When you start a business, how you structure it determines how you and your business will be treated legally and how you’ll pay taxes. Each type of business ownership structure has its pros and cons depending on the kind of business you run, how much money you earn and how you want to run the business.
In this guide, we explain each business structure to help you determine which is best for your new or growing business.
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1. Sole Proprietorship
A sole proprietor is anyone who owns an unincorporated business alone. That means no separate business entity exists; you simply operate the business and personally own its equipment, materials, intellectual property (IP), profits and liabilities.
You become a sole proprietor as soon as you start doing any work as a self-employed person. That includes freelancers, gig workers and other independent contractors, as well as any small business owners who don’t register a separate business entity.
You don’t have to register as a sole proprietor with your state or the IRS in most cases; you can operate under your personal name and Social Security number if you prefer. You can register an employer identification number (EIN) with the IRS for tax purposes (usually preferred if you pay employees or contractors). You might also have to register a tax ID with your state if you do business that would incur sales tax.
An operating agreement is not necessary for a sole proprietorship because you’re the only person involved.
Financial and legal liability for business activities falls 100% on a sole proprietor. There’s no distinction between you and the business, so you’re personally responsible for any taxes and debts the business incurs, as well as any legal action taken against the business.
2. Partnership
A partnership is any business relationship among two or more people who share the responsibilities and profits of a business.
A partnership can operate without registration, similar to a sole proprietorship that splits benefits and liabilities among partners.
A partnership agreement is necessary to set the terms of a partnership. Partners create this document among themselves (or with the help of lawyers) to determine how they’ll distribute profits and losses from the business.
Financial liability for a partnership falls personally among the partners, according to the terms of the partnership agreement. Legal liability might be limited to the business in some states.
Types of Partnerships
Partnerships are classified according to how they distribute liability among partners, as follows:
- General partnership: Each partner has total liability for all of the business’s financial and legal obligations, including obligations caused by another partner’s actions.
- Limited partnership (LP): At least one partner (the “general partner”) has total liability, while one or more “limited partners” (usually investors) have limited liability.
- Limited liability partnership (LLP): Each partner has total liability for business obligations but is protected from liabilities due to other partners’ conduct. LLPs are typically reserved for professionals like doctors, lawyers and accountants, and are only available in some states.
- Limited liability limited partnership (LLLP): Operates like a limited partnership, but the general partner also has limited liability. LLLPs are not available in all states, and their liability protection has not been thoroughly tested in court.
3. Limited Liability Company (LLC)
An LLC is a business entity created by state statute. Specific regulations vary slightly by state, but generally, an LLC is a way to create some legal separation between you and your business. LLC owners are called members, and most states allow any number of members; if the LLC has just one member, it’s called a single-member LLC.
You have to file articles of organization to start an LLC with your state. Depending on the state, you might register with the secretary of state’s office, the state department of revenue, a dedicated business agency or another government agency. Initial registration involves choosing a legal name for the LLC, which can be anything that isn’t too similar to an existing registered business in the state, and naming those responsible for the business’s ownership and finances.
You typically pay a fee of around $100 to register an LLC, but the exact amount varies by state. You also pay an annual filing fee or additional tax in many states, which can be as little as $10, but might be several hundred or several thousand dollars in some states.
You need to create an operating agreement to govern an LLC with multiple members. You might also have to create an operating agreement for a single-member LLC if your state requires you to file one with your registration.
The agreement will classify your LLC as either member-managed or manager-managed, allowing either all members to make business decisions or designating select agents, such as a board of directors, to run the business. Most small businesses are member-managed, but you might prefer a manager-managed structure if you want to allow the business to take on passive investors (i.e., silent partners) or cooperative member-owners.
Financial liability for an LLC falls personally among the members, according to the terms of the operating agreement. Legal liability for an LLC might be limited to the business according to state statute.
The LLC is a blending of both a corporate structure with the structure of a partnership.
More often than not we recommend that partners select an LLC or even a corporate structure [over an LLP].
– Jonathan Lazarow, a partner at the corporate and intellectual property law firm Ambrose Lazarow
4. Corporation
A corporation is a business entity recognized by the IRS and registered with your state. Unlike other business structures, a corporation is a tax-paying entity separate from its owners. The corporation earns money and distributes profits to shareholders.
You might be familiar with this structure on a large scale: public corporations, where anyone can trade shares through a stock exchange. The ownership and distribution process is similar on a smaller scale for private corporations, where ownership is limited to agreed-upon investors.
“Choosing to organize your business as a corporation may have benefits over other entity structures,” says Lazarow. “It really depends on the business you are operating, how you are going to be funded/financed, the number of shareholders, governance and tax.”
Forming a Corporation
To form a corporation, you must file articles of incorporation with your state’s business agency stating its name, purpose, address, owners and other details. The state might also require you to submit a copy of corporate bylaws, the legal agreement that governs how the business will be managed, who holds which responsibilities and how ownership and profits are distributed.
