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When you're starting or growing a business, the business structure you choose can affect your profits, legal risks, growth prospects and more. Corporations, sole proprietorships and partnerships each have advantages and disadvantages. Here's how a corporation, a sole proprietorship and a partnership differ.
What Is a Corporation?
A corporation is a business entity that exists independently of its owners, reducing the owners' liability risk. Small businesses typically use one of three types of corporate structures: C corporation, S corporation or limited liability company (LLC).
A C corporation is the standard corporate structure—what most people think of when they think of incorporating. You incorporate by filing documents with your state. Corporations can issue stock to an unlimited number of shareholders, which gives them great flexibility to raise money from investors.
An S corporation is the same as a C corporation in most respects, including liability protection, filing with the state and compliance requirements. The major differences are how taxes and shares are treated. Unlike the double taxation that C corporations pay, S corporation owners' profits are taxed as personal income. In addition, S corporations are more restricted in issuing shares.
Limited Liability Company
An LLC combines the tax advantages of a sole proprietorship or partnership with the protection from liability of a corporation.
LLCs are typically the easiest and least expensive corporate structure to establish and operate. There are fewer documents to file and fewer regulations to comply with. LLC owners are not personally liable for the business's debts or legal issues, so their personal assets are protected. Because business profits and losses are reported on the owners' personal tax returns, filing tax returns is simple and taxes are usually lower than with other corporations.
Pros and Cons of a Corporation
Pros of Corporations
- Owners are protected from personal liability, so their assets are not at risk.
- Corporations can continue to exist even if owners leave the business.
- Corporations have more opportunities to raise financing from investors, including selling shares.
- Banks are typically more willing to give loans to corporations than to other types of businesses.
Cons of Corporations
- Corporations involve greater complexity and more paperwork than other business structures, making them more expensive to establish and operate.
- To remain in good standing with the state, a corporation must follow time-consuming legal regulations such as keeping records, naming a board of directors, meeting regularly and filing annual reports.
- C corporations face "double taxation." First, the business's profits are taxed. Then, the shareholders or owners pay personal income tax on their profits from the business.
- S corporations are restricted to 100 shareholders or less, who must be U.S. citizens or residents. This can make it more difficult to raise capital compared to a C corporation that can have unlimited shareholders.
- The IRS tends to examine S corporations more closely than other forms of business come tax time.
What Is a Sole Proprietorship?
A sole proprietorship is a one-person business that is considered the same legal entity as its owner. It is the most basic form of business.
If you start a business and do not register as any other type of business entity, you are a sole proprietor by default. However, because you don't have a separate business entity, you and your business are considered one and the same when it comes to debts, business credit and legal liability. You are the sole business owner, make all the decisions and personally bear all the responsibility.
Pros and Cons of a Sole Proprietorship
Pros of a Sole Proprietorship
- There's no need to register as a business entity, file legal documents of incorporation or worry about compliance with regulations regarding corporations.
- You can run the business as you see fit without answering to partners or shareholders.
- Because income flows through to your personal income, there's no need to file separate taxes for your business.
Cons of a Sole Proprietorship
- You're personally responsible for your business's debts and legal problems. If a customer or employee sues your business, for example, the court may come after your personal assets, such as your home or savings.
- Should you apply for business credit cards, business loans or lines of credit, lenders may rely on your personal credit information when considering your application. If you can't pay back business debt, it could hurt your personal credit score.
- You have no shares or ownership to offer investors, making it difficult to get business financing.
- Banks are typically less willing to give a business loan to a sole proprietorship than to a corporation or partnership.
What Is a Partnership?
A partnership is a business that has two or more co-owners and is typically governed by a partnership agreement.
The most common types of partnerships business owners use are general partnerships and limited partnerships. (A third type, limited liability partnership, is typically used by professionals such as doctors or dentists.)
A general partnership is essentially a sole proprietorship, but with two or more partners. If you bring another owner into your sole proprietorship (for instance, your spouse joins your business), it becomes a general partnership, with no need to register with your state.
As in a sole proprietorship, general partners are personally responsible for business debts and legal liabilities. General partners receive a share of the profits and pay self-employment taxes on that money, as well as income taxes.
