Key Takeaways
1. When growing your business, whether domestically or internationally, it is crucial to consider the best type of business entity for your business.
2. Sole proprietorship is a straightforward, usually default, business structure or entity: However, it subjects the business owner or entrepreneur to unlimited liability.
3. Partnership is a popular business entity or structure for professional service firms, though, as with sole proprietorship, it means that all business owners take on significant liability.
4. Incorporated business entities or structures, such as Limited Liability Companies (LLCs) or corporations strictly limit the liability of the ultimate business owners. However, they tend to be more complicated and expensive to set up than sole proprietorships or partnerships.
When setting up or growing your business, it is essential to think carefully about the type of business entity you will use as the vehicle for your enterprise. While sole proprietorship is the most common type of business structure in the world, it is not appropriate for many businesses.
Here we set out the main types of business entity available for your business, sole proprietorship, partnership, limited liability company and corporation, and consider the pros and cons of each.
What are the different types of business entity?
1. Sole proprietorship
A sole proprietor (also known as a ‘sole trader’ in some jurisdictions), is an individual operating a business under their own personal identity: There is no legal separation between the business and the individual who owns it.
Depending on the country or region, a sole proprietorship may need to be registered with tax authorities or other government regulators to ensure tax and business law compliance.
Pros and cons of sole proprietorship
Pros of sole proprietorship
- Ease of set-up
- Sole proprietorship is usually the default business entity: I.e., anyone who begins operating their own business without taking any other steps will automatically become a sole proprietor. By contrast, other common business types, such as companies, partnerships or corporations must be initiated through legal documentation.
- Note, this does not mean that the sole proprietor has no obligation to register with authorities (they usually do). What it means is that the existence of this business form does not depend on any specific documentation or regulation.
- The ease of setup is the reason that this business form is commonly chosen by independent contractors: Read more in our comprehensive ‘Independent contractor vs sole proprietor‘ guide.
- Low Cost
- The cost of setting up a sole proprietorship is low: Often no money is required, or a minimal registration fee.
- Ongoing compliance
- Ongoing compliance requirements are usually minimal. While taxes must be filed at required intervals (often quarterly), there is no requirement to register annual returns for the business, nor to have financial accounts audited.
- Tax simplicity
- Usually, the business owner can deduct a prescribed set of expenses from their revenue, and then pay tax at the regular ‘personal income’ tax rate (i.e., same as an employee).
Cons of sole proprietorship
Alongside the benefits of sole proprietorship, this business model is not without its disadvantages, namely:
- Generally higher tax burden
- While filing taxes may be easier for sole proprietors, if the business is succesful, generally the business pays a higher proportion of its revenue in income tax, than it would if incorporated.
- The reason for this is that, in most countries, personal income tax rates go higher than corporate income tax rates. Furthermore, an incorporated body can generally distribute a certain amount as dividends, which are taxed at a lower rate than business income.
- Raising capital or debt is more difficult
- In sole proprietorship, there is no equity in the business that can be acquired by a third party (e.g., shares). Furthermore, lenders are more wary of making loans to sole proprietors as any personal financial issues of the sole proprietor can more readily disturb business operations.
- Unlimited liability
- In an incorporated body, such as a Limited Liability Company (more on this below), the owners of the business (the ‘members’ or ‘shareholders’) limit their liability by their capital contribution to the firm. This means, if the business becomes insolvent (unable to pay its debts as they fall due and payable), the owners’ potential loss is limited by that contribution.
- In sole proprietorship, the sole proprietor’s liability is unlimited: If the business becomes insolvent, creditors can force the business owner into personal bankruptcy and pursue their personal assets (such as the family home or personal bank accounts).
- It is difficult to sell the business
- In a corporation (more on this below), a majority stake in the business can be sold simply by selling a majority of the shares in value. In sole proprietorship, there is no ownership interest in the enterprise that can be purchased: It is possible, however, for the assets of the business to be purchased by a third party.
2. Partnership
A partnership (also known as a general partnership), involves two or more individuals going into business together according to the terms of a partnership agreement. This business form is particularly common among professional service forms such as accountancy and legal practices.
Pros and cons of partnerships
Pros of partnership
- Control
- The partners work on a day-to-day level in the business, and have complete control over the business. There are no ‘silent’ partners who don’t work in the business but nevertheless exert control (except in a ‘limited partnership‘, more on this below).
- Ease of setup
- A partnership is formed by both parties agreeing to the terms of a partnership agreement (ideally signed, and in writing). There is no need to register with any body in order for the partnership to take effect.
- Privacy
- Who the partners are, their capital contributions and the financial circumstances of the partnership, are an entirely private matter. This is not listed on any public database as shareholdings and directorships of incorporated bodies sometimes are.
