Business Entity Definition and How To Choose

Deciding what type of business entity is best for a new venture is among the first choices an entrepreneur faces. The legal structure will define how the business is taxed, the ways it can raise capital, who’s financially on the hook if something goes wrong, and the amount of paperwork involved.

Your choice of business entity won’t make or break your business success. But changing it later can be expensive and time-consuming. You may need to re-register your business with local and state authorities and file new tax paperwork. Here’s what to consider when choosing a business entity.

What is a business entity?

A business entity is the legal structure that a company or individual uses to register with the government, pay taxes, and conduct daily operations. It determines whether the business is treated as a separate legal entity apart from its owner, or whether the owner and the business are legally one and the same.

This distinction defines who is financially liable if the business takes on debt, is sued, or fails to pay taxes. In a structure that separates the business from its owner, the owner’s personal assets, like a home or personal savings account, are generally shielded from creditors seeking repayment of business debts. In a structure that doesn’t recognize a distinction between owner and business, the owner’s assets may be subject to seizure by creditors and litigants against the business.

Choice of entity type can inform how ownership itself is structured:

• A sole proprietorship has a single owner with full control over the business.

• Partnerships divide ownership, and often decision-making authority, among two or more partners in accordance with the partnership agreement. 

• Limited liability companies (LLCs) allocate ownership in the form of membership interests, which members can divide however they agree, as outlined in the operating agreement. 

• Corporations distribute ownership through shares of stock, which can be held by a small group of shareholders (known as a closely-held corporation) or sold broadly to public investors. 

Finally, the choice affects how much administrative overhead the business takes. Different entity types have varying annual or biannual reporting obligations, some requiring recurring fees.

Types of business entities

• Sole proprietorship
• General partnership
• Limited partnership
• Limited liability company
• Corporation
• Nonprofit

The different types of business entities have disparate rules about liabilities and taxation, as well as how much administrative work is involved.

Sole proprietorship

A sole proprietorship is an unincorporated business owned and operated by one person, with no legal separation between the owner and the business. It’s the simplest and most common type of business entity in the US. It often requires no formal registration beyond local licensing, and it lets a small business owner conduct business under their own name.

Business profits are reported directly on the owner’s individual tax return, making the sole proprietorship structure a pass-through entity. This means the business itself doesn’t pay separate taxes on profits. The trade-off of operating as a sole proprietor is personal liability. The owner is fully responsible for all business debts and financial obligations. 

This structure is most suitable for a business in its earliest stages, before it takes on significant risk, production capacity, or outside investment. The ability to obtain a bank loan can be limited because the business’s creditworthiness is only as good as the owner’s.

General partnership

A general partnership is similar to a sole proprietorship, but it involves two or more people who agree to share ownership, profits, and business responsibilities. Like a sole proprietorship, it’s a pass-through entity and requires minimal paperwork to form. A general partnership is the default entity for any two or more people doing business together in the US.

Typically, a general partnership just needs a partnership agreement that outlines each partner’s role, but it’s not required. 

General partners, like sole proprietors, are personally liable for the business’s debts, and can be held responsible individually for decisions made by other partners. Some states also recognize a limited liability partnership (LLP). This limits each partner’s liability for the business’s debts while still holding them liable in the event of professional misconduct. 

Raising capital is limited under this structure, because there’s no stock to sell to investors. Partners typically self-fund or borrow money based on their own credit rating. This makes a general partnership a good fit for two or more people starting a business together before it needs outside investment.

Limited partnership

A limited partnership (LP) includes at least one general partner, who manages the business day to day and holds full personal liability, and one or more limited partners, who invest capital but aren’t involved in daily business operations. Limited partners are only liable up to the amount they invested in the business.

Like general partnerships, limited partnerships are considered pass-through entities for all partners, general or limited. Profits and losses of the business pass through directly to partners, who then report their share of the partnership’s profits on their personal tax returns.

This structure is a common choice among businesses that want outside investors without giving them a say in management. Limited partnerships require more formal paperwork than a general partnership, including state registration. 

Limited liability company

A limited liability company (LLC) combines liability protection with the simpler tax treatment of sole proprietors and partnerships. LLCs can have one owner or many.

