Sole proprietorship, partnership, LLC, or corporation – which is best?

Starting a business is exciting. But how to structure it can be daunting. Nonetheless, one of the most important decisions you'll make early on is choosing the best legal structure for your new business.

So what'll it be? Sole proprietorship, partnership, LLC, or corporation? And how do you decide which is best for you?

Great questions because your decision will profoundly impact many things. Among them are ownership options, perceived credibility, ability to raise money, ability to attract people, personal liability protection, and tax savings. You must understand how each of these is affected by your choice of entity.

Unfortunately, most new entrepreneurs discount the significance of entity choice. They merely slide into business and end up with a business structure they neither intend nor understand and expose themselves to unlimited personal liability and unnecessary taxation.

On the other hand, when armed with a clear understanding of your options and careful planning, you'll have the ideal legal structure, avoid unnecessary risk, and maximize tax savings.

So let's go back to where we began.

You have four primary business structures to choose from when starting your for-profit business. They are sole proprietorship, general partnership, LLC, and corporation.

We'll look at each at the highest level. In subsequent posts, I'll discuss each entity in more detail.

Sole Proprietorship

Ownership. Your business is a sole proprietorship if you are the sole owner and do not formally organize as a corporation or LLC.

Credibility. Due to the informality of a sole proprietorship and the fact that you are the sole owner, you take a hit on credibility. There is only one person with skin in the game that your customers can depend on. If you leave or die, the business leaves or dies with you.

Raising capital. You only have two reliable sources of money: (1) your personal assets and (2) loans you guarantee and secure with those assets.

Personal liability. When something goes wrong, everything you own is at risk. You are personally liable for all business debts, taxes, obligations, and liabilities, as well as any legal claims against employees acting within the course and scope of their employment.

Taxation. You report business revenue and expenses on IRS Schedules C and SE with IRS Form 1040.

General Partnership

Ownership. Your business is a general partnership when you and at least one other person own it and do not formally organize it as a corporation, LLC, or limited partnership.

Credibility. Due to the availability of more capital and because there are multiple owners, customers perceive general partnerships as a slightly more credible business structure. Third parties feel more comfortable dealing with a business with more financial and human resources.

Raising capital. In addition to your assets and credit, you have access to those of your partner.

Personal liability. As a general partner, you are 100% personally liable for all partnership debts, taxes, obligations, and liabilities. You are also responsible for legal claims against employees acting within the course and scope of their employment.

To make matters worse, you can even be held liable for personal debts that your partner charges to the business.

Taxation. Your general partnership files IRS Form 1065 but does not pay income tax. Instead, profits and losses pass to each partner on IRS Form K-1. In turn, each partner reports their share of profit or loss on IRS Form 1040.

Limited Liability Company (LLC)

Ownership. When you file Articles of Organization (or similar charter document) with the state, observe certain limited formalities, and comply with state regulations, you have an LLC. There can be one or more owners, referred to as members.

Credibility. Due to the formalities of forming an LLC, customers perceive them as a more credible business structure than a sole proprietorship or general partnership.

Raising capital. Your ability to raise money as an LLC depends on whether you are a single-member or multiple-member company.

As a single-member LLC, you will still depend upon your assets alone.

As a multiple-member LLC, you have access to other members' assets.

Furthermore, with an LLC, you can sell membership interests to investors who can act as silent partners, an option not available to you as a sole proprietor.

Finally, an LLC can ultimately establish credit in its name, without the personal guarantee of any member, when it has a proven track record of solid recurring revenue.

Personal liability. As an LLC member, you are not personally liable for the LLC's debts, taxes, obligations, and liabilities or any legal claims against any of your employees that act within the course and scope of their employment. Your liability is limited to your investment in the business.

Taxation. By default, the IRS treats single-member LLCs as disregarded entities (sole proprietorships) and multiple-member LLCs as general partnerships.

A single-member LLC treated as a disregarded entity reports business revenue and expenses on IRS Schedules C and SE with IRS Form 1040.

A multiple-member LLC treated as a partnership completes IRS Form 1065 but does not pay income tax. Instead, profits and losses pass to each member on IRS Form K-1. In turn, each member reports their share of profit or loss on IRS Form 1040.

Notably, LLCs can elect to be taxed as a C or S corporation.

Corporation

Ownership. When you file Articles of Incorporation (or a similar charter document) with the state, observe certain formalities, and comply with state regulations, you have a corporation. There can be one or more owners, referred to as shareholders.

Credibility. Customers perceive a corporation as the most credible business structure. You prove your legitimacy and professionalism because you are willing to make the financial and time commitment necessary to stand above your competitors by formally structuring and organizing your company as a corporation.

Raising capital. A corporation has the ultimate flexibility to acquire financial and human capital. A corporation can issue shares to new investors and go public. Furthermore, you can offer employees stock and enhanced tax-free benefits, enabling you to attract and retain top talent.

Personal liability. As a corporate shareholder, you are not personally liable for the corporation's debts, taxes, obligations, and liabilities or any legal claims against employees acting within the course and scope of their employment. Your liability is limited to your investment in the business.

Taxation. By default, the IRS treats a new corporation as a C-corporation. C-corporations file IRS Form 1120 and pay taxes on their profits.

However, by making an S-corporation election with the IRS, a corporation can elect to be taxed like a partnership. S-corporations file IRS Form 1120-S and do not pay taxes on their profits. Instead, profits (and losses) pass to the shareholders in proportion to their ownership interest on IRS Form K-1. Each shareholder reports the profit or loss on IRS Form 1040.