What are the Different Types of Business Entities?

a businesswoman who has Sole Proprietorship over her business working from her laptop

When starting a new business, it is critical to contemplate what form the company will take. The legal business form determines how it operates, how it is taxed, and who is liable for its debts. It is the type of entity chosen that sets the stage for everything that comes afterward.

So, what are the different types of business entities, and what do they mean for each business in terms of organization, taxation, and liability?

 

What Is a Business Entity?

 

A business entity is an organization formed by one or more people intending to conduct business within the state in which it is formed. The state governs the organization and requirements of each entity formed within its borders. Still, the implications of the chosen business entity type extend beyond state borders to how the organization is taxed at the federal level.

Business entities typically come in six types:

 

  • Sole proprietorships
  • Partnerships
  • Limited liability companies
  • C-corporations
  • S-corporations
  • Non-profit organizations

The business entity type is formed with the state’s Secretary of State and should be formed before the organization commences to do business. If the company has not been filed with the Secretary of State, it will be treated as a sole proprietorship or partnership.

Let’s take a look at each organizational type.

 

Sole Proprietorships

 

A business started by the business owner or the business owner and spouse together but a separate entity isn’t filed with the state is a sole proprietorship. The costs and profits of a sole proprietorship are filed on the owner’s personal tax return, and the income is treated as the owner’s income. Because the income flows directly to the owner for tax purposes, a sole proprietorship is considered a “pass-through entity.”

Instead of having its own taxpayer identification number (TIN), a sole proprietorship shares its tax ID with the taxpayer. Legally, the owner of the sole proprietorship is the company and is liable for any debts or judgments the company incurs.

 

Partnerships

two young businesswomen working in a partnership for their business

Like a sole proprietorship, a business entity owned by multiple people but not filed with the state is considered a partnership. The partners agree to share the profits and liabilities of a partnership based on their share of ownership, which flows directly to their tax returns, making this entity type a pass-through entity.

A partnership will most likely have its own tax identification number, and the partners will have a legal agreement amongst them. Also, the partners are not shielded from any liabilities incurred by the company.

The partnership will file its own taxes on a Schedule 1065 IRS tax form for tax purposes, and each owner will receive an IRS form K-1 for their share of the profits.

 

Limited Liability Companies (LLCs)

 

A sole proprietorship or partnership can be formed as an LLC with the state, which protects the owners from the company’s liabilities if they don’t sign personal guarantees on the contracts. Just like a sole proprietorship and partnership, the earnings of the LLC are also treated as pass-through income.

If the LLC is a single-member LLC (one owner or spousal ownership), it is filed on the owner’s tax return on Schedule C, just like a sole proprietorship. If the LLC is a partnership, it also files a separate tax return on an IRS Schedule 1065 despite the earnings or losses being considered pass-through income and each owner will receive a K-1.

If the LLC is a partnership, the owners may want an operating agreement. That agreement might restrict an owner from selling their company share and specify that the LLC dissolves if an owner dies.

LLCs tend not to have arduous requirements from the state other than confirming that it is still in existence with the state yearly. They are easy and can be managed by one managing partner.

The main advantage of an LLC is that it shields the owner(s) from liability.

 

C-Corporations

 

A C-corporation is a business entity filed with the state that most likely intends to become a publicly traded company with no limit to the amount of shareholders. [1] Unlike previously discussed entities, which were pass-through entities, a C-corporation files a tax return and pays federal taxes based on its earnings.

If the company’s shareholders earn dividends from the company or sell their stock for a gain, they will pay taxes at their personal tax rate. This tax treatment is the biggest drawback to a C-corporation; it is subject to double taxation. A managing partner or owner doesn’t govern a C-corporation; it requires directors and officers and must file regular reports.

The owners (shareholders) are insulated from the corporation’s liabilities.

 

S-Corporations

An S-corporation is a corporate form reserved for small to medium businesses that will not be publicly traded on an exchange. Still, they provide the owners with substantial tax benefits beyond a C-corporation. An S-corporation may have up to 100 shareholders; like an LLC, it is a pass-through entity.

a businesswoman reviewing paperwork for her s corporation

An S-corporation could have as few as one shareholder, but it will always file its own taxes on a form 1120-S. It won’t pay taxes as the profits or losses flow to the owners and are taxed under their income tax rates, so unlike a C-corporation, an S-corporation isn’t double taxed.

The owners are shareholders and not partners, so they can easily sell their shares to others. At the same time, the company requires directors, officers, and regular reports filed with the state, just like a C-corporation.

It is important to note that an S-corporation is an IRS designation. It could be filed with the state as an LLC, but files a form with the IRS to be taxed as an S-corporation. [2]

 

Non-Profits

 

It is commonly known that non-profits do not pay taxes, but most don’t know that they still must file tax returns and have management and capital requirements to maintain their non-profit status.

The government recognizes several types of non-profit organizations, and each must meet requirements that apply to its primary purpose. [3] It could be a homeowners’ association, labor union, charity, or social welfare organization (to name a few), and each must meet specific stipulations. Most important to non-profits is that no profits flow to any individual. While a non-profit can certainly pay employees, it cannot distribute profits.

 

Summing It Up

 

Considering what business entity a business should be is an important consideration. While these are some simplified explanations, the benefits and disadvantages are much more complex and depend on how the organization will operate. 

The business owner should consult with professionals to determine which business type works best for them.

References

1. Huston, H. (2022, September 13). Compare S corporation vs C corporation

Wolters Kluwer. https://www.wolterskluwer.com/en/expert-insights/s-corp-vs-c-corp-differences-benefits 

C corporation advantages

Unlimited number of shareholders
There is no limit on the number of shareholders a corporation taxed under Subchapter C can have.

No restrictions on ownership
Anyone can own shares, including business entities and non-U.S. citizens.

No restrictions on classes
A C corp can issue more than one class of stock, including stock with preferences to dividends and distributions.”

 

2. Internal Revenue Service. (2023b, February 7). S Corporations

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.”

3. What is a “Nonprofit”? (n.d.). National Council of Nonprofits. 

https://www.councilofnonprofits.org/what-nonprofit 

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