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When setting up a business, there are many decisions that entrepreneurs need to make to start their venture off on the ground. The kind of business entity they choose that determines how their company is taxed and how much liability protection they receive could be one of the most crucial decisions. The entity you choose can have a major impact on everything from the ease of getting small business loan to the amount you pay in taxes.

State laws and the Internal Revenue Service determine what kinds of entities you are able to form. The most popular are partnerships, sole proprietorships and corporations. Each has its own pros, cons, and benefits, including the degree and type of legal protection offered along with tax treatment and paperwork requirements.

A sole proprietorship is a simple form of a business. It is a business that can be formed without formalities and the owner is responsible for all company debts and obligations. Some sole proprietors opt to name their business in their state as D/B/As but this doesn’t provide any protection against personal liability.

Partnerships are made up of two or more persons who wish to conduct business in a group. They are taxed as a sole proprietorship with profits and losses recorded on the owners’ personal income taxes at the end of the fiscal year.

Corporations are separate legal entities that have the purpose of holding assets and providing services to make a profit. These corporations have to file federal and state tax returns, which can be costly for smaller businesses. They are subject to what is known as double taxation, meaning they are taxed once on their earnings, and again when they distribute funds to shareholders.