Are you thinking about how to start a business or are you working for yourself already? If so, you need to understand the different types of businesses — and think about what kind of business entity makes the most sense for you to start.
While many people default to operating as a sole proprietorship when they first start earning money outside of a traditional job, this business structure isn't the only one — and it isn't always the best one. And if you hope to grow your company, or have already started doing so, exploring different types of businesses becomes even more essential.
Are you not sure where to start when it comes to picking the right business entity? This guide to the types of businesses will help you to make a more informed choice.
Why it's important to understand the types of businesses
Your choice of business structure is one of the single most important decisions you make when you decide to hang up a shingle.
The type of business entity you use to operate your company can affect the personal risk you take on by starting a business, as well as how you're taxed and how difficult or easy it is to hire employees. The amount you'll have to spend up front and the paperwork you'll have to do can also be affected by your choice.
For those who hope to grow a big company or a business that will last beyond their lifespan, the choice of business type can also affect your ability to find investors as well as the likely longevity of your company.
All in all, picking your business type is not a decision to take lightly as the cost of making the wrong choice can be a substantial one.
How to pick the right type of business for you
We'll be diving into the specifics of the different types of businesses a little later. But before we do, it's important to ask yourself a few key questions. Your answers will help you to decide which business structure is best for you.
How do you want to handle liability?
Your company could get into debt if you take out personal loans or apply for a business credit card. Your company could also be sued if something goes wrong.
With certain types of business structures, such as a sole proprietorship or partnership, your personal wealth is at risk of being lost if your company can't pay its bills or finds itself liable for losses after legal action. With other kinds of business entities, such as an LLC or corporation, you can limit your liability to the amount you invest in the business (as long as you don't cosign for any of the LLC’s business credit cards or other debt).
Business structures that protect you from personal liability are generally more complicated to start and they also require you to maintain certain formalities, such as not mixing business and personal funds. You'll need to decide if you're willing to take on the risk of being personally liable or if you want to expend the extra time and effort to get protection for your personal assets.
Do you plan to hire employees?
If you plan to hire employees, you'll need an employer identification number (EIN) and you'll need to understand your obligations as an employer. You also take on more risk because your company can be considered liable for negligence by your employees while they are on duty.
While one of the benefits of sole proprietorship is the simplicity of getting started, you lose a lot of that simplicity when you have to get an EIN and go through the steps to hire staff. Because of this, and the added risk of having people work for you, you may want to think about choosing a different business structure if you're going to hire people to work for you.
Will you have a partner or investors?
Sole proprietorships, by definition, have one owner. So if you want to start a business with co-owners, you'll need to look into business structures such as a partnership, LLC, or corporation.
If you hope to have people invest in your business and want to give them an ownership stake, you may want to look into business structures that allow you to issue stock — such as a C-corp or S-corp. S-corps have more restrictions on how many co-owners you can have as well as who can have an ownership stake, so you'll need to consider whether you're willing to accept these restrictions.
When you have partners in a general partnership, it's also essential you realize you could be liable if they make mistakes that lead to a lawsuit against your business or that result in your company becoming indebted. On the other hand, an LLC or corporation can help to protect you and other company co-owners.
How do you want to handle your taxes?
Sole proprietorships don't have a separate identity from their owners. Other types of businesses, such most single-member LLCs, are considered “disregarded entities” so the IRS doesn't recognize that the business has a separate identity even though it technically does.
This is important because when a business isn't treated as a separate legal entity, this means the company doesn't file its own tax returns. Owners simply declare income, deductions, credits, and losses on their personal returns. This makes life a lot simpler but you have a lot less flexibility in how you're taxed compared with other business entities.
Other types of businesses, such as partnerships and S-corporations, have a separate legal identity but are considered “pass-through entities.” That means the business has to file some tax paperwork of its own to tell the IRS about its profits and losses and claim deductions and credits. But the company itself does not pay taxes. Instead, profits and losses are passed through to owners who declare them on their personal returns. This means doing more tax paperwork but you have a lot more flexibility in how you are taxed on earnings.
Finally, C-corporations are taxed as separate entities. The company files a tax return and pays taxes on income minus deductions and credits. As profits are distributed to owners, they also have to report them on their individual tax returns. This can lead to double taxation. But C-corps are taxed at a different rate and can claim some deductions and credits not available to other business entities.
You'll have to consider how much tax paperwork you want to do and what type of business entity provides you with the most advantageous tax treatment so you can choose the right one to meet your needs.
