The Best Business Types for Small Businesses (& When You Should Incorporate)
Many small businesses begin as sole proprietors or general partnerships, but incorporating your business is often an essential step to scaling.
Here’s a look at what incorporation is, when to incorporate, what your options are, and why it’s a good choice at any stage— whether you’re starting your first company, or continuing on your current venture.
What is Incorporation?
Incorporating means you’re forming a separate legal entity for your business, which limits your personal responsibility for your company’s debts, losses, and liabilities.
The word ‘incorporation’ technically means ‘forming a corporation,’ but it’s also used as a loose umbrella term for creating any type of separate business entity, like a Limited Liability Company (LLC)— an easy compromise between a corporation and a sole proprietorship.
Why You Should Incorporate Your Small Business
From the moment you start your business in the United States, you’re automatically considered a sole proprietor until you register your business as a separate legal entity.
Being a sole proprietor means you don’t have to file the paperwork associated with other business structures, but it also means there’s no legal separation between you and your business, and no separation or protection of your personal assets.
If you can’t repay a loan in your company’s name, for example, a debt collector could go after your car or house as repayment, since, as a sole proprietor, you and your company are legally the same entity.
Similarly, if a hazardous material was found in one of your company’s products, you, personally, could face a lawsuit and be held financially responsible for the cost.
The same goes for any sort of legal action against your business or debts, and the opposite is also true. If you ran into debt in your personal life, your company’s assets could be repossessed as repayment.
Financial Limitations of Sole Proprietorships
Operating as a sole proprietor makes it difficult to receive loans or investments, because not having a separate legal entity for your business is seen as a liability.
Sole proprietors also cannot build business credit, because they technically only have personal credit.
And companies that are sole proprietorships can’t be sold or passed to another owner, which also means they can’t be inherited by a family member.
Popular Business Entity Types for Small Businesses
There’s a few different business entity types to choose from, but many lawyers, accountants, and entrepreneurs suggest first forming an LLC or S-Corp, unless you plan to grow very rapidly, in which case a C-Corp may be best.
The right choice depends on your particular situation, how you prefer to operate your business, and whether you're going to expand.
For now, here’s a look at the most popular business entities for small businesses or startups:
1) Limited Liability Company (LLC)
A Limited Liability Company (LLC) is one of the simplest and most common business legal structures (or ‘entities’) for both ecommerce and non-ecommerce small businesses alike.
That’s mainly because LLCs offer liability and asset protection without being subject to double taxation. Let’s explain a bit more about what this means.
Tax Advantages of LLCs (Pass-Through Taxation)
One of the advantages of LLCs is that the Internal Revenue Service (IRS) allows business owners to choose how they want their LLC to be taxed.
This means you can choose to be taxed as a sole proprietor so that your company’s net income will be taxed as your personal income.
This is called “pass-through” taxation. By contrast, corporations are often taxed twice— once at the corporate level and again at the personal level, which is called "double taxation."
Increased Credibility of LLCs
When you go from being a sole proprietor to an LLC, your business automatically looks more legitimate both to customers and to potential investors.
However, investors usually prefer to invest in corporations rather than LLCs, so you may want to consider becoming an S-Corp (or, if you anticipate high growth, even a C-Corp) if you’re hoping to attract investors.
LCCs Offer Simplicity
LLCs are also relatively simple to set up, and unlike corporations, they don’t require a board of directors, shareholder meetings, or other managerial formalities.
Their flexible structure makes it easier to transition your business into a corporation later if you think you’ll be expanding rapidly.
Here’s a quick list of the advantages of LLCs, some of which we’ve already covered.
The Benefits of LLCs:
- Separates your personal assets from your business assets
- Provides flexible tax advantages
- Requires minimal paperwork
- Allows you to build business credit
- Has a flexible company structure
- Makes it easier to separate business and personal expenses
- Makes it easier to get a loan
- Can have one owner, or an unlimited amount of co-owners (called ‘members’)
- Enhances your credibility
- Can exist perpetually, regardless of whether another member leaves or sells their part of the company
- Can later be restructured to form a corporation
2) Limited Liability Partnership (LLP)
A Limited Liability Partnership (LLP) is essentially an LLC, but for multiple owners instead of one. In an LLP, the partners of the company have personal liability protection for the debts and losses of the company, but they also have less liability for each other’s actions, offering added protection if partners make poor business decisions.
They’re often a good choice for small or new businesses who have multiple owners, but New York and California limit LLP eligibility to professionals like lawyers or law firms, accountants, and doctors, meaning many small businesses who operate in either state won’t qualify.
As with LLCs, LLPs have pass-through taxation, meaning the owners have the option to report their share of profits and losses on their personal tax only, avoiding double taxation.
You can learn more about LLPs here.
What Documents Do I Need to Form an LLC or LLP?
