One of the first hard questions every entrepreneur faces is, “Which legal entity should I choose for my business?“ It's an important decision because it affects how much legal protection you get, how you set up your accounting system, and what type of tax return you're going to file.

For small businesses, the three most common business entities are sole proprietor, S corp, and LLC. Here's a quick overview of how they work and what the main differences are.

Sole Proprietor

A sole proprietorship allows you to go into business for yourself and is by far the simplest type of business to own and operate. At the end of the year, you gather up your business income and expenses and report them on your personal tax return (on Schedule C, to be exact).

The biggest drawback of sole proprietorships is that they don’t provide any legal protection to business owners. However, if you’re a freelancer or one-person business and you’re in an industry that doesn’t involve much legal risk (like consulting or website design or mobile dog washing), a sole proprietorship is generally the easiest way to go.

S Corp

In a nutshell, a corporation is a separate legal entity that provides its owners (called shareholders) with substantial protection against lawsuits and legal claims. Lawyers and accountants refer to this as the “corporate shield,” and that layer of protection is something many business owners want and need.

From an operational and tax point of view, there are two different types of corporations: S corps and C corps. Although they function similarly in a broad sense, S corps and C corps are very different in terms of the types of ownership they allow and the way they pay taxes.

Overall, S corps are the preferred choice for smaller, privately-held businesses that have one owner or a small group of individual shareholders. That’s because S corps are classified as “pass-through entities” by the IRS, which means all profits and losses pass through to the owners' personal tax returns and the business itself pays minimal corporate taxes.

In contrast, C corps are the preferred choice for larger companies that plan to have lots of shareholders and sell multiple classes of stock. Unlike S corps, C corps are not classified as pass-through entities by the IRS. That means they pay higher taxes than S corps: first at the corporate level (on net income), then again at the individual level (on shareholder distributions). This is something accontants refer to as “double taxation” and that, plus the administrative burden of establishing and maintaining the corporate structure, are the biggest drawbacks of C corps.

Limited Liability Company (LLC)

LLCs are another popular choice for small business owners. Why? Because they provide the same core benefits as S corps — legal protection and minimal corporate taxes — but require less administration and paperwork. In addition, LLCs allow more flexibility than S corps in how profits can be allocated among members. (Note: In an LLC owners are called “members” while in a corporation they’re called “shareholders." Who knows why, that’s just the way it is.)

On the downside, the legal rules surrounding LLCs are not as well-established as the rules governing corporations. Therefore, an LLC probably isn’t the best choice if you plan to operate in multiple states, sell stock to investors, or become the next IPO-ready unicorn.