3 Types of Business Entities: Everything You Need to Know
The 3 types of business entities that are most common are the sole proprietorship, limited liability company (LLC), and corporation. Each has their own distinct advantages and disadvantages, depending on what you and your business need.3 min read
2. Sole Proprietorships
3. Limited Liability Companies (LLCs)
The 3 Basic Business Entities
The 3 types of business entities that are most common are the sole proprietorship, limited liability company (LLC), and corporation. Each has their own distinct advantages and disadvantages, depending on what you and your business need.
Sole proprietorships are the most basic business entity. They are run by one business owner who has both all the decision-making power in the company, but also all of the liability. This means that any business-related expenses will come directly out of their personal finances, since personal and business finances will be intermingled. The sole proprietorship may appeal to those who have no interest in running a large business or going through a more involved start-up process.
Advantages of the sole proprietorship include:
- Easy, fast, and cheap start up.
- Few, if any, ongoing formalities.
- No unemployment tax for the business owner.
- Freedom to mix personal and business assets.
While disadvantages of this business model include:
- Unlimited personal liability related to losses, debts, and other business liabilities.
- Inability to raise capital by selling stake in the business.
- Little possibility for the business's continuation after the sole proprietor’s death.
Limited Liability Companies (LLCs)
A step up from the sole proprietorship in terms of complexity is the limited liability company, or LLC. The LLC was created in state legislatures in the 1980s and 1990s as a hybrid of the sole proprietorship and corporation with the intent of stimulating growth in small business. As such, this entity combines the simpler administration and tax treatment of the sole proprietorship with the limited liability protections of the corporation. It is most popular with those looking to have an operation bigger than an sole proprietorship but not as complex as a corporation.
Advantages of the LLC include:
- Limited liability for business-related debts and legal issues.
- Profits and losses being reported on your individual return, rather than taxed at both the corporate and individual level. This is called “pass through taxation,” which avoids “double taxation,” thus saving you money.
- No necessity for an LLC to be managed by its members; outside managers can be brought in to run the company, if this is deemed preferable. This situation is called manager-management, while the former is called member-management.
- A flexible distribution model. The LCC’s profit and loss distribution model also does not have to abide by a strict structure. Corporations require distribution to be proportional to investment, while LLC’s can set up almost any distribution model they desire.
Disadvantages of the LLC, on the other hand, include:
- An inability to issue stock, which makes it more difficult to raise money through a sale of shares in the company. If more flexibility in financing is desired, the LLC may not be ideal.
- Greater difficulty in incentivizing employee performance. The cost of benefits cannot be deducted with an LLC, nor can stock options be offered to your employees.
- More paperwork. LLCs must file Articles of Organization in order to be established, and it is recommended that an operating agreement detailing the rights and responsibilities of the members be drafted. EIN number application, tax status selection, annual report filing, and other filings may be necessary.
- More taxes. LLC members must pay the Medicare/Social Security tax and self-employment tax, which come to 15.3%.
The most complex of the major business models is the corporation. It is a business that is owned by shareholders, managed by a board of directors, and operated by officers. It is often used when having a large operation is envisioned as the end goal.
Advantages of the corporation include:
- The same limited liability advantage as LLCs.
- A reliable body of legal history for owner guidance; LLCs have not been around as long.
- Greater ease in raising capital. Stock can be sold privately or publicly.
- Ownership can more easily be transferred through the use of securities.
- Unlimited life. Corporations need not fold with the departure or death of the owner or owners.
Corporation disadvantages include:
- Annual meetings and other operational formalities are required.
- Set up is more complicated and expensive.
- There are more annual fees and state filings involved.
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