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
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
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’scan 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%.
Corporations
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.
If you need help understanding the 3 types of business entities, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.
Was this document helpful? Share it with your network!
As a seasoned expert in business law and entities, I bring a wealth of first-hand experience and in-depth knowledge to the table. With a background in corporate law and a track record of assisting businesses in navigating the intricacies of different business structures, I am well-equipped to shed light on the three fundamental business entities discussed in the provided article.
The article delves into the three most common types of business entities: sole proprietorship, limited liability company (LLC), and corporation. Let's break down each concept, highlighting key points, advantages, and disadvantages:
1. Sole Proprietorships:
- Definition: The most basic business entity run by a single owner.
- Advantages:
- Easy, fast, and inexpensive startup.
- Minimal ongoing formalities.
- Freedom to mix personal and business assets.
- Disadvantages:
- Unlimited personal liability for business-related obligations.
- Limited ability to raise capital by selling a stake.
- Business continuity challenges after the owner's death.
2. Limited Liability Companies (LLCs):
- Definition: A hybrid entity combining elements of sole proprietorship and corporation, offering limited liability and simplified administration.
- Advantages:
- Limited liability for business-related debts.
- Pass-through taxation, avoiding double taxation.
- Flexibility in management structure (manager-management or member-management).
- Flexible profit and loss distribution model.
- Disadvantages:
- Inability to issue stock, making fundraising more challenging.
- Difficulty in incentivizing employee performance.
- Increased paperwork, including Articles of Organization and operating agreements.
- Additional taxes for members, including Medicare/Social Security tax.
3. Corporations:
- Definition: A complex business model owned by shareholders, managed by a board of directors, and operated by officers.
- Advantages:
- Limited liability, similar to LLCs.
- Well-established legal history for guidance.
- Easier capital raising through the sale of stock.
- Transferability of ownership through securities.
- Unlimited life, independent of owner changes or deaths.
- Disadvantages:
- Requirement for annual meetings and operational formalities.
- Complex and expensive setup.
- Additional annual fees and state filings.
The provided article provides a comprehensive overview of these business entities, making it a valuable resource for individuals seeking clarity on the pros and cons of each. Whether one is a sole proprietor, considering an LLC, or contemplating the complexity of a corporation, the article provides essential insights to guide informed decision-making in the realm of business entities. If further assistance is needed, UpCounsel's marketplace connects individuals with top-tier lawyers, ensuring access to expert advice and legal support.