To form either an LLP or LLC, you’ll need to file Articles of Organization within your state. Usually this paperwork is filed with the Secretary of State or a subsidiary for a filing fee of around $50 to $100.
If you’re forming an LLP, it’s highly recommended that you also create a partnership agreement, which outlines each partner’s responsibilities and their protected assets.
Similarly, if you’re forming an LLC, you’ll want to create an operating agreement.
An online legal service like Rocket Lawyer can also help you register your business as an LLC, LLP, S-Corp, or C-Corp with affordable and personalized advice on the best business entity type for your company.
3) S-Corporation (Small Business Corporation)
An S-Corp (Small Business Corporation) is a tax filing status that avoids the double taxation that larger corporations, known as ‘C-Corps,’ experience.
As an S-Corp, your company’s income will be taxed as your personal income, as with an LLC or sole proprietorship. S-Corps can be a good choice for businesses who are expecting to expand more rapidly, but who also anticipate having less than 100 shareholders in the foreseeable future.
Benefits of S-Corps:
- Provides limited liability protection
- Allows for ‘pass through’ taxation
- Are limited to 100 shareholders (and each shareholder must be a U.S. Citizen)
- Generally more attractive to investors than an LLC
- Can issue stocks
- Can open a business cash account or credit card
- Can build business credit
- Can exist perpetually, regardless of whether a shareholder leaves or sells their part of the company
You can learn more about S-Corps here.
While experts usually don’t recommend forming a C-Corporation unless you anticipate rapid high growth, it’s important to understand what a corporation is so that you can decide if it’s something you want to aim for now or in future.
What is a C-Corp?
A C Corporation (C-Corp) is ideal for business owners who want the same limited liability protection offered in other business entities like LLCs and LLPs, but also envision large growth.
C-Corps generally allow for an unlimited number of investors and the credibility that comes with the business entity that most major U.S. companies use.
However, you’ll be taxed both at the corporate level for the income tax of your company’s profits, and then again at the personal level, unless you qualify for S-Corp tax status.
Corporations, while offering the strongest legal protections to their owners, also usually cost more to form. They require extensive record-keeping, operational processes and reporting, as well as Articles of Incorporation.
We recommend checking with your accountant first before registering as a C-Corp to go over the pros and cons for your business.
When should you incorporate your small business?
While this will vary from owner to owner, lawyers, accountants, and entrepreneurs generally advise incorporating as early as possible.
It’s often considered essential if you intend to expand your business, and the more you intend to expand, the more important it becomes.
There’s certain criteria, however, that can help determine how necessary incorporation may be for you.
You should definitely consider incorporating when:
- You’re ready to hire employees. Whether you hire employees or take on contractors, certain business structures provide protection from personal liability, access to tax deductions, and other benefits.
- You’re growing steadily. More money, more problems. Since your personal assets and your sole proprietorship’s assets are one and the same, you may want to incorporate to protect your personal interests as your business grows.
- You want to expand beyond the home office. Again, expanding your business (even if you’re just renting an office) opens you up to additional liabilities that can be minimized through incorporation.
- You want extra funding. If you’re thinking about outside funding, incorporating will open more doors. In fact, many banks and investors will only consider funding incorporated businesses.
What State Should You Incorporate In?
When you incorporate your business, you file your paperwork at the state level, usually with the Secretary of State.
You can register your business in any state you wish as long as your business meets that state’s guidelines, which is why you’ll often find different opinions on the best state to incorporate in.
Delaware, for example, is a popular state for incorporation because it doesn’t disclose the names of business owners and doesn’t charge state corporate income tax unless you’re doing business there (though there is a franchise tax).
Trials involving Delaware corporations are also heard by a judge specializing in corporate law, and are settled without a jury. Additionally, Delaware state laws protect Board of Director members from lawsuits.
That’s why incorporating in Delaware often makes corporations more attractive to Venture Capital investors and investment bankers, who may require corporations to be registered in Delaware before investing.
But while some states may offer the prospect of lower taxes, less regulation, enhanced investment appeal, and privacy, the truth is that you’ll have to comply with the tax rates and regulations of both your state of operation and your state of incorporation.
This could cancel out a lot of the perceived benefits of out-of-state incorporation and may not make sense for the majority of small businesses. Likewise, the attractiveness of VC funding is usually more applicable to high growth startups than small business owners.
If you incorporate outside the state where you’re doing business, you’ll also need to go through an added process of registering that out-of-state business entity to allow it to legally do business in your home state. This generally adds extra time and cost to the process.
How to Form an LLC, C-Corp or S-Corp
While you can file the paperwork yourself, a simple and affordable way to form an LLC, S-Corp, or C-Corp is to go through an online legal service.
There’s a number of online legal services that will advise you on the best type of incorporation for your particular business, then draft and file the paperwork for you, and we’ve found Rocket Lawyer has a good reputation for fast affordable incorporation services tailored to individual companies.