Sole Proprietorship, LLC or Corporation? How to Choose a Business Structure

Choosing a business structure is one of the first legal decisions you’ll make as a business owner. It affects how you pay taxes, how much paperwork you’ll handle, how you can raise money and how much of your personal property could be at risk if the business runs into trouble. There’s no single best choice for everyone. The right structure depends on your goals, your industry, your state and your income. Here’s an overview of the most common options.

Sole proprietorship

If you start doing business on your own without forming a legal entity, you’re generally a sole proprietor by default. Many freelancers, consultants and side hustlers operate this way, often without realizing they’ve chosen a structure at all.

Sole proprietorships are simple and inexpensive. There’s usually no formal registration required beyond any local licenses and a doing business as registration if you use a name other than your own. Business profits are reported on your personal tax return, typically on Schedule C, and you pay income tax and self-employment tax on your net earnings.

The major downside is that there’s no legal separation between you and the business. You can be personally responsible for business debts and lawsuits, which means your personal assets, such as savings, a car or even your home, could be at risk if the business is sued or can’t pay its debts.

Partnership

When two or more people do business together for profit without forming another type of entity, they may be considered a general partnership. Like sole proprietorships, general partnerships are relatively simple to start.

Partners typically share profits, losses and management responsibilities. Partnerships don’t pay income tax themselves; instead, profits and losses pass through to the partners, who report them on their personal tax returns. The partnership files an informational return.

In a general partnership, partners typically share personal liability for the business’s debts and obligations, including those created by other partners. Limited partnerships and limited liability partnerships offer some liability protection for certain partners, but they involve more formal requirements.

A written partnership agreement is important. It should cover how profits are split, each partner’s responsibilities and decision-making authority, how disputes are resolved and what happens if a partner leaves, becomes disabled or dies.

Limited liability company

A limited liability company, or LLC, is formed by filing documents with your state, usually called articles of organization. LLCs are popular with small businesses because they combine some of the liability protection of a corporation with flexible tax treatment and relatively simple operations.

An LLC can help separate your personal assets from business debts and liabilities in many situations. If the business is sued or can’t pay its debts, owners’ personal assets are generally protected, though there are important exceptions.

By default, single-member LLCs are taxed like sole proprietorships and multi-member LLCs are taxed like partnerships, with profits passing through to owners’ personal tax returns. However, LLCs can elect to be taxed as a corporation, including as an S corporation, which may offer tax advantages in some situations.

States charge fees to form an LLC, and many charge annual fees or require annual reports. Fees vary widely by state. Creating an operating agreement that outlines ownership and how the business will be run is a good practice, even for single-member LLCs.

C corporation

A C corporation is a separate legal entity owned by shareholders. Corporations offer strong liability protection, and they can raise money by selling shares, which makes them common for businesses planning to seek outside investors.

C corporations are separate taxpayers. They pay corporate income tax on their profits, and shareholders pay tax again on dividends they receive. This is often called double taxation. Corporations also involve more formal requirements, such as a board of directors, bylaws, shareholder meetings, recordkeeping and annual filings.

S corporation

An S corporation isn’t a separate type of business entity. It’s a tax election that eligible corporations and LLCs can make with the IRS. S corporation status lets profits, losses and certain deductions pass through to owners’ personal tax returns, avoiding corporate-level income tax in most cases.

S corporations have eligibility rules, including limits on the number and type of shareholders and a single class of stock. Owners who work in the business must pay themselves reasonable compensation through payroll, with taxes withheld. Profits beyond that salary may be distributed without self-employment tax, which can create tax savings for some business owners. However, running payroll and meeting requirements adds cost and complexity.

Factors to consider

When choosing a structure, consider how much personal liability protection you need based on the risks of your business, how you want to be taxed, how much paperwork and cost you’re willing to manage, whether you plan to raise money from investors and how many owners the business will have.

Your choice isn’t necessarily permanent. Many businesses start as sole proprietorships and form an LLC or corporation as they grow, take on more risk or earn more income. Changing structures may involve new registrations, an EIN and tax considerations.

Get advice

Liability protection has limits, and the best structure depends on your state, income, industry and goals. The SBA has a free guide to business structures on its website. An accountant can help you understand the tax implications of each option, and an attorney can help you understand liability and legal requirements. Small Business Development Centers can also provide free guidance.