Business 101: Types of Entities
There are four types of business entities - S-Corp, Partnership, Sole Proprietorship, and Corporation - all distinct legal structures for businesses.
So what’s the difference? Here’s the short story:
Sole Proprietorship: A sole proprietorship is the simplest form of business entity. It's owned and operated by a single individual who is personally responsible for all aspects of the business. Sole proprietors are not taxed separately from their business income, and they have unlimited personal liability for business debts and obligations.
Partnership: A partnership is a business owned by two or more people who share the profits and losses of the business. There are two main types of partnerships: general partnerships and limited partnerships. In a general partnership, all partners are personally liable for the business's debts and obligations. In a limited partnership, one or more partners have limited liability, while others have unlimited liability.
Corporation: A corporation is a separate legal entity that is owned by shareholders. Corporations can be publicly traded or privately held. Shareholders have limited liability for the corporation's debts and obligations, and the corporation pays taxes on its profits.
S-Corporation: An S-Corporation is a special type of corporation that provides the limited liability protection of a corporation while also allowing the company's profits and losses to be passed through to its shareholders for tax purposes. This means that S-Corporations are not taxed at the corporate level, but rather the shareholders are taxed on their share of the company's profits.
Each type of entity has its own advantages and disadvantages, and the best choice depends on the specific needs and goals of the business. It's important to consult with a legal or financial professional before deciding which type of entity to choose.
For those who want even more information before going into those conversations, here’s the long story:
A sole proprietorship is a type of business entity where an individual owns and operates a business as a single person, without forming a separate legal entity. In a sole proprietorship, the owner is personally responsible for all aspects of the business, including its debts and liabilities.
One of the main advantages of a sole proprietorship is that it is simple and easy to set up and operate. There are few formalities or legal requirements, and the owner has complete control over the business. The owner also receives all of the profits from the business.
However, a major disadvantage of a sole proprietorship is that the owner has unlimited personal liability for the debts and obligations of the business. This means that the owner's personal assets, such as their house or savings, could be at risk if the business incurs significant debts or is sued.
Additionally, a sole proprietorship may have limited access to capital and resources compared to other types of business entities, such as corporations or partnerships. It can also be more difficult for a sole proprietorship to raise funds or attract investors.
Sole proprietorships are commonly used by freelancers, consultants, and small business owners who operate on their own and do not require the benefits of limited liability protection or access to significant capital.
A partnership is a type of business entity in which two or more individuals or entities (such as corporations or other partnerships) own and operate a business together, sharing in the profits and losses of the business.
In a partnership, the partners contribute capital, labor, or other resources to the business, and in return, they share in the profits and losses according to their ownership interest. The partners also have joint and several liability for the business's debts and obligations, which means that each partner is personally liable for the entire amount of the partnership's debts and obligations.
There are two main types of partnerships: general and limited. In a general partnership, all partners are personally liable for the business's debts and obligations, and they have equal management rights and responsibilities. In a limited partnership, one or more partners have limited liability for the business's debts and obligations, while others have unlimited liability. The partners with limited liability are typically passive investors who do not participate in the management of the business.
Partnerships are typically governed by a partnership agreement, which outlines the terms and conditions of the partnership, including the rights and responsibilities of each partner, the division of profits and losses, and the procedures for dissolving the partnership. A partnership agreement is not required by law, but it is recommended to avoid disputes and misunderstandings among the partners.
A corporation is a type of legal entity that is separate and distinct from its owners, who are known as shareholders. A corporation can enter into contracts, sue and be sued, and own property in its own name.
In a corporation, shareholders own the company and elect a board of directors to oversee the management of the company. The board of directors then hires officers and employees to manage the day-to-day operations of the business. Shareholders are not involved in the management of the company unless they also serve as directors or officers.
One of the main advantages of a corporation is that it provides limited liability protection to its shareholders, which means that the personal assets of the shareholders are generally protected from the company's debts and liabilities. However, this protection is not absolute, and there are some situations in which shareholders may be held personally liable for the company's obligations.
Another advantage of a corporation is that it can issue stock to raise capital and attract investors. This can make it easier for the company to raise funds to grow and expand.