The types of businesses
Now that you know a few of the factors that will go into determining which business structure is the best fit, let’s talk about each of the types of businesses in a bit more detail. Once you read through these business descriptions, you should be able to pick the right one for you.
A sole proprietorship is a business with a single owner that does not have an independent identity from its owner. It's the simplest type of business andit tends to be the best type for people who want to work for themselves without doing a lot of extra paperwork.
Pros of sole proprietorships include:
- Simplicity: You don't have to file any paperwork with the IRS or the government. You just submit a personal tax return along with a Schedule C declaring business profits and losses.
- Low cost: Since you don't pay to form a sole proprietorship and you don't have to prepare an additional tax return, there's no cost associated with organizing as a sole proprietorship.
There are downsides though:
- You have to apply for an EIN if you want to hire any workers. This means you're doing extra paperwork with the IRS anyway.
- You have no flexibility in how you're taxed. All business income is taxed as ordinary income.
- You have full liability for company losses. If the business goes bankrupt, you go bankrupt. If the company is sued, your personal assets are at risk.
- Ownership transfers are difficult. It's usually hard to find investors and the company likely will die with you since it doesn't exist separately from you.
If you want to form a business with others, a partnership is the simplest type of business. It's considered a pass through entity so owners declare profits and losses on their personal tax returns. While a partnership does have to file tax forms declaring profits and losses and explaining how they were distributed among different partners, the partnership itself doesn't pay any taxes.
To form a partnership, you'll probably have to submit some paperwork to your state. This can come at an added cost, as can the extra tax forms you have to file if you choose to hire an accountant. Still, there's generally less complexity and cost in forming a partnership than in incorporating.
Pros of a partnership include:
- The ability to go into business with co-owners to share the risk of loss
- The fact income and losses pass through to owners so the partnership doesn't have to pay taxes
Downsides of a partnership include:
- The need to prepare a partnership agreement and likely submit paperwork to the state
- Extra tax compliance obligations
- The risk of personal liability as each partner is liable for losses that the partnership incurs
- The risk of conflict between partners
- Challenges associated with one or more partners leaving, which need to be managed with a partnership agreement that addresses what happens in case of departure, death of a partner, or disability of a partner.
Example: If two people start an accounting or law firm together, they may decide to structure it as a partnership.
Limited partnerships work similarly to a standard partnership except at least one partner is protected from personal loss. The partnership must have at least one general partner that faces personal liability.
General partners both own and operate the business, while the limited partner is an investor who takes a hands-off approach. Limited partners can invest money and benefit by receiving a share of profits, which are declared on personal tax returns. But they don't have the right to make day-to-day decisions regarding company operations.
Benefits of a limited partnership include:
- The ability to more easily attract investors who can become limited partners
- Protection from personal liability for limited partners
- Limited partnerships can be easier to establish than corporations or LLCs
- General partners are liable for company losses
- A limited partnership can be more complex to set up than a sole proprietorship or general partnership
Example: In the world of real estate, a general partner would be the person who is actively managing a set of properties and making the daily business decisions, while the limited partner or partners are simply investing funds in the venture.
There are two different types of corporations, although C-corporations are the default and you have to specifically elect to be treated as an S-corporation.
C-corporations are taxed at a special corporate rate, can issue different classes of stock, and can have an unlimited number of shareholders. S-corps, on the other hand, are pass-through entities so owners are taxed on profits at their ordinary income tax rate. But there are many more restrictions on who can own shares in an S-corp and how many shareholders the S-corp can have.
Corporations tend to be best for entrepreneurs willing to do extra paperwork in order to get more liability protections, more flexibility in taxes, and more options for finding investors or other co-owners.
Pros of corporations include:
- The ability to take profits as distributions or dividends: For C-corporations, this means shareholder owners can be taxed at the capital gains tax rate. For S-corps, you can avoid FICA taxes on distributions.
- Strong liability protections: As long as you keep your personal finances separate and don't commingle business and corporate funds or cosign for business debt, your potential losses are limited to the amount you invest.
- Easier transfers of ownership: You can issue stock to co-owners or investors
- Independence: Corporations are entirely separate legal entities from owners. They can live on indefinitely.
- Higher cost and complexity to form a corporation: You'll have to file Articles of Incorporation with your state as well as paperwork with the IRS.
- Tax compliance costs: Both S-corporations and C-corporations must file their own tax returns. S-corps don't pay taxes on profits or claim losses, though — these are passed through to owners. C-corps do pay taxes on income, and owners also pay taxes when they take their share of profits.
