When starting a business, one of the most important steps is deciding which type of structure your organization will have.
As a business owner, you get to decide what type of legal entity1 you're going to establish, as well as what kind of organization you'd like to be taxed as. The type of business structure you choose will determine which income tax return form you file and may impact how you structure benefits and perks for yourself, your family, and your employees.
There are many forms of business ownership to choose from. How do you know which one is right for the organization you want to start?
This article will explain the different types of business entities and how each option may impact your organization.
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When do you choose an organizational structure?
Choosing a structure for your organization is one of the first tasks you'll need to complete. Before registering your new company2 with your state, you'll need to obtain a federal tax ID3 known as an employer identification number (EIN). You must choose an entity type with the IRS to get an EIN.
While some states allow you to change your organization's structure through a process called entity conversion, there may be limitations depending on your location. That's why choosing the right entity type for your organization upfront is important.
What are the different types of business ownership?
The eight business types are:
- Sole proprietorship
- Close corporation
- Limited liability company (LLC)
- Nonprofit corporation
We'll examine each of these entity types in the sections below.
Let's start off with the simplest structure. The most basic type of business structure is a sole proprietorship4 (or "sole-prop"). A sole proprietor is someone who owns an unincorporated business by themself. There is no distinction between the organization and the owner in a sole proprietorship. The owner is entitled to all profits and is personally responsible for all of the business's debts and losses. Owners also assume all personal liabilities and business liabilities.
For example, let's say you take out a loan to start your own bakery. If the profits you earn from your bakery aren't enough to cover the debt, you alone are expected to come up with the money out of pocket to pay off the loan. Likewise, if you have any personal debts unrelated to your business, a creditor could go after the profits or assets from your bakery to settle the debt.
You are automatically considered a sole proprietor if you don't register as an organization. With a sole proprietorship, you can still register a trade name for your organization, but you won't have the same access to loans and investors as other types.
Next up is partnerships5. A partnership is a single business where two or more people share ownership. Each person contributes money, property, or labor and expects to share in the profits and losses of the business.
A partnership must file an annual information return to report details like income, deductions, gains, and losses from its operations, but it doesn't pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes their share of the partnership's income or loss on their tax return.
There are four types of partnerships:
- General partnerships (all partners have equal liability)
- Limited partnerships (LPs)
- In an LP, one partner has unlimited liability, and all other partners have limited liability. The partners with limited liability have less control over the organization.
- Limited liability partnerships (LLPs)
- An LLP provides liability protection to all partners and from each other, helping to protect personal assets and business assets.
- Joint ventures (a partnership created just for a single project)
No matter the type, partners aren't considered employees, so they shouldn't be issued a W-2 form.
Here's one you've undoubtedly heard of before—corporations6. Also known as “C-corporations” or “C-corps,” a corporation is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs. So if the business goes bankrupt, the shareholders aren't personally responsible for the debts and liabilities they would be if the business was a sole proprietorship or a partnership.
Corporations are more complex than other business structures because they tend to have more administrative fees (like paying executive-level salaries and benefits or covering regular inspections) as well as complex tax and legal requirements. Because of this, corporations are more common with established, larger companies with multiple employees.
In forming a corporation, prospective shareholders exchange money, property, or both for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions7. For example, C-corps are the only kind of corporate entity that can deduct contributions to eligible charities as a business expense, so long as they aren't more than 10 percent of taxable income in a given year. A C-corporation is recognized as a separate taxpaying entity for federal income tax purposes. A corporation conducts business, realizes net income or loss, pays taxes, and distributes profits to shareholders.
The profit of a corporation is taxed to the corporation when earned and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation doesn't get a tax deduction when distributing dividends to shareholders. Shareholders also can't deduct any loss from the corporation.
C-corps are great options for organizations that need to raise funds from investors or that plan to go public on the stock market.
C-corporations are synonymous with corporations, but they aren't the only type. The three types of corporations are C-corporations, S-corporations, and B-corporations.
Here's where it gets a little tricky, so let's break it down. An S-corporation8 ("S-corp") is a special type of corporation created through an IRS tax election. An eligible domestic corporation or limited liability company (LLC) can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S-corporation.
