Introduction
When an individual or group of individuals decides to start a business, they must decide on what type of organization they will do business as. This decision should not be taken lightly and should be made with the assistance of a business attorney and CPA.
In the United States, there are four basic types of business structures: sole proprietorship, partnership, limited liability company (LLC), and corporation.
Sole Proprietorship
A sole proprietorship is a business structure in which an individual conducts business as him or herself rather than through a separate legal entity. The major benefit of a sole proprietorship is that it does not require the creation and filing of legal documents, nor does it require the issuance of an employee identification number (EIN). Filing taxes is also easier – the proprietor simply attaches a schedule C (business profits and losses) and schedule SE (self-employment tax) to their personal returns.
Proprietorships have several major drawbacks, however. The first is that the lack of separation between business and owner means the proprietor will have unlimited liability. In other words, the personal assets of the owner are at risk in the event of a lawsuit.
Another disadvantage of a sole proprietorship is the lack of stock shares or other equity units. Because the company is indistinguishable from its owner, and an individual cannot sell stock in him or herself, the proprietorship must be funded with the owner’s personal resources.
Finally, the lack of a separate legal entity means that company cannot survive the death of its owner.
For most businesses, the disadvantages of a sole proprietorship will likely outweigh the advantages.
Partnerships
A partnership is an organizational form in which two or more parties contribute capital and / or services to the company. The terms of the partnership are outlined in a key governing document called the partnership agreement.
Partnerships are considered “pass-through” entities by the IRS. The partnership does not pay taxes. Rather, the profits and losses are passed through to the partners, who report the income or loss on their personal returns.
There are three common types of partnerships: general partnerships, limited partnerships, and limited liability partnerships.
A general partnership is a jointly owned business where the partners equally share the debts and liabilities of the partnership. General partnerships do not offer limited liability – the partners’ personal assets can be at risk in the event of a lawsuit or default.
General partnerships were often commonly used for professional service organizations but have become less prevalent in recent years.
A limited partnership is an organization structure in which some partners – the limited partners (“LPs”) – have limited risk.
A limited partnership must be managed by a general partner, who is responsible for managing the operations of the firm and accepts unlimited liability for doing so. The limited partners are the investors in the partnership. They have little to no operating involvement and are granted limited liability – i.e., their risk is limited to their investment.
Limited partnerships are common structures for investment funds, such as hedge funds and private equity funds. For these funds, the investment management firm acts as the general partner responsible for selecting and managing the investments, and the investors in the fund are the limited partners.
A limited liability partnership (LLP) is like a general partnership except that the LLP offers all partners limited liability from the debts and obligations of the partnership.
LLPs require that all partners share equally in operational responsibilities.
Limited Liability Company (LLC)
A limited liability company (LLC) is an entity formed under state statute which provides limited liability to its owners. Laws governing LLCs vary from state to state.
LLC owners are called members. These members can be individuals or other entities. Many LLCs designate a manager – either an individual or an entity – to oversee the firm’s operations. In contrast, a member-managed LLC grants each member the ability to make managerial decisions and to act as an agent of the company.
An LLC requires the members to file articles of organization with the state. In addition, most states require the LLC to file an annual report and pay a filing fee in order to maintain its active status.
Most states have no restrictions on the number of members an LLC can have. Most states also allow LLCs to be formed with a sole owner – known as a single-member LLC.
As a default, the IRS classifies an LLC as a partnership. However, the IRS allows LLCs to elect to be taxed as a C – or S – corporation.
Although not all states require one, it is prudent for an LLC to have a written operating agreement. Like a partnership agreement, the operating agreement states the rights and responsibilities of the members. A written operating agreement can be used for both multi-member and single-member LLCs.
An LLC is easier to form and requires less record keeping than a corporation. As such, LLCs have become the most common business structure for small businesses in the U.S.
Corporations
A corporation is a legal entity created under state law which is considered a “legal person” distinct from its owners. Thus, corporations provide their owners with limited liability.
A corporation is formed when it files articles of incorporation with the state it chooses to incorporate in. The articles of incorporation, also called the corporate charter, contain important information about the corporation, such as the corporation’s legal name, place of business, and number and type of stock shares issued.
A corporation must designate a board of directors and corporate officers. The role of the board of directors is to represent the interests of shareholders by setting business strategy and overseeing the corporation’s managers. The corporate officers are the company’s executives who manage the firm’s day-to-day operations.
A corporation’s key governing document is the corporate by-laws. The by-laws establish the details of how the company will be run.
Corporations generally have greater recordkeeping requirements than other organizational structures. For example, the board of directors must meet periodically. The board must keep records of these meetings, in addition to records of any major corporate resolutions.
There are two types of corporations: S-corporations (“S-Corp”) and C-corporations (“C-Corp”).
An S-corporation is a type of corporation in which profits and losses are passed through to the shareholders. This feature of S-Corps makes the form attractive for many small businesses.
An S-Corp’s beneficial tax treatment comes with several restrictions. Particularly, S-Corps can have no more than 100 shareholders. In addition, shareholders must be “natural persons” – i.e., legal entities such as LLCs, partnerships, and corporations cannot own stock in s-corporations. These restrictions make raising significant amounts of capital difficult.
A c-corporation is the form used by most large companies. This form is especially efficient for raising large amounts of capital. C-corps are well structured for the separation of ownership and management, have no restrictions on the number of shareholders, nor do they have restrictions on who can own the shares. In addition, the shares can be listed on a public stock exchange, which opens the company to large amounts of potential capital.
A C-Corp is taxed as an entity. Should the company distribute profits to shareholders in the form of dividends, these dividends will be taxed on the individual shareholder’s return. This double-taxation of corporate profits is the major drawback of the C-Corp form.
Conclusion
Choosing a business structure is one of the earliest and most important decisions entrepreneurs can make. The form of business structure determines how company profits will be taxed, how the company will raise capital, and the liability which the owners will incur. Prospective business owners should consult an attorney and CPA with business formation experience before making this very important decision.
