What Is a Small Business? Definition, Characteristics, and Challenges

What Is a Small Business?

A small business is a company of relatively limited size, as measured by its revenues, number of employees, or both. Often described as the “backbone” of the U.S. economy, small businesses range from sole proprietorships to partnerships and corporations with multiple owners and sometimes hundreds of workers. According to the U.S. Small Business Administration (SBA), there are more than 33 million small businesses in the country today, employing close to 62 million Americans.

Understanding Small Businesses

Small businesses are typically defined by metrics such as their number of employees and their annual revenues.

For simplicity’s sake, the U.S. Small Business Administration’s Office of Advocacy generally defines one as “an independent business having fewer than 500 employees.” But, as explained in the next section of this article, under the SBA’s official standards, a small business can have as many as 1,500 employees, depending on the industry, and its annual revenues can range as high as $40 million.

Most small businesses, however, are truly small. In 2023, according to SBA data, close to 82% of small businesses in the U.S. were one-person operations, with no employees aside from the owner.

What Are NAICS Codes?

The federal government established the North American Industry Classification System (NAICS) in 1997. Its purpose, according to the United States Census Bureau, was to create a standard that federal statistical agencies could use in “classifying business establishments for the purpose of collecting, analyzing, and publishing statistical data related to the U.S. business economy.”

The NAICS assigns six-digit codes to businesses. The first two digits refer to the sector of the economy in which they operate, the next two to their particular subsector and industry. The remaining digits further narrow the type of business it is, to the point that NAICS codes can be highly specific. For example, an orange grove is a 111310, while an apple orchard is a 111331, and an advertising agency is a 541810, while a public relations agency is a 541820.

The NAICS codes do not differentiate between small and large businesses. For example, both a single-person ad agency and one with thousands of employees and offices all over the world would both have the same six-digit number.

However, the Small Business Administration uses the codes and applies its own “size standards,” either in terms of annual receipts or number of employees, to determine what constitutes a small business within a particular field. The SBA defines annual receipts as the company’s total income or gross income plus cost of goods sold (COGS).

For example, an orange grove qualifies as a small business if it takes in no more than $4 million annually, while an apple orchard can take in up to $4.5 million. An ad agency is small if its revenues are under $25.5 million, while a PR agency can only have revenues of up to $19 million and remain small by definition.

When the SBA divides businesses into small and large by numbers of employees, the maximums can vary widely across industries. For example, a fruit and vegetable wholesaler can have no more than 100 employees and be considered small, while an aircraft manufacturer can have as many as 1,500. Generally speaking, 1,500 is about the maximum for any type of enterprise under current rules.

The SBA size standards are especially important for businesses competing for government programs or contracts, as explained below. The SBA website has a Size Standards Tool that businesses can use to see if they qualify as small under its criteria.

Importance of Small Businesses

Small businesses are vital to the U.S. economy. In fact, by its definition, the SBA’s Office of Advocacy says small businesses constitute 99.9% of U.S. businesses overall. Together, they account for 43.5% of the country’s gross domestic product (GDP) and 39.4% of private sector payrolls.

Small businesses also accounted for 62.7% of net new job creation from 1995 to 2023, the SBA says.

Small Business Resources

Small businesses that qualify are eligible for funding and other forms of assistance through the federal government, state and local governments, and private and nonprofit sources. Among the major ones:

SBA Loans

The SBA doesn’t offer loans itself but provides guarantees to approved lenders, making it easier for small businesses to borrow money. SBA loans range from $500 to $5.5 million and can be used for working capital or to finance the purchase of fixed assets, such as machinery. The SBA also has a loan program for exporters.

Grants

Small-business grants, which normally do not have to be paid back, are harder to obtain than loans. The SBA doesn’t provide grants for starting or expanding small businesses, but the federal government has several grant programs for specific types of businesses. Two of them are the Small Business Innovation Research (SBIR) program and the Small Business Technology Transfer (STTR) program.

The U.S. Treasury Department, through its State Small Business Credit Initiative, also provides money to states, U.S. territories, and tribal governments, which they can then use to support small businesses in their area.

In addition, some state and local governments and a number of private corporations have their own
grant-making initiatives aimed at encouraging small business.

Government Contracting

As the SBA points out, “The U.S. government is the largest customer in the world. It buys all types of products and services—in both large and small quantities—and it’s required by law to consider buying from small businesses.”

To facilitate that, the SBA offers programs to help small businesses compete for federal contracts, some targeting specific types of business owners, such as women, Native Americans, or military veterans. It also administers Small Business Development Centers in every U.S. state and territory, in conjunction with the private sector, educational institutions, and state and local governments. Their goal is to provide resources to current and would-be small business owners.

Types of Small Business Structures

Small businesses can choose to structure themselves in a variety of ways for tax and legal purposes. Here are the common types, listed in relative order of complexity.

Sole Proprietorship

The simplest and most common type of small business, sole proprietorships can have only one owner. The owner doesn’t have to file a separate tax return but reports their business income (or losses) on a Schedule C form attached to their regular 1040 tax return.

Partnership

If two or more people want to own a business together, they can form a partnership. Partnerships come in two basic types: limited partnerships (LPs) and limited liability partnerships (LLPs). In a limited partnership, one person serves as the general partner and takes on most of the liability, or risk, for the company, while the other partner or partners have more limited exposure. In a limited liability partnership, all partners have limited liability. In both cases, the income from the business passes through to the owners, who report it on their individual tax returns.

Limited Liability Company

A limited liability company (LLC) can have one or more owners. As with the two types of partnerships, it is set up to reduce the owner or owners’ personal liability in the event of a lawsuit or other financial difficulty. LLC income can be reported on either an individual tax return or a business tax return.

Corporation

Corporations can also shield their owners from financial liability resulting from the actions of the business. There are two basic types: S corps and C corps. S corps can have from one to 100 owners, who report their share of the company’s profits or losses on their individual tax returns. C corps, which are probably what most people think of as a corporation, can have a single owner or many thousands of them, in the form of shareholders. C corps file corporate tax returns and any dividends they pay out are also taxable on the recipients’ individual tax returns, a situation sometimes referred to as double taxation.

Benefits of a Small Business

Small businesses can benefit their owners in a range of ways. The business is likely to be less bureaucratic than a large company, allowing its owner or owners a greater degree of autonomy. If the business is profitable, its owners also stand to benefit more directly than they would as employees of a larger enterprise.

Owning a business can also entitle a person to a long list of tax deductions that they might not be eligible for otherwise. For example, if they work from home and maintain an office there, they may be able to write off a portion of their housing costs.

Challenges Facing Small Businesses

Running a small business isn’t for everyone. Just as owners stand to profit more if the business succeeds, they may suffer more financially if it fails. Many times they will have put their life savings on the line.

Small businesses can face other challenges based on their size. They may find it harder to raise capital for expansion or other purposes. They may also have more trouble hiring employees in a tight labor market if they’re unable to offer wage and benefit packages that are competitive with their larger counterparts.

However, many small businesses manage to overcome the obstacles. Looking at the pre-Covid years of 1994 to 2000, the SBA reports that an average of 67.7% of new businesses survived at least two years. In other words, about a third of new businesses failed, but two-thirds made it that far. The five-year survival rate for that period was 48.9%.

The Bottom Line

Small businesses play a big role in the U.S. economy. While they can be risky for their owners, they also hold the potential for significant financial rewards. In addition, studies have shown that small business owners are often happier in their jobs than people who work for others. A 2023 Pew Research Center study, for example, reported that, “Most self-employed workers (62%) say they are extremely or very satisfied with their job, compared with 51% of those who are not self-employed.”