Forms of Business Ownership

Starting a new business is a daunting task, requiring a variety of important decisions. One of the most critical is determining what type of legal entity you should adopt. The various forms of business organization are established by the states, but there is substantial similarity among them. This article focuses on the six options that determine your federal tax liability under the Internal Revenue Code:
  • Sole Proprietorship
  • Partnership
  • Corporation
  • S-Corporation
  • Trust
  • Nonprofit Organization
Another option, the Limited Liability Company (LLC), is a state designation that is normally taxed as a partnership at the federal level. It provides a blend of the limited liability of a corporation with the pass-through income of a partnership.

The LLC is a good option for small companies with a single owner who wants to separate personal assets from those of the business. An LLC with only one shareholder is taxed as a sole proprietor using Form 1040 Schedule C. Be aware that the limitation of liability may not shield you from certain instances of misrepresentation or fraud.

Sole Proprietorship

Many people start out as sole proprietors because it’s simple and requires no forms to set up. They are also referred to as freelancers, consultants, and independent contractors. Business income and expenses are reported on Schedule C.

Since the owner is the business, there is no distinction between them for legal purposes. The owner is entitled to all profits, but is personally liable for all losses and debts incurred by the business. All assets are at risk whether they are used in the business or not. A sole proprietor cannot transfer their business to someone else. They must sell all the assets and liabilities to the new owner who would establish his own business entity.

You can use your own name or adopt a trade name to operate your business. Depending on the state, you may need to file a “doing business as” statement that connects the true owner to the specific business.


This is an unincorporated business consisting of more than one person, with at least one general partner who manages the business and is liable for its debts. Other individuals who invest in the business but do not participate in its management are called limited partners, and are liable only up to the amount of their investment.

Partnerships do not pay income taxes, but pass through profits and losses to the partners to report on their individual returns. The formula is based on the fractional share of ownership attributed to each partner. Partnerships are dissolved whenever more than 50% of the ownership interest changes.


A corporation is a separate business entity that has at least one shareholder. Unlike proprietorships and partnerships, the shareholders of a corporation are shielded from its debts and liabilities. The corporation has the power to decide the portions of the profits to be retained by the company and distributed to shareholders. Taxes are paid at the corporate level and are not passed through to the shareholders.

Corporations may be public or private. Publicly held corporations must abide by the rules and regulations of the Securities and Exchange Commission, including all the financial disclosure and reporting requirements. Raising capital is usually easiest with a public corporation that can sell unlimited shares of stock. Privately held corporations are not subject to the same regulations since the stock is not traded on the public exchanges.


S-Corporations must have at least one shareholder, but not more than 100. Any shareholder that works for the business must be paid a reasonable salary that is separable from any profit or loss distributions. This is a key point since payroll taxes are only paid on the salary portion of the total compensation. If you own an S-Corporation and do the work yourself, you are risking a tax audit if the amount you are paying yourself is not sufficient relative to the value of your services on the open market.

Like an S-Corporation, LLCs and partnerships are taxed at the shareholder level. The difference is that LLCs and partnerships are not required to pay a reasonable salary to the managing shareholders. General partners are considered self-employed and are subject to self-employment tax on their share of profits. Limited partners and LLC shareholders only pay self-employment tax on guaranteed payments for services rendered to the company.


A trust is a legal entity set up to manage and control property and assets. A business is one type of asset that could be part of the trust. The trustee(s) actively manages the trust for the benefit of the named beneficiaries.

The trust is essentially the owner of the business and the profits and losses revert to the trust until distributed to the beneficiaries. The trust provides a means to protect the assets from lawsuits and creditors by limiting their liability. Depending on the specific jurisdiction and type of trust, it offers certain tax advantages to the beneficiaries.

Management of the trust is conducted according to the written wishes of the grantor who created and signed the declaration. The trustee(s) is legally obligated to perform in accordance with these instructions.

Nonprofit Organization

Nonprofits are exempt from income taxation if they are established for a legitimate civic, charitable, or artistic purpose. They are subject to detailed reporting requirements to ensure they are compliant with all state and federal laws. Their records must validate the nature of their activities, acquired assets, and sources and amounts of income. The establishment of nonprofit organizations is strictly controlled by applicable laws and regulations.

Bottom Line

This article summarizes some of the key forms of business organization, but only scratches the surface of the many factors that should be considered. It may also make sense to change your business depending on its stage of development and whether or not it’s profitable. You could conceivably change the form of business multiple times. Consult with a tax attorney or CPA regarding the various tax consequences to you and your business.

Make sure you also fully understand the liability issues that you will encounter under the different forms of business, especially if your personal assets are on the line. Your risk of being sued for bad decisions, accidents and property loss should be carefully assessed, and appropriate insurance protection should be in place.

Strike a balance between the needs of your business, the liability issues you may face, and the tax consequences of how you operate your business. Since each business is different, your choice of business type should reflect your unique situation.

Michael Sanibel is a freelance writer specializing in business, marketing, personal finance, law, science, aviation, sports, entertainment, travel, and political analysis. He graduated from the United States Air Force Academy and is also licensed to practice law in California and New Hampshire. Michael wrote this feature article exclusively for Debbie (, an organization dedicated to helping small businesses succeed.