A sole proprietorship, LLC, and corporation are three of the structures you can choose for your business. Because each has its strengths and weaknesses, it's best to examine them all in closer detail to help with your decision.

Choosing Your Entity

When you're operating a business, there's almost no more important decision than picking your entity type. In addition to impacting your chances of success, the entity you choose will influence your tax burden and whether you will be personally liable for the debts of your company. While each entity type has its advantages, no entity will meet the needs of every business.

A variety of factors you need to consider when trying to select your entity are:

  • Your industry.
  • Your business location.
  • How many owners your business has.
  • An exit strategy for leaving your business.

Business owners should do a great deal of research before choosing their entity.

Sole Proprietorships

The most common business entity is a sole proprietorship. These businesses are very easy to structure because they require one sole owner. The business and the owner are the same from a legal standpoint. The primary benefits of sole proprietorships are their easy setup and their simple taxation.

The drawbacks of this structure involve personal liability. Because the owner and the business are legally indistinguishable, the owner is personally liable for all debts of the business. This can include lawsuit judgments. Sole proprietorships do not provide liability protections for business activities. You should keep this fact in mind if your industry exposes to you a high amount of risk. Although your personal liability increases, sole proprietorships do offer much more streamlined taxes.

Like limited liability companies (LLC), the IRS treats sole proprietorships as disregarded entities. With a disregarded entity, the business is never taxed directly. Business income is instead reported on the business owners 1040 Form.

Limited Liability Company

One of the more recently created entity types is a limited liability company. State law creates these entities, and when you form an LLC, you will be able to elect your tax status with the IRS. LLCs can opt for being taxed as a corporation, partnership, or sole proprietorship.

LLCs are very simple to form and offer flexibility in several areas, which is why they are one of the most popular entity types. With an LLC, company owners will receive personal liability protections that are similar to those of a corporation.

One disadvantage of LLCs is that some states require that the company be dissolved if an owner dies or leaves the company. If you are the only owner of your business, you can convert to a single-member LLC so that you will be personally protected from business debts. Those who earn freelance income can set up an LLC to avoid paying business and personal taxes on this income. LLCs have the option of being taxed as pass-through entities, which means that expenses and incomes show up on the personal return of the business operator.

C Corporations

For business owners who one day plan to take their company public and sell stock on an exchange, the best option is structuring as a C corporation. C corporations are legal entities that are separate from their owners, who are known as shareholders. With a C corporation, a shareholder's personal assets receive protection from business liabilities.

Unfortunately, double taxation applies to C corporations, which is a fairly large drawback. The profits of a C corporation get taxed twice: Once at the corporate level and then again at the personal level on the shareholder's tax returns. C corporations are also required to observe strict formalities such as holding annual shareholder meetings. If these formalities are not observed, the shareholders of the company may lose their personal liability protections.

S Corporations

For small businesses, one of the most beneficial entity types is an S corporation. S corporations provide the same limited liability protections of C corporations while also offering the beneficial taxation of partnerships. Unfortunately, not every business is able to structure itself as an S corporation.

For example, S corporations can only have 100 shareholders or less, and the shareholders are either U.S. citizens or resident aliens. Like C corporations, S corporations must follow corporate formalities to preserve their shareholder's liability protections.

If you need help choosing between a sole proprietorship LLC corporation, you can post your legal needs on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.