The Different Types of Business Entities
While there are a variety of designations at the state level for federal tax purposes there are only six forms of business organizations:
- Sole Proprietor (Form 1040 Schedule C or Schedule F),
- C-Corporation (Form 1120),
- S-Corporation (Form 1120S),
- Partnership (Form 1065),
- Trust (Form 1041), and
- Non-profit organization (Form 990)
You may notice that the limited liability company (LLC) is not listed above. That's because an LLC can be treated (for tax purposes) as a sole proprietor, as a partnership, as a C-corporation, or as an S-corporation.
The owners of the limited liability company (LLC) can pick which tax treatment will apply. By default, an LLC with just one owner is considered a disregarded entity, with the result that the LLC is treated for tax purposes in the same way that the owner of the LLC is taxed.
By default, an LLC with two or more owners is considered a partnership. An LLC can opt out of the default treatment by electing to be treated as a Corporation. After electing to be treated as a corporation, owners of an LLC can further elect to be treated as an S-corporation.
Overview of Each Type of Business Organization
- Sole proprietors are unincorporated businesses. They are also called independent contractors, consultants, or freelancers. There are no forms you need to fill out to start this type of business. The only thing you need to do is report your business income and expenses on your Form 1040 Schedule C. This is the easiest form of business to set up, and the easiest to dissolve. (An LLC with only a single shareholder, a so-called single-member LLC, is taxed as a sole proprietor on a Schedule C.)
- C-Corporations are incorporated businesses. The shareholders of C-corporations have limited liability protection, and corporations have full discretion over the amount of profits they can distribute or retain. Corporations are presumed to be for-profit entities. Corporations must have at least one shareholder.
- S-Corporations are a type of corporation. The shareholders of S-corporations have limited liability protection, and the corporations have full discretion over the amount of profits they can distribute or retain. An S-corporation must have at least one shareholder, and cannot have more than 100 shareholders. The net income of the S-corporation is imputed as income to the shareholder, even if the S-corporation decides to retain some or all of the net income.
- Partnerships are unincorporated businesses. Like corporations, partnerships are separate entities from the shareholders. Unlike corporations, partnerships must have at lease one General Partner who assumes unlimited liability for the business. Partnerships must have at least two partners. The net income of the partnership is imputed as income to the partners, even if the partnership decides to retain some or all of the net income.
- Trusts are usually formed upon the death of an individual and are designed to provide continuity of the investments and business activities of the deceased individual. We will not discuss trusts further.
- Nonprofits are corporations formed for a charitable, civic, or artistic purpose. Nonprofits are generally exempt from federal and state taxation on their income, and so they are often called "exempt organizations." Nonprofits reporting their activities, income, and assets to ensure that they are in compliance with federal and state laws governing charities.
As mentioned above, sole proprietors, S-corporations, and partnerships are taxed at the shareholder level. Corporations, however, are taxed at the corporate level. Business considerations play a crucial role in deciding which form of organization is best for your enterprise. Balance the tax benefits of incorporating with various business and legal needs.