There are three basic types of business entity from a taxation point of view. These are proprietorships, partnerships and corporations. For the greater part, it is local law that determines the type (sometimes called the form) of business enterprise.

A business entity that has only one owner and has not incorporated is called a proprietorship. A business with two or more owners that has not incorporated is a partnership. Any business can incorporate and thus become a corporation under local law, regardless of the number of owners.

The type of business entity you select for your business will have significant federal income tax consequences. Proprietorships and partnerships that have not incorporated will not pay any separate income taxes on business profits. Their profits or losses will pass through to the owners, who must declare these income / loss items on their personal income tax returns and pay tax accordingly. In general, the owners of an unincorporated business can transfer property to or from the business without this being recognized as a taxable transaction. Unincorporated businesses may have two significant disadvantages that are not directly related to taxation.

One drawback with being an unincorporated business entity is that when significant capital needs to be raised, willing outside investors could be difficult to find. The other disadvantage concerns liability. There is simply no way to escape unlimited liability; the owner of a proprietorship becomes personally liable for all the debts and liabilities of the business. If there is more than one owner, it would be preferable to have at least one of them with the personal capability to absorb unlimited liability for all claims against the business.

In an increasingly litigious society, it is best to protect oneself by placing some limitation on personal liability. This is the attraction offered by incorporation, since it provides investors limited liability from claims. The corporation has thus become a popular form of business entity. For a widely held business enterprise, incorporation will make it easier to obtain financing, because it is easier for investors to put money into the corporation through buying debt and equity securities that the corporation is authorized to issue.

However, if the business entity is a corporation, its earnings- including dividends - will be subject to federal income tax. Once the shareholders receive the dividends, they also have to pay personal income tax. In other words, the income gets taxed twice. If the corporation incurs losses, the tax benefit will remain with the corporation, but cannot be used to reduce the personal tax liabilities of the owners.

The newer form of business entity is the limited liability company (LLC). A LLC is in essence a partnership in which there is no general partner. Its owners have no personal liability for the debts of the business. Federal tax laws do not recognize the LLC as a separate type of tax entity and most are treated as partnerships for federal taxation purposes. In terms of flexibility, the LLC has an advantage over the S corporation, because their ownership requirements are less rigid and they have more flexibility in allocating profits and losses among the owners.

The S corporation, however, has several advantages over the LLC. It will be easier to convert an existing C corporation to an S corporation than to a limited liability company. As a business entity, the S corporation provides a greater level of certainty in jurisprudence than the LLC does.