How to Choose the Right Business Structure: LLC, Corporation, or Sole Proprietorship

From personal liability to administrative costs, several factors influence whether your business should be set up as a limited liability company (LLC), sole proprietorship, or corporation. While these terms may feel intimidating at first, they don’t have to be. To simplify your decision-making process, we’ll cover all of the liability, taxes, costs, and complexity involved with each business structure.

Why Your Business Structure Matters More Than Most Founders Realize

Forming a business isn’t merely filling out paperwork. The business type you choose will affect your personal liability, tax obligations, administrative fees, and funding options.

Personal Liability

As a founder, you may be personally liable for injuries, contract violations, and other issues. In a sole proprietorship or general partnership, there is no legal separation between the owners and the business. If your business faces a lawsuit or major debts, your home and savings could be at risk. In comparison, limited liability companies, C corporations, and S corporations create a legal wall between personal and business assets.

For example, let’s assume someone trips on wet stairs and breaks their neck. If you are a sole proprietor, the injured party could go after your personal assets to recover their $500,000 in medical bills. When you incorporate as an LLC, your assets are generally protected.

How You Pay Taxes

Different types of corporations, partnerships, and sole proprietorships will have to pay different types of taxes. Sole proprietorships, partnerships, S corps, and LLCs are taxed as pass-through entities. This means all income and losses for the year ultimately appear on the owner’s personal tax return.

Meanwhile, C corporations face double taxation. On a corporate level, they must pay a 21% tax. Then, shareholders have to pay taxes on the dividends.

While LLCs are pass-through businesses by default, you can choose to be taxed as a sole proprietor, partnership, S corp, or C corp. By changing the underlying structure, you can directly affect your overall tax rate and how much you must pay in self-employment taxes.

Your Ability to Raise Money

The type of business ownership and structure will affect how you can raise money. Before you set up your business, you should carefully consider your future funding goals.

• Sole Proprietors: A sole proprietor cannot issue stock. However, the owner can obtain loans based on their own credit history.
• S Corps: An S corp’s shareholders must be United States citizens or residents. This business type can only have one stock class and a maximum of 100 shareholders.
• C Corps: This is the standard structure for venture capital (VC). C corps can issue preferred stock, have unlimited shareholders of any type or nationality, and are the only structure eligible for an eventual initial public offering (IPO). VC investors prefer C corps for practical reasons: institutional funds often include tax-exempt or foreign investors who face complications when investing in pass-through entities, and preferred stock lets VCs negotiate liquidation preferences and control terms that other structures can't easily accommodate.
• LLCs: LLCs can be used for sole proprietorships, S corps, and C corps, so they don’t inherently impact your ability to raise money. However, the underlying structure you choose will affect the types of investors, loans, and funding options you can access. Institutional investors are less familiar with LLCs.

Administrative Cost and Complexity

Some structures are far more complex than others. In general, the more flexibility and protection you get, the more administrative work you’ll need to do. 

Sole proprietorships require no fees and minimal compliance. At tax time, the sole proprietor can report their earnings on their personal income tax return. 

Meanwhile, an LLC must pay a state filing fee of $50 to $500. They are generally expected to submit an annual report and must have an operating agreement in effect.

Corporations face a higher administrative burden. S corps must pay the owner a W-2 wage, which increases the payroll costs and complexity. Annual tax filings, state-by-state registered agent requirements, and annual reports are also generally required. For a C corporation, board meetings, bylaws, and stock issuance are required. Some states also have added requirements.

The Main Business Structures

To get a better understanding of the different types of business structures, let’s take a brief look at each structure.

Sole Proprietorship

This is the basic business structure. You don’t have to register or fill out special forms. All of your business income is reported on Schedule C of your personal tax return. While you can enjoy convenient filing and registration requirements, you don’t get any liability protections.

Works Well For: Freelancers, side hustles, consultants, and low-risk businesses that want to test their proof of concept

General Partnership (GP)

A GP is the default option when two people start a business together and haven’t formally registered. Each partner is given an equal share of decision-making, profits, and liability. 

