Choosing the Right Business Structure

The entity you choose for a business determines two things above all: whether your personal assets are exposed to business debts and lawsuits, and how profits are taxed. Formation is governed by state law and tax treatment by federal law, which is why an LLC formed under state law can be taxed several different ways. The summaries below describe the general rules.

Sole Proprietorship

A sole proprietorship is the default when one person does business without forming an entity. There is nothing to file to create it, though a local business license or a fictitious name (DBA) registration may be required.

There is no legal separation between the owner and the business, so the owner is personally liable for every business debt and claim — personal savings and property are at risk. For taxes, income and expenses are reported on Schedule C of the owner's personal return, and net earnings are subject to self-employment tax as well as income tax.

General Partnership

A general partnership forms automatically when two or more people carry on a business for profit together, even without paperwork. A written partnership agreement is strongly advisable because state default rules otherwise govern profit splits, decision-making, and what happens when a partner leaves.

Each partner is personally liable for partnership obligations, and in most states that liability is joint and several — a creditor can pursue one partner for the entire debt. Partners can also bind the partnership through their own actions. The partnership itself pays no income tax; it files an informational return and each partner reports their share on their personal return, generally subject to self-employment tax.

Limited Liability Company (LLC)

An LLC is created by filing articles of organization with the state. Members are generally not personally liable for the company's debts, so exposure is usually limited to what they invested — provided formalities are observed, finances are kept separate, and the company is adequately capitalized. Personal guarantees on loans and a member's own negligent acts remain personal responsibilities.

By default, a single-member LLC is disregarded for federal tax purposes and reported on the owner's return, while a multi-member LLC is taxed as a partnership. An LLC may instead elect to be taxed as a C corporation or an S corporation. LLCs offer flexible management and profit allocation through an operating agreement, though some states impose annual fees or franchise taxes.

C Corporation

A C corporation is a separate legal entity formed by filing articles of incorporation. Shareholders enjoy limited liability, and the structure — a board of directors, officers, stock, bylaws, and recorded meetings — is the familiar framework for outside investment. Venture investors generally expect a corporation, often a Delaware one.

The trade-off is double taxation: the corporation pays tax on its profits, and shareholders pay again on dividends they receive. Salaries paid to owner-employees are deductible to the corporation, which is one reason closely held corporations often distribute profits as reasonable compensation. Corporations also carry the heaviest compliance requirements.

S Corporation

An S corporation is not a separate entity type but a federal tax election available to eligible corporations and LLCs. Profits and losses pass through to shareholders' personal returns, avoiding entity-level federal income tax while preserving limited liability.

Eligibility is restricted: generally no more than 100 shareholders, only individuals and certain trusts and estates as shareholders, no nonresident alien shareholders, and only one class of stock. Owner-employees must be paid reasonable compensation subject to payroll taxes, with remaining distributions not subject to self-employment tax — the main reason the election is popular. Some states tax S corporations differently than the federal rules.

Limited Partnership and Limited Liability Partnership

A limited partnership (LP) has at least one general partner who manages the business and is personally liable, and one or more limited partners who invest and receive liability limited to their contribution, provided they do not participate in management. LPs are common in real estate and investment funds.

A limited liability partnership (LLP) allows all partners to participate in management while shielding each from liability for other partners' negligence and, in many states, from general partnership debts. Several states restrict LLPs to licensed professionals such as attorneys, accountants, and architects. Both are pass-through entities for tax purposes.

Factors to Weigh

• Liability exposure: how likely is a claim in your industry, and what insurance is available alongside the entity's protection?
• Tax treatment: pass-through versus entity-level tax, self-employment tax, and how much profit you plan to reinvest rather than distribute.
• Outside investment: whether you will raise capital, and whether investors will expect stock in a corporation.
• Ownership and succession: how many owners, whether interests will be transferred, and what happens if an owner leaves or dies.
• Cost and administration: state filing and franchise fees, annual reports, recordkeeping, and payroll requirements.
• State of formation and where you operate: registering as a foreign entity in other states adds cost and filings.

Because entity choice affects both legal exposure and tax bills for years, most owners benefit from reviewing the decision with a business attorney and a tax professional before filing — and revisiting it as the business grows.