Corporations are subject to more complex legal and regulatory requirements than other types of business entities, such as partnerships and sole proprietorships. They must follow certain formalities, such as holding annual shareholder meetings and keeping corporate records, and they are subject to federal and state tax laws. The extra work to complete these requirements is generally outweighed by the benefits of limited liability and access to capital that a corporation provides.
An S Corporation, or S-Corp for short, is a type of corporation that provides the benefits of limited liability protection to its owners (known as shareholders), while also allowing the profits and losses of the company to be passed through to the shareholders' personal tax returns.
To qualify for S-Corp status, a corporation must meet certain eligibility requirements and file an election with the IRS. Some of the requirements include having no more than 100 shareholders, having only one class of stock, and all shareholders must be U.S. citizens or residents.
One of the primary benefits of an S-Corp is that the company's profits and losses are not subject to corporate-level taxation, which means that the company itself does not pay federal income taxes on its profits. Instead, the profits and losses are passed through to the shareholders, who report them on their personal tax returns.
Another benefit of an S-Corp is that it provides limited liability protection to its shareholders, which means that the personal assets of the shareholders are generally protected from the company's liabilities and debts.
However, S-Corps are subject to some additional restrictions and requirements compared to other business entities. For example, S-Corps must follow certain rules regarding the allocation of profits and losses among shareholders, and they must file annual reports with the state in which they are incorporated.
What about an LLC?
No, an LLC (Limited Liability Company) is not a type of corporation. LLCs and corporations are both types of business entities, but they are distinct legal structures with different characteristics.
Corporations are owned by shareholders and are generally subject to more formalities and regulations than LLCs. Corporations can issue stock, which can be bought and sold by shareholders, and they are taxed as separate entities from their owners. Corporations can also have different classes of stock with different rights and privileges.
On the other hand, LLCs are owned by members and are generally less formal and more flexible than corporations. LLCs can have different classes of membership interests, but these are generally not bought and sold in the same way that stock in a corporation is. LLCs are taxed as pass-through entities, meaning that the profits and losses of the company are passed through to the members and reported on their individual tax returns.
While both LLCs and corporations offer limited liability protection to their owners, they have different legal structures, tax treatments, and ownership models.
What about a non-profit?
A non-profit organization is a type of corporation. Non-profit organizations are typically organized as corporations under state law (your state may differ), with specific provisions in their articles of incorporation that establish their non-profit status. Non-profit corporations are typically formed for charitable, educational, religious, scientific, or literary purposes, and are exempt from paying certain taxes.
Non-profit corporations are owned by their members or governed by a board of directors, and are subject to state and federal laws that regulate non-profit organizations. Non-profit corporations must meet certain criteria to maintain their tax-exempt status, such as limiting their activities to specific charitable or educational purposes, and not distributing profits to individuals or shareholders.
While non-profit corporations are similar to for-profit corporations in terms of their legal structure, ownership, and governance, they are subject to different regulations and tax treatments. Non-profit corporations may be eligible for tax exemptions and deductions, and may be required to file additional paperwork with the IRS and state regulatory agencies to maintain their tax-exempt status.
What about Independent Contractors?
No, an independent contractor is not a type of corporation. An independent contractor is a person who provides services to another party under a contract or agreement, but who is not an employee of that party. Independent contractors may work for themselves or for a business entity, such as a sole proprietorship, partnership, LLC, or corporation.
While independent contractors may work for corporations or other types of businesses, they are not themselves corporations. Independent contractors are considered self-employed, and are responsible for paying their own taxes, obtaining their own insurance, and managing their own business operations. They are not employees of the business they work for, and are generally not entitled to benefits such as health insurance or retirement plans.
In contrast, corporations are legal entities that are formed under state law, and are owned by shareholders or members. Corporations can have employees, independent contractors, or both, and are subject to different tax rules and regulations than independent contractors. While independent contractors may work with or for corporations, they are not themselves corporations.
Not sure what kind of business entity you are looking to set up? It’s best to talk to an accountant and tax professional before you have to set something up twice! Feel free to set up a meeting to talk!