The Entity Choice: Sole Proprietorship, S Corp, or LLC?


One of the first tricky issues that every entrepreneur faces is choosing the right legal structure for their business. There’s tons of information about this topic online but, to cut to the chase, the vast majority of small companies operate as sole proprietorships, S corps, or LLCs. We call these entities “the big three,” and here’s a quick overview of each.

 

1. Sole Proprietorship

A sole proprietorship allows you to go into business for yourself, plain and simple. This is by far the easiest type of business to own and operate, and you report all income and expenses on your personal tax return (Schedule C, to be exact). The biggest drawback of sole proprietorships is that they don’t provide the same legal protection as corporations or LLCs. However, if you’re a freelancer or one-person business and you’re in an industry that doesn’t entail much legal risk, then a sole proprietorship is generally the simplest way to go.

Pros:
  • Easy to form and operate.
  • No corporate tax return required.
Cons:
  • No legal protection, the owner is personally responsible for all liabilities of the business.
  • A sole proprietorship can have only one owner — any more than that and you’ll need to form a partnership, corporation, or LLC.

 

2. S Corp

A corporation is a separate legal entity that provides its owners — called "shareholders" — with substantial protection against legal claims (often referred to as “the corporate shield”). There are two types of corporations: C corps and S corps. While they function similarly in a broad legal sense, they’re completely different with respect to the type of ownership they allow and the way they pay taxes. 

Overall, C corps are the preferred choice for large companies that plan to have lots of shareholders and multiple classes of stock. In contrast, S corps are the go-to choice for smaller, privately-owned businesses with a limited number of shareholders. The biggest advantage of S corps is that they pay lower taxes than C corps because they are "pass-through entities." This means that all profits and losses pass directly through to the owners’ personal tax returns, and the business doesn’t pay any corporate taxes.

Pros:
  • Legal protection for owners/shareholders.
  • Pass-through entity (no corporate taxes).
Cons:
  • Administrative burden (articles, bylaws, maintaining corporate records).
  • S corps have specific ownership restrictions (maximum of 100 shareholders, all shareholders must be U.S. citizens, only one class of stock is allowed).

 

3. Limited Liability Company (LLC)

Basically, LLCs offer the same major benefits as S corps (legal protection and no corporate taxes), but they are widely regarded as easier to form and operate. In particular, LLCs require less paperwork than S corps and provide greater flexibility in how profits can be allocated among owners. On the downside, the legal rules surrounding LLCs are not as well-established as those surrounding corporations. Therefore, an LLC may not be the best choice if you plan to operate in multiple states or raise capital from investors.

Pros:
  • Legal protection for owners/members.
  • Pass-through entity (no corporate taxes).
  • Easier to manage than S corps.
Cons:
  • Legal treatment varies from state to state.
  • Because they cannot issue stock, LLCs are not viewed as “investment-ready.”

Legal stuff: This information is provided for educational purposes only and does not constitute advice for your specific situation.

William Keller