Example: Many large businesses in the U.S. are corporations, including companies such as Apple and McDonalds. Corporations can be privately owned or publicly traded, but they exist as separate legal entities with their own rights and obligations under the law.
LLCs, or Limited Liability Companies, exist as a separate legal entity from owners. Owners are called members and they don't face a risk of personal loss due to business bankruptcy or business debts.
Single member LLCs are considered disregarded entities by the IRS so they are treated just as sole proprietorships — meaning, you don't have to file separate tax forms. Multi-member LLCS are taxed as partnerships by default. But both single and multi-member LLCs can choose to be taxed as corporations if they'd prefer.
Key benefits of LLCs include:
- Flexibility in how you're taxed
- Simpler to create than a corporation
- Protection from liability
But disadvantages include:
- LLCs don't issue stock so transferring ownership can be more challenging
- There are still filing fees to pay and it can be more complicated and costly to create an LLC than to operate as a partnership or sole proprietorship
Example: LLCs are often smaller businesses than corporations with few or no investors and a limited number of owner members. However, some larger companies, such as Anheuser-Busch, are organized as LLCs.
Nonprofits are businesses that exist to foster the common good. Nonprofits must meet specific requirements to be classified as a tax-exempt organization but there are many different kinds of nonprofits including social welfare organizations, labor unions, religious organizations, volunteer fire companies, and public charities or private foundations.
Those who own and operate nonprofits can take reasonable salaries so this path is an option when considering how to make money. A nonprofit can even make money as long as the revenue is reinvested in the organization. Nonprofits are exempt from sales tax but still have to file tax paperwork with the IRS. In fact, paperwork requirements are extensive, and detailed accounting records must be maintained.
Pros of a nonprofit include:
- Tax-exempt status
- Eligibility for grants that are limited to nonprofit organizations
- Easier fundraising as contributions to the nonprofit may be tax-deductible
- Complex paperwork and accounting requirements
- Only certain organizations can qualify as a nonprofit
Example: Many animal rescue organizations, groups that tutor children, and many other charitable organizations are operated as nonprofits.
Co-ops are owned by the people who use the products or services the cooperative organization provides. A co-op doesn't exist to help owners or investors make a profit, but instead exists to provide benefits to the member owners.
Co-ops provide liability protection for owners and there is lots of flexibility in who can become a co-op member. Co-ops are also exempt from taxes up to a certain income limit, and owners of the co-op declare profits and losses on personal tax returns.
Pros of co-ops include:
- Easier to form than corporations or other types of businesses
- Less tax paperwork for tax-exempt co-ops
- Owners can benefit from more control since the organization is owned by and exists to serve its members
- Difficulty attracting investors
- Co-ops aren't usually nimble organizations because many members have to be involved in decision-making
Example: An example of a co-op may include a small community grocery owned by those who shop at the market. On the other end of the spectrum, are co-ops such as the Green Bay Packers and outdoor gear company REI.
What if you want to switch business types?
After reading through these types of businesses, you may realize that your current business entity is not the best one. Or you may be concerned that if you start a business today, your needs and goals may change in the future.
Many companies switch to a different business entity during the course of their operations. You may start as a sole proprietorship, for example, but decide to form a partnership if someone wants to go into business with you. Or you may opt to switch to being a corporation so you can get investors or change the way you're taxed.
Changing to a different type of business can be simple or difficult, depending on what kind of change you want to make. If you've formed a C-corporation and want to become an S-corp, for example, you simply need to submit an S-corp election form to the IRS and make sure you meet the requirements to be considered an S-corp. Changing from a sole proprietorship to a partnership or corporation, on the other hand, would require much more paperwork including filing documents with your state and the IRS as well as incurring new tax obligations.
You need to think about what you hope to accomplish by changing business structures and whether it's worth the time and cost of doing so.
Choosing the right business structure from the start can help you to set your company up for success while also protecting your personal wealth. Consider the paperwork requirements and cost of starting your business, the risk you're taking on, and the tax treatment of different business entities when deciding what business structure is best for your needs.
No matter what type of business you start, though, remember that you should keep your business and personal finances separate. Having a business credit card and/or providing them for your employees can make your business’s accounting process much easier.
And no matter what type of business you choose to start, it will take dedication to make your business a success. Fortunately, small business is the backbone of the American economy, so hopefully your company can contribute in its own way while providing you with a satisfying career you love.