Business Entity: Different Types and How to Create One

What is a Business Entity?

A business entity is an organization founded by one or more individuals to conduct a specific business or allow them to engage in a trade or similar activities. Business entities, also referred to as business structures, are formed at the state level by filing documents with a state agency like the Secretary of State.

The four major business entity types include sole proprietorship, partnership, limited liability company (LLC), and corporation. The entities are expected to comply with the state laws by filing specific documents and paying any obligatory fees to set up the business legally.

Your choice of business entity will determine the organization's structure and, in turn, the documents you will need to file, your ability to raise money, how liability is determined and how taxes are paid. The type of business you wish to engage in and the number of owners will highly determine the type of business entity you choose.

Four Types of Business Entities

There are many types of business entities recognized by the state. However, these four are the major ones that business owners choose from.

1. Sole Proprietorship

A sole proprietorship is undoubtedly the easiest business entity to set up and operate. When you launch a business and are the sole owner or the operator, you are a sole proprietor under the law. This entity doesn't require registration with the state, but you might be required to apply for local business permits and licenses, depending on your industry.

Example: Service professionals like consultants and freelancers are often sole proprietors. Established businesses like retail stores with one person at the helm can also be sole proprietorships.

Pros for Sole Proprietorships:

• The business is easy to start as you don’t need any state registration.
• Corporate formalities and paperwork requirements are not necessary when setting up.
• With this type of structure, tax filing is easy. You don't separate your tax as either business or personal; you only file one tax.
• You can deduct most of your business losses from your personal tax return.

Cons for Sole Proprietorships:

• You are personally liable for all business debts, which can put your personal assets at risk should your business be sued. (No limited liability protection).
• It isn't easy to secure a business loan and raise money. Lenders and investors tend to prefer corporations and LLCs.
• Building business credit and getting a business loan with an unregistered business entity is hard.

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2. Partnership

A partnership is an unincorporated business entity formed by two or more individuals. All partners agree to manage the business and share profits and losses. Partnerships come in two forms: general partnerships (GPs) and limited partnerships (LPs).

General Partnerships

A general partnership resembles a sole proprietorship closely, but for the fact that these have two or more owners. The business may not need to register depending on the state, but might need to pay for business licenses and permits depending on their industry. In most states, a general partnership is formed by signing a partnership agreement by all members.

Advantages of partnership:

• The business entity is easy to start and dissolve as you don’t need any state registration.
• Owners can deduct most of their business losses from their personal tax returns.
• Corporate formalities and paperwork requirements are not necessary when setting up.
• All owners share in any profits and losses from the business.
• Having several partners share in the start-up struggles can be very helpful.

Read more about the advantages of a partnership.

Disadvantages of a partnership:

• Each one of the owners is personally liable for business debts and liabilities.
• Building business credit and getting a business loan with an unregistered business entity is hard.
• In some states, all partners are personally liable for each other's negligent actions ( joint and several liability ).
• Each partner has independent power to loans and contracts binding the business.
• Disputes amongst the owners/partners can derail the business.
• Partnership dissolves automatically if a partner dies.

Limited Partnership

A limited partnership (LP) is a form of a registered business entity. Of the partners, only one partner has complete responsibility and general liability for the business. The others only provide money and don't actively manage the business.

The LP files returns that report the business’ income, gains, losses, and deductions. However, they don't file income tax. Profits and losses made by the LP business are passed to the business partners, with the silent partners only sharing in the profits and not the losses or liability.

Pros of a limited partnership:

• A good option for raising money as investors can join the partnership without personal liability.
• The general partner still maintains control over their business even after getting funding from limited partners.
• Limited partners can withdraw from the partnership without dissolving the business.

Cons of a limited partnership:

• General partners solely bear all business debts and liabilities.
• Setting up an LP business requires a state filing, making it more expensive to set up than a GP.
• Any limited partner of an LP who takes an active role in business risks facing personal liability.

Examples: Red Bull & GoPro, Apple & MasterCard, Airbnb & Flipboard.