A limited partnership is registered with the state and includes one or more general partners, as well as limited partners who are protected from legal and financial liability. General partners handle day-to-day business operations and decisions. In terms of liability and taxation, they're treated the same as in a general partnership.
Limited partners aren't involved in daily operations or decision-making; they're typically investors. Because their role is limited, so is their liability. Limited partners aren't personally responsible for debts or legal issues of the business. They pay income tax on their profits from the business, but don't pay self-employment tax.
Pros and Cons of Partnerships
Pros of Partnerships
- A partnership is a relatively easy way to structure a business with two or more owners.
- There is less paperwork and fewer compliance requirements than with a corporate structure. Some general partnerships are formed on a handshake with no partnership agreement.
- Limited partners are shielded from personal liability for the company's debts and legal issues.
- Because partners' income passes through to their personal income tax, partnerships typically pay less in taxes than corporations.
- It may be easier to get business loans as a partnership than a sole proprietorship. A partnership has more individuals the lender can tap to repay the loan.
Cons of Partnerships
- Any contract or debt that one general partner agrees to binds the other general partners, whether they knew about it or not.
- General partners are jointly and individually responsible for the company's debts and liabilities. If one partner takes out a loan and doesn't pay it back, the other general partner is personally responsible.
- Personal disagreements between partners can destroy the company unless your partnership agreement spells out you'll handle these situations.
Which Business Structure Should You Choose?
The right business structure for you depends on a variety of factors, including:
- Your personal assets
- The level of risk in your business
- Your tax situation
- Your business growth plans
- How you expect to finance your business
- How you envision your business's future
Here are some examples of business structures entrepreneurs might choose for different scenarios.
You're fresh out of college and start a part-time side gig selling handmade clothing on Etsy. You work out of your apartment and never meet customers in person.
Assessment: Since you don't have a store or work with customers in person, and no one is likely to be injured by your wares, the risk of a lawsuit is slim. Because you don't own a home and have few assets, you don't have a lot to protect. Your business is only part-time and you don't plan to look for a loan or investors.
Business structure: Keep it simple with a sole proprietorship. You can always change your business structure if the venture grows.
You're launching a restaurant with your best friend. You've studied business, while she's worked in restaurants her whole life. You plan to run it together; your wealthy uncle has agreed to finance the startup.
Assessment 1: Your uncle is contributing money, but nothing else. Because running a restaurant is time-consuming, you'd like to keep things simple in terms of paperwork and taxes.
Business structure 1: A limited partnership with your uncle as the general partner will protect his assets while keeping him out of the day-to-day decisions. There's minimal documentation required, and you won't have to file separate business taxes.
Assessment 2: Restaurants are risky, capital-intensive businesses. A customer could slip, fall and sue you. Even with your uncle's money, you might need a loan to tide you through a slow season.
Business structure 2: Even though it's more time-consuming than forming a partnership, incorporating may make more sense. You and your partner can protect your assets and have an easier time getting business loans or business lines of credit.
You've started what you're sure is the next big social media platform based on code you wrote in college. Private investors have already shown interest, and you think you can get venture capital. But you need to hire in a hurry to build out your idea. Even though you can't pay employees much right now, visions of going public and becoming the world's next billionaire dance in your head.
Assessment: Any business based on intellectual property is vulnerable to lawsuits from people who claim to have had your idea first. You want to raise large sums of money, but in the meantime, you need a way to compensate employees without cash. You have big dreams.
Business structure: A C corporation offers the most protection for your personal assets. You can issue stock to your first employees to make up for their low wages. As a C corp, it will be easier to get business loans, venture capital and private investors—and eventually go public.
The Bottom Line
The business structure you select affects your legal and financial liability, taxes, fundraising potential and more. Before making the decision, consider consulting with a small business expert. Small Business Development Centers and SCORE offices nationwide work in partnership with the Small Business Administration to provide free guidance from experienced business owners and advisers.
No matter what form of business you choose, your personal credit is a factor when you're starting out. Check your credit report and credit score before applying for a business credit card in your company's name. The card issuer will report your account to the three business credit bureaus: Experian, Dun & Bradstreet (D&B) and Equifax—your first step in establishing business credit.