The 3 Types of Business Organization

The Business Entity Concept

In accounting there's something called the "business entity concept," and that just means an organization's records should only record business transactions, not personal transactions. There must be a financial separation between the business owner and the business entity itself. Every activity in a business has an associated cost or value, and part of an accountant's job is to quantify those transactions, which is exactly why this separation matters so much.

So that's why choosing the right entity is so important. The legal structure you pick shapes how those transactions get recorded, taxed, and reported, and it determines how exposed you personally are if the business runs into trouble.

Now, there are three types of business organization, and there are some key differences between them that make each of them great or terrible depending on your business.

Sole Proprietorships

First is the sole proprietorship. This is where one individual owns the entire business.

Some advantages are that sole proprietorships are: easy to form, have favorable tax treatment, and provide a high level of owner control.

However, sole proprietorships also pose unlimited personal liability, limited life for the business, and it can be harder to raise capital.

Sole proprietorships can be great for individuals just starting or running a small operation, but the drawbacks of this entity type will most likely hold you back at higher levels of business.

Partnerships

Next up is the partnership. This is where two or more people come together, contributing money, property, or services to co-own the business.

Partnerships share some of the same perks as sole proprietorships. They get favorable tax treatment and are still relatively easy to form. But they also unlock something sole proprietorships can't: better access to capital and expertise, since now you've got more than one person's resources and skill set behind the business.

That said, partnerships come with their own baggage. You've still got unlimited personal liability, though there are structures like a limited liability partnership that can help soften that risk. The business also has a limited life, just like a sole proprietorship. And forming one is actually more complex, because you need a written partnership agreement that spells out things like decision-making authority and how profits get split. Skip that step, and you're setting yourself up for conflict down the road.

So partnerships are a solid step up if you're teaming up with someone else, but you're still personally exposed if things go wrong.

Corporations

Last up is the corporation, and this is where things really change.

A corporation is legally separate from its owners. It's basically its own "person" in the eyes of the law, which means the business operates as a standalone entity, and the owners hand off the day-to-day decisions to agents who run things on their behalf.

That separation is huge, because it gives owners limited liability. Your personal assets aren't on the hook the way they are with a sole proprietorship or partnership. Corporations also have an easier time raising large amounts of capital, whether that's through loans or selling stock. And because stock can be sold or transferred so easily, the business can keep going even beyond the life of its original owners.

But that protection comes at a cost, literally. Corporations face double taxation: the business pays income tax on its earnings, and then the owners get taxed again when they receive dividends.

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Source: Principles of Financial Accounting, Chapter 2, "Introduction to Financial Statements," section "Types of Business Structure," p. 54. OpenStax. Available free at openstax.org.