Other forms of partnerships operate as legal entities fully registered with the state and with limited liability protection shielding the partners' assets. The debate on general partner vs. limited partner centers on personal responsibility and liability for business losses and liabilities. These partnerships also include the limited liability partnership (LLP) and limited liability limited partnership (LLLP).

Here is an article that explores more about partnerships.

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3. Limited Liability Company (LLC)

A limited liability company take the positive features of other businesses with liability protection. The owners of a limited liability company are only responsible for its debts up to the extent of their invested capital. That is to say, the structure of an LLC protects its owners from any personal responsibility for liabilities and debts incurred by the LLC.

Legally, a limited liability company is an entity separate from its owners. It can be owned by one individual (including another business) or many people ( multi-member LLC ), making it a valuable alternative for individual business owners. All LLCs should have a business plan and an LLC operating agreement that sets out the financial details and working relations between the owners and the managers.

Examples: Pepsi-Cola, Blackberry, Nike.

Pros of a limited liability company:

• LLC owners have no personal liability for the business's liabilities and debts.
• You have the option to choose if your LLC gets taxed as a corporation or partnership to avoid double taxation.
• LLC has fewer corporate formalities than B corp, C corp, and S corp.
• LLC have no ownership restrictions; owners can range from 1 number to whichever maximum.
• Active members of an LLC can deduct operating any operating losses against a member’s regular income

Cons of a limited liability company:

• An LLC with partners who are also employees with fringe benefits like medical insurance, parking, and group insurance must treat them as taxable income
• Profits from an LLC are subject to Medicare and social security taxes, meaning the owners might end up paying more taxes compared to owners of a corporation.
• LLC’s require registration with the state to conduct business, making them more expensive to create than partnerships or sole proprietorships.

LLCs must also have articles of organization, which is basically a founders’ agreement or internal regulations that bind and guide the operations and interactions. You will also need to agree on having a member-managed LLC vs. a manager-managed LLC.

Here is an article with more on LLCs.

4. Corporation

A corporation is a popular type of legal business entity where owners are protected by limited liability. Its charter restricts its name and scope of activities. A corporation, is a legal entity that can make a profit and be held legally liable. Stakeholders who are also employees can take advantage of certain tax-free benefits like health insurance.

Corporations cost more to set up compared to other business structures. They also require extensive operational processes, bookkeeping, reporting, and tax compliance. Corporations pay income tax on their profits and depending on the type of corporation, may at times taxed twice - from the profits and dividends. They are a good choice for businesses with medium to high risk.

There are two main types of corporations: C corporations and S corporations. C corporations have their income taxed separately from their shareholders, and therefore face double taxation. S corporations instead have their income taxed directly as part of their shareholders’ income, although they are subject to additional restrictions on their ownership. Some states tax S corporations separately in the same way as C corporations, but most states and the federal government give them this pass-through tax status.

Examples: Microsoft, Apple Inc., Walmart Inc. are all corporations.

Pros of a corporation:

• Owners/ shareholders have no personal liability to liabilities and debts of the business.
• Corporations can raise money by offering stock.
• C corporations are subject to more tax deductions than other business structures, with their owners paying lower self-employment taxes.

Cons of a corporation:

• C corporations are more expensive to create compared to partnerships and sole proprietorships.
• They face double taxation by taking corporate tax returns and still having shareholders pay taxes on their dividends.
• Has too many formalities like holding shareholder and board meetings, creating bylaws, and keeping minutes of all meetings.

Other types of corporations like S corp and B corp, also governed by corporate bylaws. When setting up, there must first be a shareholders' agreement.

There is more on Corporations in this article.

How to Create a Business Entity

1. Sole proprietorship: Write a business plan, obtain a DBA certificate if operating under a name that isn’t your own, and you are set to start operating.
2. Partnership: Operates more or less like a sole proprietorship, so follow the process above. The only extra document is a partnership agreement.
3. LLC: Write a business plan, file documents with the state, create an operating agreement, operate your business.
4. Corporation: Choose the business name, determine the initial directors, file documents with the state, draft corporate bylaws and adopt them in a board meeting, issue shares.

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