- Flexibility
- As the partnership is a creation entirely of the free decision of two or more individuals, it can be structured however those parties like, usually without reference to statute.
Cons of partnership
- Unlimited liability
- In a general partnership, each of the partners has unlimited liability for the debts of the business. Therefore, the failure of the business puts the partners personally at risk of bankruptcy. In some jurisdictions, limited partnerships are allowed where a subset of the partners, the ‘limited partners’ have limited liability. However, even in a limited partnership, the general partners who run the business on a day-to-day level must have unlimited liability.
- Difficulty in raising capital or debt
- “While it is generally easier to raise capital or debt for a partnership than a sole proprietorship (as there are multiple partners able to contribute), it is still difficult to get funding from a third party. It is easier in the case of a limited partnership, where a third party acquire a stake in the business.” – says Martin Kanaan – Head of Marketing and Business Development at MakoLab
- Complicated decision-making processes
- In a partnership, all major decisions need to be signed off by each of the partners. This makes it more difficult to respond to events and move quickly. It also increases the risk that personality clashes interfere with business decisions.
3. Limited Liability Companies (LLCs)
A Limited Liability Company (LLC) is the name given in the US to a special form of incorporated legal entity.
An LLC is owned by its members, who may be one or more individuals, or may also be incorporated entities. In an LLC, taxes are ‘passed through’ to the members, so that the company itself doesn’t pay taxes, and the individual members simply pay a tax on any profits in their own personal tax returns.
They are generally set up via lodging a ‘Certificate of Organization’ or ‘Articles of Organization’ with state authorities.
LLCs need not have a board of directors, but may have a ‘board of managers’ or an individual manager.
Pros and cons of LLCs
Pros of LLCs
- Limited liability
- It’s in the name — the members have limited liability, meaning that their personal assets are (generally speaking) safe in the case of business insolvency. Note, however, under certain circumstances the creditors can ‘pierce the corporate veil’, and go after members personally. Furthermore, members will be personally liable wherever they have personally guaranteed a debt (as is commonly the case).
- Tax ease
- The straightforward pass-through of taxes means there is little additional tax burden to operating through an LLC.
- Flexibility
- There are few requirements specifying how the business will actually run: For example, the members do not need to run the business themselves and can have the task delegated to professional managers. It is recommended that the planned operation of the business is set out in a ‘operating agreement’.
Cons of LLCs
- Compliance burden
- As an incorporated business type, the LLC must be registered with the authorities, and satisfy annual compliance requirements.
- Single-member LLCs are vulnerable
- A single-member LLC may not be eligible for general asset protection provisions. Furthermore, where there has been mixing of business and personal funds, there is a heightened risk that a Judge will ‘pierce the corporate veil’, making individual members personally liable for business debts.
- Additional taxes
- Members who work in the business may be subject to self-employment and payroll taxes as if they were a sole proprietor.
C Corporation
A C corporation (‘C corp’, like an LLC, is an incorporated body in the United States. However, unlike an LLC, corporate income tax is paid on C corp profits, and they must file their own tax returns. Most large companies in the US are C corps. Strictly speaking, C Corp is a tax designation rather than a business type — the business type is ‘corporation’: Where a corporation is eligible for, and applies to be designated for, ‘pass through’ of income to the members, they are known as an S corporation or S corp.
In a corporation there is a strict delineation between the owners (members), the governors (the board of directors) and the ultimate managers (the officers) of the corporation.
Pros and cons of C corporations
Pros of C corps
- Limited liability
- As with LLCs, the liability of members is limited by their capital contributions.
- Ease of issuing shares
- A C corporation can easily issue shares to third parties: This can be particularly valuable when raising capital.
- International reputation
- the US C corporation is a gold standard internationally for incorporated business types: The business form is well-understood and considered a secure partner for doing business globally.
Cons of C corps
- Tax burden
- In a sense, C corps are ‘taxed twice’, as any income of the corporation is subject to income tax, while any dividends issued are subject to dividend tax.
- Compliance burden
- Setting up a C corp means filing a range of documents with the authorities (such as the ‘Articles of Incorporation’, as well as filing annual returns and tax returns on behalf of the business.
Video: Which type of business entity? LLC or Corporation?
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Frequently asked questions
In the US, the four main types of business entity are sole proprietorship, partnership, limited liability company (LLC) or corporation (whether designated as a C corporation or an S corporation).
‘C corporation’ and ‘S corporation’ are different tax designations for corporations in the United States. A C corporation of ‘C corp’ pays corporate income tax on all its profits, whereas an S Corporation of ‘S corp’ can ‘pass through’ profits directly to members who pay personal income tax on those profits.
