Starting a new business? Read this first

The COVID-19 pandemic seems to have sparked a boom in the creation of small businesses in the United States.¹Each year during the past two-and-a-half years, substantially more new businesses were formed than were formed annually in the preceding decade.²

If you are one of the entrepreneurs now making a go of it, be warned: How you legally organize your enterprise can be critical to its ultimate success and your personal financial health.

Which of these six legal entities should your business be: sole proprietorship, general partnership, limited partnership, S corporation, C corporation or limited liability company (LLC)?

The choice you make affects (among other things) the taxes that the business and, ultimately, you will owe, your personal protection from any debts the business might incur and losses it might sustain as well. You can usually change the form later if necessary, but it’s usually simpler and, in the long run, less expensive to make the right choice at the time of formation.

Key pros and cons of the six most common U.S. business entities

Here are some of the most important features of each of the six types of business entities, starting with the simplest.

1. Sole proprietorship

Technically, a sole proprietorship isn’t a form of business entity at all. It is, literally, a non-entity. You simply start operating a business. 

Pros: Because sole proprietorship tend to be simple and inexpensive to “create,” they are by far the most popular form of organization. In 2018, the Small Business Administration reported that 23 million small businesses (73% of the total) were sole proprietorships.³

Cons: The disadvantages of doing business as a sole proprietor are significant when it comes to both personal liability and tax reporting. That’s because no line marks where the owner’s personal life ends and business life begins:  

• Liability—You are personally liable for any and all of the business’s debts and losses.   
  
• Taxes—All tax items (income, gains, deductions, losses, credits) are reportable on your individual income tax return. The fact that business and personal affairs are intermingled can make bookkeeping difficult (which items are personal and which belong to the business?), and can attract unwanted attention from the Internal Revenue Service. Taxing authorities pay particular attention to claimed deductions.

2. General partnership

If more than one individual starts a business, the simplest form of entity is a general partnership. 

Pros: Usually, a written agreement is not needed (though generally advisable), and there tends to be no limit to the number of partners (though most general partnerships tend to be formed by pairs of siblings or good friends). Partners are usually free to agree on owning the partnership’s interests unequally.

Taxes for a general partnership are basically the same as they are for a sole proprietorship. A general partnership is a “pass-through” entity: It is disregarded for income tax purposes.  

All tax items (income, deductions, etc.) flow through proportionally to the partners according to their ownership interests. No taxes are imposed on the partnership itself.

Cons: Each person in a general partnership is personally exposed to unlimited liability for all the partnership’s debts and other liabilities. That is to say: Get sued, and all of you are completely on the hook. 

3. Limited partnership 

Often, a would-be founder, needing capital to implement a new idea, solicits funds from investors who, in exchange for their investment, typically receive the lion’s share of the business’s ownership and profits.  

Many investment partnerships, such as real estate, hedge and private equity funds, are organized as limited partnerships (LPs).

Pros: Like sole proprietorships and general partnerships, LPs are pass-through entities for income tax purposes. (On occasion, allocations of tax items, such as income and deductions, are not pro rata.) The limited partners are liable for the partnership’s debts and losses only to the extent of their respective investments in the partnership. This arrangement is generally considered fair, as the limited partners are passive investors, with no say over the day-to-day management of the business.

Cons: All LPs have at least one general partner, whose personal assets are subject to the debts of the entire partnership. An LP’s creation must be evidenced by a written agreement; therefore, LPs are costlier to organize than proprietorships and general partnerships. LPs also are usually subject to state-level fees and reporting requirements.

4. Subchapter S corporation

There are, for tax purposes, two types of corporations, each getting its name from an Internal Revenue Code subchapter that authorizes them. C corporations are separate, taxpaying entities, while S corporations generally are not burdened by taxes at the corporate level.   

Owners of businesses with a relatively small number of shareholders often want to organize as an S corporation; but not all of them can.  

Pros: All properly organized corporations tend to insulate their shareholders from personal liability for a corporation’s debts and losses.  

The advantage of an S corporation is that, like a partnership, it is a disregarded entity for income tax purposes.

Cons: Complying with the relatively rigid rules required to preserve S corporation status can be difficult.  Certain entities, such as many types of trusts, cannot be shareholders. Unlike with a C corporation, S corporations can have only one class of stock (though they it can have both voting and non-voting shares).  And if an S corporation election is inadvertently terminated (as sometimes happens), unpleasant tax ramifications often follow.  

5. Subchapter C corporation

Pros: Many large business owners usually choose C corporation status to enable them to have an unlimited number of shareholders from around the world, multiple classes of stock (voting and non-voting), as well as ready access to public capital markets, from which they can raise money to expand operations. 

Cons: Unique among business entities, income earned by a Subchapter C corporation is subject to “double taxation” (i.e., first, the corporation’s earnings are taxed, then shareholders pay tax on dividends they receive from net earnings). Also, the law discourages C corporations from accumulating earnings without any active trade or business use.

A potential partial remedy for this “con”: Recently, some long-term founding C corporation shareholders have been able to mitigate the double taxation by running the corporation in such a way that their ownership is considered “qualified small business stock” (QSBS). Owners of QSBS can generally avoid, on the sale of their shares, capital gains tax up to the greater of $10 million or 10 times their basis in the shares sold.  

Whether your business even can, let alone should, be organized to take advantage of the QSBS tax break is a topic to be examined carefully with your tax advisors.

6. Limited liability company  

Among our clients, the limited liability company (LLC) is perhaps the most common of all forms of business ownership—and it’s easy to see why. 

Pros: An LLC is a highly flexible form of ownership that tends to offer the most attractive features of a partnership (no taxation at the entity level) and a corporation (liability for the entity’s losses is limited to the entity’s assets). An LLC can have one, or more than one, owner and may have the flexibility to determine how it is treated for tax purposes: as a disregarded entity; a partnership; or a corporation. Most choose not to be taxed as corporations.

Cons: As with an LP, forming an LLC requires paperwork. In the case of an LLC, not only must a certificate or organization be filed with a state, but also an operating agreement must be executed. Also, an LLC usually incurs annual filing fees and other administrative costs.

We can help  

Speak with your J.P. Morgan team about what kind of entity you want your business to start out as, or be changed into. We can work closely with your tax advisors and can help you look holistically at your plans for both the business and your family, making sure all support your long-term goals.

This material is distributed with the understanding that it is not rendering accounting, legal or tax advice. Consult your legal or tax advisor concerning such matters. For a complete discussion of risks associated with any investment, please review offering memorandum and speak with your J.P. Morgan Advisor. JPMorgan Chase & Co. and its subsidiaries do not render accounting, legal or tax advice.

¹Frank Sorrentino, “Pandemic & New Ways of Doing Business,” Forbes, May 24, 2022.

²U.S. Census Bureau, Business Formation Statistics, November 10, 2022.

³2018 is the latest year for which the Small Business Administration has such data at present. See  www.startups.com/library/expert-advice/sole-proprietorship.