December 11, 2020 By SmartBiz Team

No two companies operate exactly the same, but most companies fall into several common types of business entities. The government regulates these business entity types to universalize taxation processes, offer expanded liability protection for some businesses, and provide a way for the public to invest in certain companies. Learn more about the most common types of business entities below.

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What is a business entity?

A business entity is any formal organization that conducts business. Each type of entity has different tax obligations and business owner liability protections.

How business entities work

When you start a new company, deciding on a type of business entity is among your most important tasks. To register as a certain type of business, you’ll likely file the appropriate information with the relevant state agency (often your state secretary’s office). Different business types may also require you to pay different filing fees.

Types of business entities

The best business entity type for your company may depend on the number of owners or shareholders in the business, the need for liability protection, desired taxation structure, and more. The company types from which you can choose include:

1. Sole proprietorship

A sole proprietorship is a type of business entity in which the business owner and the company are indistinct for legal and tax-related purposes. That’s why most independent contractors are sole proprietors.

The advantages of a sole proprietorship include extensive control over your work. You’re your own boss, so you get to decide how and when to serve your clients.

Disadvantages include no liability protections – since a lawsuit against your sole proprietorship means a lawsuit against you, all your assets are on the line. For a comprehensive look at sole proprietorships’ advantages and disadvantages, read the SmartBiz Loans blog Sole Proprietorship Business: How to Start Your Own.

2. Partnership

A partnership is a type of business entity with two or more owners. To become a partner in a company, a person will add their money, skills, labor, and/or property to the business. All partners share in the company’s profits and losses.

Partnerships are most common among professional groups or people who want to experiment with a new business idea before formally launching a company. Read more about partnership fundamentals via the SmartBiz Loans blog How To Set Up Business Partnerships for Success.

There are four types of partnerships, with owner liability differing for each:

  • In a general partnership, owners have unlimited liability.
  • In a limited partnership (LP), one partner (sometimes called a general partner) has unlimited liability while the remaining partners (sometimes called limited partners) have limited liability. The partner with unlimited liability will have significantly more power in business matters than will the other partners.
  • In a limited liability partnership (LLP), all owners are liable for at most the amount of money they contribute to the company.
  • In a limited liability limited partnership (LLLP), there may be more than one general partner, and these partners have limited liability but the same power as in an LP. The limited partners will have the same limited liability as in an LP.

The three non-general forms of partnerships are more common among partnerships with investors.

No matter the type of partnership chosen, the company’s income will be added to the owners’ business income and taxed as such. This is called pass-through taxation, and it’s the same tax structure found in sole proprietorships and S corporations. This tax structure avoids corporate double taxation and is among the primary advantages of a partnership. The major disadvantages of a partnership include their limited liability protections.

3. Limited liability company (LLC)

A limited liability company (also occasionally known as a limited LLC or limited liability LLC) combines certain elements of partnerships and corporations (which are discussed next in this list). They combine the pass-through taxation of partnerships with the full personal liability protection of corporations. They are recognized at the state level, as the IRS taxes multi-member LLCs as partnerships and single-member LLCs as sole proprietorships.

In some professions, the state professional licensing board for your industry must approve your articles of incorporation. In this case, your company is a professional limited liability company (PLLC).

The primary advantages of LLCs include their full protection of owners’ personal assets from seizure due to legal action against the company. Their disadvantages include their potential for dissolution, as unlike with corporations, some state laws may require business owners to dissolve their LLCs if a co-owner dies or goes bankrupt.

4. C corporation

The C corporation entity is one of the two primary types of corporations, which are independent business entities with several shareholders. This entity is not a pass-through entity, so the IRS taxes corporate income at the corporate tax rate of 21 percent (formerly 35 percent, but the Tax Cuts and Jobs Act of 2017 lowered it). Business owners and shareholders pay personal income taxes on the money they earn from the corporation.

C corporations are the most common type of business entity among corporations. Their advantages include easier fundraising from the public through stock sales and pursuing investors. Their disadvantages include double taxation (separate taxation of business and personal income) and an inability to claim the qualified business income tax deduction.

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5. S corporation

An S corporation is the other primary type of corporation. It is a pass-through entity, and any sole proprietorship, partnership, LLC, or C corporation can apply for S corporation classification via IRS Form 2553. All shareholders pay personal income taxes on the money they earn from an S corporation.

S corporation advantages include pass-through taxation (which means no double taxation) and the ability to claim the qualified business income tax deduction. S corporation disadvantages include a maximum of 100 shareholders, the ability for only individuals and some trusts to be shareholders, and the funding challenges that come with these shareholder limits. Learn more about S corporation and C corporation operations from the SmartBiz Loans blog: S corporations vs. C corporations.

6. Professional corporation

A professional corporation is a type of business entity in which the owners provide the company’s services as employees. Professional corporations are primarily state-level classifications, so the IRS typically taxes them as partnerships. However, a professional corporation may apply for the special IRS classification of personal service corporations (PSCs) and thus be taxed as a C-corporation if:

  1. At least 95 percent of its services are in the health, performing arts, law, engineering, actuarial science, consulting or accounting fields, and
  2. Employees providing the company’s professional services, retired employees who once did so, or their heirs or estates own all outstanding company stock.

The advantages of a professional corporation include corporate liability protections and no requirement to dissolve if an owner dies or goes bankrupt.

Disadvantages include passive loss limitations that limit the number of tax deductions that nonactive shareholders can take.

7. B corporation

A B corporation is not a state- or federally-recognized business type. Instead, it is a designation that the nonprofit B Lab awards to a company with business practices that minimize negative social and environmental impacts, maximize public transparency and legal accountability, and demonstrate equal commitments to profit and purpose.

The main advantage of a B corporation is that it’s an internationally recognized symbol of excellent business practices. The main disadvantage is that you’ll pay an annual fee to remain certified.

8. Nonprofit

A nonprofit organization uses all its earnings to promote a cause and cover all involved administration expenses. The main advantage of this type of business entity is that, sometimes, nonprofits are tax-exempt. There are two main disadvantages: One, unless your company is a humanitarian, social justice, or political policy organization, you likely can’t apply for nonprofit status. Two, given nonprofits’ tax-exempt status, your company will likely face more scrutiny while applying for nonprofit classification.

9. Cooperatives (co-op)

Cooperative companies, also known as co-ops, are business entities taxed as C corporations whose customers are also their owners. Co-ops members buy company shares, share all company earnings (or don’t directly pay to use the company’s products and services), and receive limited liability. Members must also regularly contribute to the company’s operations.

The main advantage of co-ops is that they provide a legal structure for business owners interested in decentralizing work practices and sharing expenses. The main disadvantage is that, since ownership is equally shared among many members rather than one or a few, co-ops may struggle to obtain loans from banks and other traditional lenders.

Your type of business entity may affect your funding options

Just as co-ops may struggle to access small business loans, so too may other types of business entities face limits obtaining funding. For example, S corporations aren’t as appealing to investors as are C corporations, which may need a strong initial public offering for rapid growth. Depending on your company type and funding situation, SmartBiz Loans may be able to help.

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