Even if a partner wasn’t involved, they can be liable for what the other partner does. Because of this, a written partnership agreement is strongly recommended.

Works Well For: Low-risk partnerships that want to test an idea before making a more formal business arrangement

Limited Liability Corporation (LLC)

By far, this is the most popular structure in the United States. While LLCs are pass-through businesses by default, you can elect an S corp or a C corp status. If you do, you will be taxed as if you were one of these corporate structures.

LLCs offer an added level of protection and flexibility. Thanks to its liability protection, members are generally not liable for the LLC’s debts. Additionally, this flexible business structure can be owned by one person or many. Management can be carried out by the members or a professional manager.

Works Well For: Small- to medium-sized businesses that want more liability protections without the added stress of a corporate entity.

S Corporation (S Corp)

An S corp is technically a tax election and not a separate entity type. Businesses can make this election with the Internal Revenue Service (IRS) to enjoy significant tax savings.

Owners in an S corp must be paid a reasonable salary, which is subject to payroll taxes. However, additional income is taxed as an owner’s distribution, which is not subject to self-employment taxes. Instead, distributions avoid self-employment taxes and pass through to the owner’s individual tax return. Someone who earns $80,000 a year and currently pays taxes as a sole proprietor could save as much as $5,000 in taxes. Meanwhile, someone who makes around $200,000 annually could save up to $12,336 at tax time.

To qualify for an S corp election, you may have no more than 100 American shareholders. You are also limited to one class of stock.

Works Well For: Profitable owner-operated businesses that already have a net income above $80,000

C Corporation (C Corp)

C corps are often considered the default corporate structure. It is considered a separate legal entity, so the corporation pays a 21% tax. This means that shareholders and the C corp face double taxation during the years when dividends are distributed. It can  issue multiple stock classes including preferred stock, have an unlimited number of shareholders of any type, and issue initial public offerings (IPOs). It is the standard option for firms seeking to raise venture capital.

Works Well For: Venture-backed startups, founders wanting qualified small business stock (QSBS) benefits under Section 1202, and companies that want to go public.

Business Structure Comparison: Side by Side

To get a closer look at how various types of corporations, partnerships, LLCs, and sole proprietorships work in practice, let’s compare the taxation type, liability protection, compliance requirements, and features associated with each structure.

How Each Structure Is Taxed

One of the most important factors in your incorporation decision is what type of tax treatment you want. To help you see the real-world impact of each decision, we’ll use an example business that brings in $100,000 in net profit. 

 

It’s important to note that these examples are simplified for illustrative purposes and do not include important factors such as tax credits and deductions.

Sole Proprietorship and Single-Member LLC Tax Treatment

When it comes to federal tax purposes, a sole proprietor and single-member LLC are taxed the same. Business income is reported on a Schedule C and paid at the individual’s personal income tax rate. However, they also must pay a 15.3% self-employment tax on top of this to cover the cost of Social Security and Medicare.

 

Out of $100,000 in net profit, someone in the 22% tax bracket will spend $22,000 on income taxes. Because the self-employment tax is only applied to 92.35% of business income, they must pay a self-employment tax of $14,130. 

 

In total, $36,130 of the $100,000 in net income must be paid in taxes.

LLC With S Corp Tax Election

When picking a tax structure, you don’t have to decide between an LLC vs. a corporation. LLCs can retain their structure and elect S corp status. In general, this approach works best for a business that already earns at least $80,000 in net profit.

An S corp owner must be paid a reasonable salary, which we will assume is $60,000. The remaining $40,000 is considered a distribution. Then, the business must pay $9,180 in payroll taxes on top of the $22,000 in income tax that is paid on the $100,000 in profits. 

In total, $31,180 of the $100,000 in net income must be paid in taxes.