S-corporations pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S-corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates, which allows S-corporations to avoid double taxation on the corporate income.
However, just like C-corporations, shareholders aren't personally responsible for any liabilities or debt incurred by the business. S-corporations are responsible for tax on certain built-in gains and passive income at the entity level.
To qualify for S-corporation status, the corporation must meet the following requirements:
- Be a domestic corporation (where you only conduct business in your home country)
- Have only allowable shareholders, including individuals, certain trusts, and estates
- This may not include partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Be an eligible corporation
Ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations.
In summary, taxation is the biggest difference between a C-corporation and an S-corporation. If you're prepared to be taxed at both the corporate and personal levels, then becoming a C-corp could be a good option for you. However, if you'd rather save on corporate taxes and manage your profit and losses through your personal income tax, an S-corp may be the better option.
A less common type of business structure is a B-corporation9. Also known as a “B-corp,” this type of for-profit corporation is taxed similarly to a C-corp. However, it's treated differently in purpose, accountability, and transparency. That's because B-corps are mission-driven as well as profit-driven. Shareholders are expected to keep the company accountable to produce some kind of public benefit and financial profit.
Depending on the state, you may be required to submit an annual benefit report to show your company's contribution to the public good.
A few B-corporations you might have heard of include Kickstarter and Patagonia. These companies care not only about making money but also about helping people in their communities, whether it's in helping small businesses, solving hunger, or advocating for the environment.
A close corporation, also known as a closely-held corporation, is similar to a B-corp but has a different corporate structure.These organizations are generally smaller companies where shares aren't allowed to be traded publicly.
They are taxed as a C-corporation unless the shareholders decide to seek an S-corp tax status from the IRS.
Benefits of a close corporation include more freedom, more shareholder control, and limited liability for owners. However, they can also be more complex to establish and owners may be subject to double taxation.
Limited liability company (LLC)
A limited liability company10 (LLC) is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The owners of an LLC are referred to as members.
Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations, or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as separate business entities. Instead, all profits and losses are “passed through” the business to each member of the LLC like a partnership. Members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Since the federal government doesn't recognize an LLC as a business entity for taxation purposes, all LLCs must file as a corporation, partnership, or sole proprietorship on their tax return. Federal tax laws automatically classify and tax certain LLCs as a corporation.
Most states require an LLC to draft and file Articles of Organization. This document outlines the rights and duties of each member as well as any liabilities. Additionally, LLCs that file as a partnership must complete an annual report.
Many of the most recognizable organizations in the United States are LLCs, including Pepsi Co, Sony, Nike, and IBM.
Finally, there are nonprofit corporations, also known as 501(c)(3) corporations. These are charitable, religious, scientific, or educational organizations that work to benefit the public good. These organizations often receive tax-exempt status for any income they earn.
Nonprofits must file with the IRS and their state to get a tax exemption.
How does your business structure impact benefits?
Many small business owners use a Section 105 medical reimbursement plan, such as a health reimbursement arrangement (HRA), to provide a tax-advantaged health benefit to their employees. The tax benefits owners can receive on Section 105 reimbursements vary by the business's structure.
For example, C-corporation owners may offer and participate in the reimbursement plan, whereas S-corporation shareholders with more than 2% ownership may offer a Section 105 plan, but aren't eligible to participate.
It's important to keep this in mind as you start your company if you plan to offer health benefits in the future.
There are other types of benefits that work differently depending on your organization’s type. For example, S-corps must report any fringe benefits for shareholders as taxable income on their Schedule K-1 (Form 1065).
The organization type you select when starting a company can greatly impact taxation and your ability to offer benefits. Understanding the difference between the types of business entities can ensure you set your organization up for success.
Once your organization is up and running, and you've hired your first employees, you'll need to establish a benefits package to retain them. When you're ready to offer personalized benefits, PeopleKeep can help. Our personalized benefits administration software enables you to provide HRAs and employee stipends your employees will love.
Schedule a call with a personalized benefits advisor to learn more about the benefits you can provide to your employees as a small business
This blog article was originally published on August 3, 2012. It was last updated on December 1, 2022.