What Type of Business Entity Should You Create?

When you start a business, you will need to decide on a legal structure for it. For most, the choice will be either a sole proprietorship, partnership, limited liability company (LLC), or corporation. What type of entity you choose will usually depend primarily on the number of business owners involved in the business and the legal liability protection you want to have.

Sole Proprietorships and Partnerships

The simplest and least expensive type of business to establish is either a sole proprietorship (if there is one owner) or a partnership (if there are two or more owners). Many small businesses start out as one of these two types of businesses, especially if the business is one where personal liability is not a big concern. You don't have to file any organizational documents with the state or pay any special fees to begin operating as a sole proprietorship or partnership. You simply open for business once you have obtained all the business licenses and permits you need and have complied with any other applicable state or local laws.

LLC and Corporations

Forming an LLC or a corporation is more complicated and costly, but may be worth the extra time, trouble, and cost depending on the type of business you have. The primary reason people choose an LLC or corporation is because of the protection these types of entities provide to business owners against personal liability for business debts and court judgments against the business. They also can have certain tax advantages, such as more favorable tax rates. In addition, with an LLC or corporation you can offer fringe benefits to employees (including the owners) and deduct the cost as a business expense.

Setting up and maintaining an LLC is usually less complicated and less expensive than forming a corporation. LLCs have become a popular choice for businesses because they combine the pass-through taxation of a sole proprietorship and partnership and provide the same protection against personal liability that corporations offer. But there may be situations where a corporation would be a better choice. For example, a corporation—unlike other types of business entities—can issue stock to owners which can make it easier to bring in outside investors.

Keep in mind that your initial choice of a business form doesn't have to be permanent. You can start out as a sole proprietorship or partnership and, later, if your business grows or the risks of personal liability increase, you can convert your business to an LLC or a corporation.

For some business owners, a less common type of business structure may be appropriate. While most small businesses will find at least one good choice among the four basic business structures described above, a handful will have special situations in which a different type of entity makes more sense. For example, two dentists looking to limit their personal liability may need to set up a professional corporation or a professional limited liability company. Or, a group of real estate investors may find that a limited partnership is the best vehicle for them.

Excerpted from Legal Guide for Starting & Running A Small Business, by Fred Steingold (Nolo).

If you have questions or concerns about what business structure makes the most sense for your business, consult an experienced business attorney.

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