C Corporation Tax Treatment

Whether you want an open corporate structure or IPO funding, a C corporation is a good place to start. In terms of taxes, a C corp pays a flat 21%. On $100,000 in profit, the C corp will pay $21,000. If some of the remaining funds are distributed to shareholders as dividends, the shareholders will have to pay between 15% and 23.8% more. In this case, the total tax could be over 35%.

However, some of these taxes can be avoided by reinvesting the funds. If the money is invested and not paid as a dividend, the shareholder doesn’t have to pay tax on it. 

Double taxation hurts owners only when profits are distributed. For high-income earners in the 37% tax bracket, retaining earnings in a C corp can offer significant benefits.

Partnership Tax Treatment

This is another structure that relies on pass-through taxation. Each partner must use a Schedule K-1 to pay taxes on profits. They are responsible for income tax and self-employment tax for any profits. On a federal level, the business does not have to file or pay its own taxes.

Even though the partners’ business is run together, taxes are done separately. Each partner is individually responsible for reporting and paying taxes on their portion of the profits.

How To Choose the Right Structure: A Decision Framework

Confused about the difference between an LLC vs. corporation? To help you choose between the various types of business ownership, we’ve broken down the decision-making framework into five key questions.

Question 1: How Much Personal Liability Risk Does Your Business Carry?

As a general rule, you need liability protection anytime a lawsuit could bankrupt you personally. If you’re in a low-risk field, like freelance writing or tutoring, a sole proprietorship will be a good place to start. As soon as there is any risk of a lawsuit, it’s time to consider an LLC or a corporation. High-risk fields, like professional services or asset-heavy businesses, should always use an LLC or corporate structure. 

Question 2: How Many Owners Are Involved?

You can set up a single-member LLC or sole proprietorship for one owner. For more than one, a corporation or multi-member LLC is a good choice. If you decide to go the GP route, don’t start a partnership without formalizing it in a written agreement.

To attract investors, you’ll need either a multi-member LLC with an operating agreement or a C corp. If you want to give the investors a true equity stake, you’ll likely need to set up a C corp.

Question 3: What Is Your Profit Level Now and in 12 Months?

A company that earns $40,000 or less in net profit should generally set up a basic LLC or sole proprietorship. An S corp isn’t financially advantageous until you earn at least $80,000 in net profit.

If you’re looking to bring in VC funding, you can ignore your current earnings. Venture capitalists strongly prefer investing in C corps.

Question 4: Do You Plan to Raise Outside Investment?

Again, a C corp is the way to go if you want VC investments, angel funding, preferred stock, QSBS eligibility, or investor protections.

Meanwhile, an LLC or S corp is a simple, tax-efficient option if you have no investment plans. If you want to invest alongside friends and family, you should opt for an LLC with an operating agreement.

Question 5: How Much Administrative Complexity Can You Handle?

The various types of corporations and business structures each have different levels of paperwork.

• Sole Proprietorship: Minimal.
• LLC: Moderate. Typically, an initial state filing and a simple operating agreement are required.
• S Corp: Moderate-High. You’ll need to handle payroll, annual compliance requirements, and quarterly filings.
• C Corp: High. Your company must hold board meetings, track stock records, and create bylaws.

While switching business structures later on is challenging, you don’t want to set up an S corp or C corp if you don’t need one. If your corporation status is not properly maintained, you can lose your liability protections.

The Upgrade Path: When and How To Change Your Structure

Although it’s easier to pick the right structure when you’re starting out, you don’t have to feel locked into your initial structure. Many companies begin as sole proprietorships and upgrade as they grow.

From Sole Proprietorship to LLC

This is an extremely common upgrade. It often happens after the proprietor takes on clients that could sue, wants to hire workers, needs to easily open a business bank account, or accumulates personal assets that need to be protected. To make the switch, companies must file Articles of Organization with the Secretary of State and apply for their employer identification number (EIN). Then, they must open a bank account and register a doing business as (DBA) name if needed. 

Cost: $50 to $500 in state filing fees.

From LLC to S Corp Election

This is just a tax election and not a structural change, so it is free as long as you file IRS Form 2553 yourself within 75 days of your business formation. If you already have an existing business, you must file this form by March 15 in order to use the election in the current year.