Owners, called members, generally aren’t personally liable for business debts or legal damages. In this way, an LLC entails limited liability protection similar to a corporation.

In contrast to a corporation, an LLC is treated as a pass-through entity for tax purposes. It avoids the double taxation of corporations, which is applied first on the corporation’s income, and again on any distributions or dividends paid to shareholders. 

An LLC is an unincorporated business structure, meaning it’s formed under state LLC statutes rather than corporate statutes. By default, the IRS and most states treat it as an unincorporated entity unless it elects to be taxed as an S corp. However, it’s still legally separate from its owners, which is how it combines liability protection with the pass-through tax treatment of sole proprietorships and partnerships. 

LLCs generally involve more setup paperwork than a sole proprietorship or partnership, including filing articles of organization with the state. This flexibility makes LLCs a common choice for small to midsize businesses that want liability protection without the burden of corporate taxation or more complex formation and reporting requirements.

Corporation

A corporation is a legal entity that is separate from its owners with strong liability protection. Shareholders generally aren’t personally liable for business debts, and their personal assets are beyond the reach of creditors and most litigants. Corporations usually form as C corporations (C corps), though some can elect special S corporation (S corp) status.

C corps

By default, a corporation is taxed as a C corp, paying corporate income tax on its profits, while shareholders pay taxes on any dividends and distributions they receive. This tax treatment is known as double taxation, and it generally results in a heavier tax burden overall. In exchange, a C corp can raise capital by issuing multiple classes of stock and have an unlimited number of shareholders. 

C corps must observe certain formalities, like holding annual board meetings, that other structures don’t require. This makes the C corp structure best suited to businesses that rely on significant outside investment, or which plan to sell shares to the public for trading on a stock exchange.

S corps

A corporation can sometimes elect S corp status, which offers the same liability protection as a traditional corporation but is taxed as a pass-through entity. That means profits are only taxed once at the owners’ personal income-tax level. 

To qualify for this tax treatment, an S corp can’t have more than 100 shareholders, all of whom must be US citizens or legal residents. Additionally, the S corp can only issue one class of stock. This makes the S corp a common choice for established small businesses that want liability protection and pass-through taxation without needing the fundraising flexibility and scope of a C corp.

LLCs can also elect S corp status under the same limitations as corporations, including limits on the number of members. 

Nonprofit

Nonprofit corporations are formed for a charitable, religious, educational, or social purpose rather than to generate profit for owners. Nonprofits can apply to the IRS for tax-exempt status, meaning the organization doesn’t pay corporate taxes on income related to its mission. A nonprofit must file annual reports with the IRS to maintain this special status.

There are no owners of a nonprofit in the traditional sense. Instead, a board of directors determines how the organization is run. Fundraising comes from grants and donations rather than equity investment, since there is no ownership interest to sell to shareholders.

How to set up and manage your business entity on Shopify

Once you’ve chosen your business’s entity type, Shopify supports it as the business grows or restructures. The choice of business entity type directly affects how you’ll set up vendor payments, payroll, and tax reporting on the Shopify platform.

You can add or edit details like a business address, associated people, or verification documents, by navigating to Settings > General in the Shopify admin panel, finding the Business details section, and clicking Edit.

Once you’ve indicated your entity type in Shopify, you can’t change it by editing your existing entity type. Instead, if you want to make a change like converting from a sole proprietorship to a corporation, you have to create a new business entity on the platform. 

Do this by adding the new entity under Business details, then switching the existing business over to it as the new default. Any business using Shopify Payments, Shopify Balance, Shopify Capital, or Shopify Credit needs those financial services deactivated first, since changing entities affects them.

Businesses can also sell from multiple entities at once, whether that’s across different stores, regions, or sales markets within a single store. You can add and manage all of them under Settings > Organization > Business entities.

Entity type affects Shopify Payments verification. In the US, individuals and sole proprietors verify using a Social Security Number (SSN) or Individual Taxpayer Identification Number (TIN). Partnerships, corporations, and nonprofits generally need an employer identification number (EIN) issued by the IRS. Because Shopify cross-references this information against IRS records, it’s important that a business’s registered legal name and tax ID precisely match its official registration information.