Business Types

From S Corps to LLCs: Choosing the Right Business Type

By: The Vanilla Team | Download PDF

One of the first tough decisions every entrepreneur faces is choosing the right type of business. Partnership or corporation? What’s the difference between an S corp and an LLC, anyway? The answers aren’t as complicated as you might expect. There are four major types of business entities, and each has its own benefits and drawbacks.

1. Sole Proprietorship. This is, by far, the easiest type of business to create and maintain. And, it’s often overlooked – in fact, the #1 mistake that many business owners make is setting up a corporation or an LLC when they could easily get by with a sole proprietorship. Unlike other, more complicated business types, a sole proprietorship can be set up instantly (you create one just by going into business for yourself) and is not subject to the annual franchise tax ($800/year in California).

The pros:

  • No paperwork required
  • No annual franchise tax

The cons:

  • A sole proprietorship can have only one owner (any more than that, and you’ll need to form a partnership, corporation, or an LLC)
  • Owner is personally liable for business debts and obligations

2. Partnership. There are two types of partnerships: general and limited. A general partnership (the more common) is relatively straightforward: all partners are treated equally, and any profits or losses pass through to the partners’ individual tax returns at the end of the year. A limited partnership is more complex because it involves two types of partners: a general partner (who solicits investments and controls day-to-day operations) and limited partners (passive investors).

Overall, the main drawback of partnerships is that they do not provide legal protection to business owners. In this type of business, general partners are personally responsible for all business debts and obligations. Not sure if a partnership is right for you? A good rule of thumb is that if you’re in an inherently risky industry with a high likelihood of being sued by customers, then you’re probably better off with a corporation or an LLC.

The pros:

  • General partnerships are relatively simple to set up and run (similar to a sole proprietorship)
  • No paperwork needs to be filed (however, drafting a partnership agreement at the outset is highly recommended)
  • Pass-through taxation (i.e. annual profits or losses pass through to the partners’ individual tax returns)

The cons:

  • Partners are personally liable for business debts and obligations
  • Limited partnerships are costly to set up and are not recommended for the average small business owner (they are most often used for real estate investments)

3. Corporation. A corporation carries its own legal status, separate and distinct from its owners. The primary advantage of corporations is that, unlike partnerships, they provide business owners with substantial protection against legal claims (often called the “corporate shield”). Most small businesses are S corporations, which are easier to maintain and pay lower taxes than regular corporations (called C corporations).

The pros:

  • S corporations are relatively simple to create and maintain
  • Owners are protected by the “corporate shield”
  • Pass-through taxation

The cons:

  • S corporations are limited to a maximum of 100 shareholders
  • All S corporation shareholders must be U.S. citizens
  • Only one class of stock is allowed (that’s why the vast majority of large public companies are C corporations)

4. Limited Liability Company (LLC). LLCs are an increasingly popular choice for start-ups and small businesses because they combine some of the best attributes of corporations and partnerships (limited legal liability, pass-through taxation, and flexibility in allocating profits and losses). However, one big drawback of LLCs is that their legal treatment varies by state, making them a risky choice if you plan to operate in multiple states.

The pros:

  • Limited legal liability for owners
  • Flexible structure
  • Pass-through taxation

The cons:

  • Legal status varies by state
  • Not the best choice if you plan to have a large number of investors or raise money from the public