After the election is set up, you must pay yourself a reasonable salary. Because of the costs of payroll, tax filing, and other administrative expenses, this switch should generally be delayed until your net profit exceeds $80,000.

Cost: $0

From LLC or Sole Proprietor to C Corp

To switch from a sole proprietor or an LLC to a C corp, you’ll need to form the C corp, transfer assets, and handle any tax events that come up. Before transferring assets, it’s worth running a UCC filing search to confirm there are no outstanding liens on your business assets. If you know that you’ll need VC funding, you should start a C corp from day one. Investors strongly prefer C corps because they don’t want to deal with the annual tax liabilities of sole proprietorships and S corps. Additionally, S corps have limitations on the number and type of shareholders.

Cost: $5,000 to $20,000

Before You Decide: Research How Businesses in Your Industry Are Structured

Before you settle on a single corporation setup, talk to people in your industry. It helps to research the types of corporations used in your industry, investor expectations, compliance needs, and other industry norms.

Look Up How Competitors Are Registered

You can use EntityCheck’s Secretary of State (SOS) business search to look up registered businesses by their EIN, name, or owner. Then, you can review their filing history, entity type, and registration status to get a better understanding of the norms in your industry. This step can be completed in minutes and is an easy way to get an inside look at your competitor’s operations.

Verify Licenses and Professional Requirements in Your Industry

Some industries require certain entity structures. For example, architectural, medical, and legal firms must use a professional LLC (PLLC) or a professional corporation (PC). Through the EntityCheck’s Professional License Search, you can identify the credentials and licenses held by other companies in your field. Then, you can use this information to determine the best setup for your business.

Frequently Asked Questions

What is the best business structure for a small business?

An LLC is generally the best starting structure because of its liability protection, easy setup, and pass-through taxation. However, the right option will vary based on your funding goals, the number of owners involved, and your current profit level. While sole proprietor ships work better for low-risk businesses, S corps become financially viable once profits are over $80,000. Meanwhile, C corps are ideal for companies that want to attract venture capital.

What is the difference between an LLC and a sole proprietorship?

While a sole proprietorship has no legal separation between the owner and the business, an LLC provides liability protection. This means that the owner’s personal assets are generally shielded if the LLC is sued. In comparison, a sole proprietorship does not offer liability protection. If a lawsuit occurs, the owner’s personal assets are also at risk. 

There are also differences in taxation. The sole proprietor’s earnings are subject to pass-through taxation, so they are taxed on the owner’s income tax return. A single-member LLC is taxed like a sole proprietor by default, but it can also have a corporate tax election or be taxed as a multi-member LLC.

What is the difference between an LLC and a corporation?

An LLC is simpler to set up and more flexible. Unlike a corporation, an LLC doesn’t require board meetings, corporate income taxation, or excessive compliance requirements. However, a C corporation can issue stock, raise capital, establish a board of directors, and plan an IPO. LLCs can elect to be taxed as an S corp or C corp.

When should I convert from a sole proprietorship to an LLC?

If your liability risk is about to grow and losing a lawsuit could affect your personal finances, you should convert to an LLC. Paying the $50 to $500 in LLC filing costs is a good idea if you’re hiring employees or concerned about a client suing.

Can I change my business structure later?

Yes, you can. The ease and cost will depend on your current structure and the structure you are converting to. While switching from a sole proprietorship to an LLC is simple and low-cost, switching from an LLC or S corp to a C corp can entail costly tax changes and greater complexity. Meanwhile, switching from a C corp to an LLC is expensive and seldom done.

Does my business structure affect how I pay taxes?

Absolutely. Sole proprietors and LLCs pay a self-employment tax and income tax. S corp owners pay payroll taxes on their salaries, while distributions are not subject to self-employment taxes. 

Finally, C corps must pay a 21% corporate income tax. If earnings are paid as dividends and not retained, shareholders are taxed on the dividends as well.