Deciding on an entity structure for your business starts with understanding that there is never one perfect choice. The right organizational form is the one that aligns best with your personal goals and business objectives.
To determine how each structure will impact your business plans, consider the rules regarding limited liability, pass-through taxation, control over company operations, availability of flexible ownership structures, and the ability to attract equity financing.
Here is an overview of your options and the primary advantages and disadvantages of each form.
The six entity structure options for doing business
- Sole proprietorship
- General partnership
- C corporation or S corporation
- Limited partnership
- Limited Liability Company (LLC)
- Limited Liability Partnership (LLP)
Sole proprietorship
A sole proprietorship is the simplest business form, with just one owner who maintains absolute control over all decision making. This is a popular option for very small businesses with zero or very few employees, as no organizational documents are required to begin operating.
The danger with sole proprietorship is that the owner is personally liable for all business debts and personal assets could be seized to satisfy judgment in the case of losing a lawsuit related to unlawful action by the owner or any employee.
Advantages:
- Easy and inexpensive to set up
- 100% control over operations
- Not required to separate personal and business finances
Disadvantages:
- No limited liability
- Financing limited to taking on debt
- Adding second owner automatically converts the business into a general partnership
General partnership
A general partnership exists when two or more individuals or entities operate a business as co-owners in order to combine business skills and capital. While most general partnerships allocate ownership equally, disproportionate allocation is possible if written into the partnership agreement.
Like a sole proprietorship, a general partnership is easy to set up but does not provide limited liability protection. Each partner is personally liable for all business obligations, including debts or injuries incurred by the actions of any partner without the consent of the others, making a general partnership something you would only want to form with people you really trust.
General partnerships do not pay taxes, with all income or losses passing through to each partner. Note that partners are taxes on all profits, even if reinvested back into the partership.
Advantages:
- Easy to set up
- No partnership agreement or filing with the Secretary of State required
- Combine strengths of each partner into one business
Disadvantages:
- General partners personally liable for all business obligations, including liability for the actions of other partners
Corporation
As a separate “person” before the eyes of the law, setting up a corporation removes shareholders from the decision-making process and limits liability to the amount of their investment. This form is attractive to investors who wish to own a share of the business and its profits without being exposed to any personal liability.
Corporations are managed by officers who make day-to-day operational decision without consultation but who are overseen by a board of directors.
C corporations do not enjoy pass-through taxation. All corporate profits are taxed first, before being distributed to shareholders. In cases where shareholders receive a large distribution that will be double-taxed, a C corporation may not be the best tax vehicle.
S corporations provide pass-through taxation similar to a partnership but these benefits do come with certain restrictions, including the number of shareholders allowed and the type of stock issued. All shareholders must be US citizens or resident aliens.
Learn more about the benefits of an S corp.
Advantages:
- Shareholders, officers and directors have limited liability for their acts
- Each shareholder’s liability limited to the amount of their investment
- Flexible ownership through the selling of shares of stock
- Raise capital from outside investors
Disadvantages:
- Complex and more costly to set up
- Must file documents with the Secretary of State
- Annual meetings and filing of reports mandatory
- Shareholders have zero right to manage operations by virtue of their ownership
Limited Partnership
A limited partnership can be formed between one or more general partners and one or more limited partners. Limited partners are not involved in any decision-making and may not perform any managerial function. The purpose of a limited partnership is typically to raise capital by bringing in an additional investor who will not play an active role in the business.
While limited partners are not liable for partnership debts and obligations, all general partners will be held to the same liability standards as a general partnership. Note that limited partners who engage in managerial activity will be deemed to be a general partner in the eyes of the law for the purposes of liability.
Advantages:
- Pass-through taxation and other tax benefits
- Limited liability for limited partners
- Attract investor capital without losing managerial control
Disadvantages:
- Limited partners have no operational control
- General partners remain personally liable for all partnership debts and obligations
- More expensive to form than general partnerships
- Certificate must be filed with the state
Limited Liability Company (LLC)
An LLC is a combination of a corporation and a partnership, except that instead of shareholders there are members, and instead of stock each member owns a “unit of interest.” There is no limit to the number of members but an LLC can be formed with as few as one.
LLCs are governed by an operating agreement that is similar to a partnership agreement but does include clauses more similar to the articles of incorporation and bylaws used in a corporation.
While LLCs do offer limited liability to all members, the protection is not exactly the same as a corporate shareholder. LLC members are personally liable to third parties in the case of that member’s own gross negligence, intentional misconduct or purposeful violation of law.
Advantages:
- Limited liability for all owners
- Pass-through taxation
- Differing allocations of profits, losses and tax benefits
- Allows foreign ownership
Disadvantages:
- Can be complex and more expensive to form
- Must file Certificate of Formation with the Secretary of State
Limited Liability Partnership (LLP)
An LLP is a form of general partnership that protects partners from the actions of other partner or employees and provides limited liability in terms of partnership obligations. While more complex and costly to form and operate, an LLP enjoys the same taxation and benefits of an general partnership but with a liability shield for partners.
In the case of an existing partnership changing status to an LLP, partners may remain liable to third parties who have done business with the partnership in the past.
Advantages:
- Allows for professional groups to operate as general partners with a certain degree of limited liability for each partner
Disadvantages:
- Can be complicate to operate in more than one state as LLP laws differ between states
- Requires filing with the Secretary of State
- Must pay an annual fee and file an annual report
Entity structure overview
| Entity Form | Limited Liability | Pass-Through
Taxation |
Participation in Management | Flexible
Ownership Structure |
Attract
Equity Financing |
| Sole Proprietor | No | Yes | Yes | No | No |
| C Corp | Yes | No | Yes | Yes | Yes |
| S Corp | Yes | Yes | Yes | No | No |
| Gen Partnership | No | Yes | Yes | Yes | No |
| Limited Partnership | Yes1 | Yes | No | Yes | Yes |
| LLC | Yes2 | Yes | Yes | Yes | Yes |
| LLP | Yes | Yes | Yes | Yes | No |
1 Limited liability does not apply to general partners in a limited partnership.
2 LLC members are personally liable for their own torts, intentional misconduct, or knowing violation of the law, and the LLC is not obligated under the LLC Act to indemnify members and managers. Corporate directors and officers do have statutory indemnity protection.
Entity structure guidance for your business
Our team believes a tax return should be the result of strategic planning, and never a surprise. Understanding your goals is critical to determining the “right” strategy, from entity structure selection to the next stock you cash out.
Start your journey to tax-efficiency by requesting a free consultation with our team here: online contact form.
