One of the first decisions that you will have to make as a business owner is how the business should be structured. All businesses must adopt some legal configuration that defines the rights and liabilities of participants in the business’s ownership, control, personal liability, life span, and financial structure. This decision will have long-term implications, so you may want to consult with an accountant and attorney to help you select the form of ownership that is right for you.
In making a choice, you will want to take into account the following:
- Your vision regarding the size and nature of your business.
- The level of control you wish to have.
- The level of “structure” you are willing to deal with.
- The business’s vulnerability to lawsuits.
- Tax implications of the different organizational structures.
- Expected profit (or loss) of the business.
- Whether or not you need to re-invest earnings into the business.
- Your need for access to cash out of the business for yourself.
An overview of the four basic legal forms of organization: Sole Proprietorship; Partnerships; Corporations and Limited Liability Company follows. Please also review this summary of non-tax factors to consider.
Sole Proprietorship
The vast majority of small businesses start out as sole proprietorships. These firms are owned by one person, usually the individual who has day-to-day responsibility for running the business. Sole proprietorships own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, you are one in the same with the business.
Advantages of a Sole Proprietorship
- Easiest and least expensive form of ownership to organize.
- Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
- Profits from the business flow-through directly to the owner’s personal tax return.
- The business is easy to dissolve, if desired.
Disadvantages of a Sole Proprietorship
- Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
- May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
- May have a hard time attracting high-caliber employees, or those that are motivated by the opportunity to own a part of the business.
- Some employee benefits such as owner’s medical insurance premiums are not directly deductible from business income (only partially as an adjustment to income).
Partnerships
In a Partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The Partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed.
Yes, it’s hard to think about a “break-up” when the business is just getting started, but many partnerships split up at crisis times and unless there is a defined process, there will be even greater problems. They also must decide up front how much time and capital each will contribute, etc.
Advantages of a Partnership
- Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement.
- With more than one owner, the ability to raise funds may be increased.
- The profits from the business flow directly through to the partners’ personal tax return.
- Prospective employees may be attracted to the business if given the incentive to become a partner.
- The business usually will benefit from partners who have complementary skills.
Disadvantages of a Partnership
- Partners are jointly and individually liable for the actions of the other partners.
- Profits must be shared with others.
- Since decisions are shared, disagreements can occur.
- Some employee benefits are not deductible from business income on tax returns.
- The partnership may have a limited life; it may end upon the withdrawal or death of a partner.
Types of Partnerships that Should Be Considered:
1. General partnership
Partners divide responsibility for management and liability, as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
2. Limited partnership and partnership with limited liability
“Limited” means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short term projects, or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
3. Joint venture
Acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such, and distribute accumulated partnership assets upon dissolution of the entity.
Corporations
A Corporation, chartered by the state in which it is headquartered, is considered by law to be a unique entity, separate and apart from those who own it. A Corporation can be taxed; it can be sued; it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes.
Advantages of a Corporation
- Shareholders have limited liability for the corporation’s debts or judgments against the corporation.
- Generally, shareholders can only be held accountable for their investment in stock of the company. (Note however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.
- Corporations can raise additional funds through the sale of stock.
- A Corporation may deduct the cost of benefits it provides to officers and employees.
- Can elect S Corporation status if certain requirements are met. This election enables company to be taxed similar to a partnership.
Disadvantages of a Corporation
- The process of incorporation requires more time and money than other forms of organization.
- Corporations are monitored by federal, state and some local agencies, and as a result may have more paperwork to comply with regulations.
- Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible from business income; thus this income can be taxed twice.
Subchapter S Corporation
A tax election only; this election enables the shareholder to treat the earnings and profits as distributions, and have them pass through directly to their personal tax return. The catch here is that the shareholder, if working for the company, and if there is a profit, must pay his/herself wages, and it must meet standards of “reasonable compensation”. This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all of the payroll taxes on the total amount.
Limited Liability Company (LLC)
The LLC is a relatively new type of hybrid business structure that is now permissible in most states. It is designed to provide limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than that of a general partnership.
The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be continued if desired by a vote of the members at the time of expiration. LLC’s must not have more than two of the four characteristics that define corporations: Limited liability to the extent of assets; continuity of life; centralization of management; and free transferability of ownership interests.
Federal Tax Forms for LLC
Taxed as a partnership in most cases; corporation forms must be used if there are more than 2 of the 4 corporate characteristics, as described above.
In summary, deciding the form of ownership that best suits your business venture should be given careful consideration. Use your key advisors to assist you in the process.