A corporation is managed by a board of directors, which you appoint initially when you form the corporation and replace or reappoint over time according to your bylaws. Bylaws also state how often board meetings and shareholder meetings take place and how many people need to be present in either meeting for decisions to be made. States dictate how many people must be on a board of directors.
Liability in a Corporation
Financial and legal liability for a corporation is limited to the business entity and doesn’t pass through to individual shareholders. Uniquely, a corporation pays taxes separately from its shareholders: The corporation earns (or loses) money and pays taxes accordingly. Then it distributes profits to shareholders, who pay individual taxes on their gains.
Corporate shares are easy to pass from one shareholder to another, making this structure the best (in some cases, only) option if you want to invite passive investment, such as venture capital. Corporations can have multiple classes of stock, allowing types of ownership that come with varying levels of responsibility and control over the business.
C-Corporation vs. S-Corporation
For tax purposes, business entities can elect to be treated as a C-Corporation or an S-Corporation. This election only changes how your business is taxed, not its ownership structure—and the business doesn’t have to be a legal corporation to elect C-Corp or S-Corp tax treatment. LLCs are automatically taxed like sole proprietorships or partnerships, but they can also elect C-Corp or S-Corp treatment.
C-Corp is the automatic corporate tax treatment. C-Corps pay taxes twice on most income: First, the corporation pays tax on revenue, then shareholders pay tax on the profits that are distributed. This isn’t usually a beneficial arrangement for small businesses or single owners, but it might make sense if you have passive investors.
An S-Corp is a special election that passes corporate income onto shareholders or members. This is similar to the way you’re taxed as a sole proprietor, LLC or partnership, except you don’t have to pay payroll taxes on profits. An accountant can help you determine what kind of tax treatment is most advantageous for your business.
5. Cooperatives and Nonprofits
Cooperative and nonprofit ownership are additional ways to organize a business under one of the business entities above.
A cooperative business structure creates a way for employees and community members to control and benefit from the business. It reduces barriers to ownership by allowing membership based on an annual fee or hours worked, for example, rather than requiring a financial investment. Cooperatives are governed by a board of directors who are elected democratically by members. Cooperatives are usually structured as multimember LLCs or corporations, and governance requirements vary by state.
A nonprofit organization is any business entity that receives a tax exemption, most commonly as a charitable organization dubbed a 501(c)(3) organization after the federal tax code governing it. Nonprofits are usually structured as corporations.
Compare Types of Business Ownership
| Sole Proprietorship | Partnership | LLC | | | |||
|---|---|---|---|---|---|---|---|
| C-Corporation | S-Corporation | Cooperative | Nonprofit corporation | ||||
| No. of owners | 1 | 2 or more | 1 or more | 1 or more | 1 to 100 | 2 or more | 1 or more |
| Tax Liability | Individual | Individual | Individual | Business | Individual, limited | Varies | Exempt |
| Employer Tax ID Required | No | No | Yes | Yes | Yes | Yes | Yes |
| Legal liability | Individual | Individual | Business | Business | n/a | Varies | Varies |
| Register with State | No | No | Yes | Yes | n/a | Yes | Yes |
| Board of Directors | No | No | No | Yes | n/a | Yes | Yes |
| Pros | No registration | No registration | Low-cost registration and diverse governance options | Unique tax breaks and diverse investor options | Tax savings for small businesses and high-earning individuals | Democratic ownership and profit sharing with workers or community members | Tax exemptions and unique eligibility for public and private grant funding |
| Cons | Full individual liability and no investor options | Full individual liability and no investor options | Full individual financial liability and limited investor options | Complex governance and legal/tax compliance | Complex tax compliance | Limited wealth-building for founders | No wealth-building for founders |
How to Choose the Right Structure for Your Business
To choose the structure that’s right for your business, ask these questions:
- How many people will own the business?
- Who will be able to make decisions about the business?
- What kind of legal and financial protection do you need?
- Will you take on investors (now or in the future)?
- Which tax treatment is most beneficial for your circumstances?
- Does the business serve a community or social purpose, or strictly a financial one?
A lawyer and tax accountant can help answer these questions for more complex businesses. You can always start simple—with a sole proprietorship or partnership—and update the business structure to an LLC or corporation down the line as the business grows and liabilities, taxes and governance become more complex.
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Frequently Asked Questions (FAQs)
Do you need a lawyer to set up a business?
It’s possible to set up a business entity without a lawyer by creating agreements and filing paperwork, but legal and tax advice can help you navigate more complex structures like corporations, cooperatives and S-Corporations. A lawyer usually isn’t necessary to organize a single-member LLC but could be helpful to create an operating agreement with partners. Find a local business attorney in your state or connect through an online LLC service.
How does your business structure impact benefits?
The way you structure your business might impact the types of benefits you offer employees, because it impacts the kinds of tax breaks you can get on the cost of benefits such as retirement accounts and health insurance.
What is a registered agent?
When you register a business with your state, you have to list a registered agent, the person responsible for receiving correspondence and filing legal and tax documents for the business. A registered agent could be one of the business owners, your lawyer or accountant, or a representative from a registered agent service.
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