mean it’s a perfect entity. The major disadvantage of the LLC compared to a sole proprietorship or general partnership is that there is a business formation requirement, and also that there’s some upkeep required, not to mention fees for formation and maintenance.
On the other hand, the corporation is a vastly superior business structure for attracting investments, because an LLC cannot issue stock. You will occasionally see an LLC receive investments in exchange for an ownership share, but this is much less common than a corporation selling stock.
In short, the corporation’s disadvantages largely come down to one simple phrase: it’s a hassle. Corporations are a hassle to set up, and they’re arguably even more of a hassle to maintain.
If you hate doing paperwork, the corporation is definitely not for you. Furthermore, the rigid structural requirements of a corporation aren’t a great fit for every business, especially smaller ones that don’t want to deal with all the formalities.
Another issue with corporations is that they can be rather costly from a tax perspective, due to the fact that they’re usually subject to double taxation. While you can get around the double taxation element by classifying as an S corp, there are many restrictions to this option that rule out most corporations from electing it.
To learn more about how corporations directly compare to LLCs, check out our comparison guide.
Can I Hire Someone to Form My New Business?
If you’re looking to form an LLC or corporation, you have some options regarding the formation process. You could tackle the DIY route, which is often extremely time-consuming, and can also be confusing if you’ve never formed a business before.
You can also hire an attorney to form your business, but this option is usually very costly, as it can cost hundreds or even thousands of dollars. We typically prefer to use an online business formation service, which allows you to get the assistance of a professional without breaking the bank.
How does this option work? First, you’ll need to choose which formation service you’d like to use. There are dozens of reputable online services that can save you a ton of time, while also costing far less than hiring a business lawyer to form your LLC or corporation.
If you want to take a look at the top options, head on over to our guide to the 7 top rated LLC services available (these companies all offer incorporation service as well).
In addition, we’ll briefly break down our top three options on this page. These are, in our opinion, the best options for business formation service:
- ZenBusiness ($39): ZenBusiness truly has it all. They provide complete business formation service along with a full year of registered agent service for one incredibly low rate, and they also have stellar customer feedback. It’s hard to go wrong with an offer like this.
- Northwest Registered Agent ($79): Northwest is a bit more expensive than ZenBusiness, but their industry-best registered agent service (included at no extra charge) includes local scanning of every document they receive on your behalf. They also have the best customer support available for business formation services. If you’re looking for more of a premium service, Northwest is an excellent choice.
- Incfile (FREE): Incfile has a business formation package that is free of charge, as long as you pay your own state fee. That’s obviously an enticing offer, especially when you consider that they also provide a year of registered agent. Throw in their strong customer feedback, and Incfile is an excellent choice for business formations.
There are many factors to consider when deciding which business structure is the best option for you. It’s difficult for us to make many sweeping general statements on this topic, because there are concrete pluses and minuses for each of these business entity types.
For the most part though, we are not fans of general partnerships or sole proprietorships, because the liability threshold is so high for owners of these informal business entities. For that matter, we don’t usually recommend limited partnerships either, because the general partner has such a heavy liability burden.
In our eyes, this decision typically comes down to whether the LLC or corporation is the better fit for your business. We hope this article helped you decide which one is the right choice for you!