Comparison of the Three Different Types of Business Entities

You've decided to take the plunge and start your own business. But before you do anything, you should compare and contrast the different business types under which you can operate. Each has different tax liabilities, management structures, and other considerations that you need to carefully think about before starting your operation. Here’s a brief comparison of the three types of entities:

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Sole Proprietorships

Flower shop owner
Photo: John Lund/Marc Romanelli/Getty Images

Most freelancers or small business contractors start off as sole proprietors. That's because they are usually the only employee of the business—think writers, artists, interior designers, and traditional one-person operations like house cleaners and lawn maintenance providers. As such, sole proprietors report only to themselves.

The downside is that as a sole proprietor you will assume unlimited liability for the debts of your company. That means that the court can order any of your personal assets (home, car, savings account, etc.) to be liquidated to pay for your business debts.

As for taxes, you must pay what often amounts to a high self-employment tax, and you will also be taxed at the individual tax rate at the federal and state level.

The upside is that you won't have to file any paperwork with the state or the IRS to start your business. However, you will be required to get a business license from the city and county (or both) in which you operate your business. You'll probably need to get a sales tax certificate from your state department of revenue as well.

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A corporation is a business made up of a group of people that together are considered a single entity with its own identity. Many business owners incorporate because, with few exceptions, the people working for that corporation—including the owner, shareholders, and officers—are not liable for any corporate debts. That means that creditors cannot attach any of their personal assets. 

Incorporating a business is handled at the state level. To incorporate your business, you normally file paperwork, called articles of incorporation, with your secretary of state. Most states require this filing be renewed yearly. The amount all this costs will differ depending on where your business is located.

As for taxes, corporations are taxed at a special rate, using special forms. The individuals in the company only pay taxes on the income derived from their positions (i.e. their salaries), not on any of the profits made by the company. 

Finally, the management style of a corporation is centralized, meaning that shareholders vote in the board of directors, who select the managers to run the company. 

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Flow-Through Entities

Flow-through, or pass-through, companies are those that, like the sole proprietorship (and unlike the traditional corporation), report and pay taxes on income made from their companies on their personal tax return. There are a few different types of flow-through entities, including the partnership, S-Corporaton, or limited liability company (LLC).

If you plan to go this route, the S-Corporation is the most easy flow-through entity to manage. While a partnership is similar to a sole proprietorship, it has at least two owners, including "silent" partners," who assume responsibility for the business. An S-Corporation (think corporation "lite"), on the other hand, needs to have only one shareholder. This makes an S-Corp a good option for people who don't want to assume the liabilities of a sole proprietorship. The number of additional shareholders is limited by the current internal revenue code, but most small businesses won't exceed the limit.

An LLC likewise enjoys the benefits of pass-through taxation and limited liability, but, unlike an S-Corp, the owners need not be U.S. citizens or residents and they are not required to hold annual meetings.