When you start a business, you will have to decide which business structure (also legal structure or business form) to adopt. If you're simply in business for yourself and don't plan on hiring employees, you may be able to get by as a sole proprietorship. However, large business entities generally incorporate, which provides certain benefits in terms of liability protection and the complexity needed for a large business.
Each business structure has its pros cons, and since every business has unique needs and goals, you need to do your research before choosing. The following is an overview of the various types of business structures, which include sole proprietorships, partnerships (both general and limited), limited liability companies (LLCs), corporations, nonprofit corporations, and co-operatives (co-ops).
We make business formation EASY. Learn about our DIY business formation services here.
Sole Proprietorships
A sole proprietorship is perhaps the simplest of all the different types of business structures. Unlike LLCs and corporations, there are no papers to file and no fees to pay in order to set up a sole proprietorship. You are the sole owner of your business, and you simply have to begin business operations in order to create a sole proprietorship.
In terms of the legal entities involved in a sole proprietorship, you and the sole proprietorship are the same thing. This means that you will pay taxes on any business profit as income on your personal taxes, and if your business has any liabilities (like a court judgment or a past due debt), you are personally liable for them.
Partnerships
A partnership is like a sole proprietorship in that it is simply a business that is owned by two or more people. Similarly to a sole proprietorship, the owners of a partnership do not need to file any papers or pay any fees to set up a partnership, the partnership simply begins when you start a business with one or more other people. Also like a sole proprietorship, each partner will report their share of the business profits on their personal taxes as income, and each partner is personally liable for any debts, claims or other liabilities that the business is responsible for.
Limited Partnerships
Unlike a general partnership, a limited partnership costs money and can be very complicated to set up. Limited partnerships are not the best choice for a small business that has a small potential for personal liability. Limited partnerships are normally organized by one or more persons, the "general partners," that are responsible for getting others to join the partnership as "limited partners."
The general partners run the day to day operations of the limited partnership for the most part. The general partners are personally liable for any debts, judgments or other liabilities that the limited partnership has, except if the general partner is a corporation or a LLC. In addition, just like a partner in a normal partnership, the general partners in a limited partnership will share in the business profits and report this income on their personal income taxes. The limited partners are not personally liable for any of the limited partnerships liabilities, and are correspondingly not included in many of the day to day operations.
LLCs and Corporations
Although creating and maintaining a corporation or an LLC will probably be more complex and costly than forming a sole proprietorship or partnership, it may be worth it for your small business depending upon the type of work you plan on doing. Perhaps the main reason you would want to organize your business as an LLC or corporation is to shield yourself from any personal liability that may arise from your small business' dealings.
Although LLCs and corporations are alike in many respects, what truly sets a corporation apart from the other types of business structures is that a corporation is its own legal and tax entity. A corporation pays its own taxes on any profits that it keeps and the owners of a corporation only pay income taxes on monies they draw from the corporation in the form of salaries, dividends and bonuses.
A LLC, just like a corporation, provides limited liability to the owners of the LLC for the business' liabilities, including debts, judgments and others. Where the LLC differs from a corporation, however, is in terms of taxes. Unlike a corporation, a LLC is not its own, separate tax entity, and the owners of the LLC must pay personal income taxes on their share of the profits that the LLC keeps during the tax year.
Organizing your business as a corporation or a LLC makes sense in two situations. First, if the business in engaged in a dangerous activity that makes it more likely to be sued, or if the business has the potential of racking up large amounts of debt, then a corporation or a LLC may be a good idea to shield the owners from personal liability. Second, if any of the owners of a business have large amounts of personal assets that they want to shield from any potential liability associated with the business, a corporate or an LLC could be the best option.
Nonprofit Corporations
A nonprofit corporation is simply a corporation that was formed with the intent to carry out a purpose that is charitable, educational, literary, religious, or scientific. A nonprofit corporation can solicit charitable givings from the public, and can also seek to raise funds by seeking private grant money from companies and individuals. One of the largest benefits to a nonprofit corporation is that the money that is taken in for the charitable purpose is normally not taxed by either the federal or state governments.
Co-Ops
A Co-Op is a business that is most associated with grassroots organizations. These businesses are owned and operated by the members of the Co-Op in a democratic fashion. Much of the time, a Co-Op is formed by consumers that want to create a friendlier place of business. As such, these organizations often spring up in the form of a grocery store or a child care center. There are some states that have written laws regarding the setup and operation of Co-Ops. If you would like to find out if your state has laws regarding Co-Ops, you should contact your secretary of state.
Learn More About Types of Business Structures by Talking to an Attorney
There are plenty of factors to take into consideration when choosing a business structure, including liability concerns and plans for future expansion. The best way to make an informed decision when choosing a business structure is to speak with a business organizations lawyer who can provide legal advice based on your specific situation.