What is a business organization? By definition, it’s an institution created to engage in commercial enterprise. There are different types of business organizational structures, which are determined by factors including taxes, paperwork, how you raise working capital and investment, as well as your amount of personal liability.
Here are the 4 main types of business ownership structures:
- Sole Proprietorship
- Limited Liability Company (LLC)
But what is the best form of business ownership? There’s no single correct answer — only what would work best for your particular organization. Let’s review the different forms of business and how each could impact you, your partners, earnings and the legacy of your business.
The 4 Main Types of Business Organizations
Depending on your organization, there’s a type of business that will best fit you and your goals. You should consider ownership structure, tax rules and other financial elements before making your decision.
Let’s take a look at each example of a business organization.
A sole proprietorship is a business owned by 1 person. It’s a business with no separate existence from the owner, as all income and losses are taxed against their personal income tax return.
Compared to other forms of business ownership, this option requires the fewest documents to complete and file. Everything funnels back to the owner, so there is no profit-sharing to sort through, making the whole process very simple. Under this type of business organization, you’re required to pay a self-employment tax against your income. You’re also directly responsible for every asset, liability, profit and loss.
- Easy setup
- Full control
- You receive all of the profits
- Direct access to feedback
- Unlimited liability
- Full responsibility
- High working capital demands
Because a sole proprietorship ownership structure doesn’t require you to separate the company from yourself as an individual, you could choose to use your name as the name of your business.
Is a sole proprietorship the best type of business organization for you? It depends on how much personal liability is a risk in your job or overall industry. The following types of companies or professions are better fits for organizing as a sole proprietorship:
- Independent consultants
- Virtual assistants
- Online drop-ship retailers
For those sole proprietorships, a good business insurance policy would shield against most issues. On the other hand, if your business operates in an industry where personal liability is more of a risk, you should avoid a sole proprietorship ownership structure.
The following types of companies and industries aren’t best suited for that type of business organization:
- The healthcare industry
- Personal care
- Food and hospitality
Your personal assets are directly at stake in a sole proprietorship, so be sure you’re protected in the event of unforeseen circumstances.
A partnership is a type of business organization between 2 or more people. As partners, these individuals share management of the business and any profits and losses.
Here are the 3 forms of partnerships:
Partnership types share similar features, though each has different ownership and liability structures. In any partnership, each partner must commit resources like capital, property or sweat equity such as skilled work or labor to share in the business’s profits and losses.
In most of these forms of business ownership, at least one partner is tasked with making decisions about the business’s day-to-day operations. While it’s not legally required, each of these types of companies should draft a formal partnership agreement as proof of their arrangement. This document will lay out each partner’s ownership stake, liability limitations, as well as their voting structures and how business decisions for the company are to be made.
Let’s take a look at the different types of business partnerships.
A business owned by 2 or more people, with a maximum of 20 owners, who have agreed to share all assets, liabilities, profits and losses of a company is classified as a general partnership. Under these legal forms of business ownership, the partners carry unlimited liability, meaning their personal assets are on the line and can be sued for the whole of the partnership’s business debts.
Taxes, however, do not flow through the partnership, meaning the partners are responsible for their own tax liabilities, including any earnings made from the partnership, on their personal income taxes.
- More partners, more capital
- Added talent
- Divided responsibility
- Greater business networks
- Tax advantages
- Unlimited liability
- Partners can disagree
- Profit is shared
Compared to a corporation or an LLC, the costs of establishing a general partnership are minimal and don’t require as much paperwork.
A general partnership features many benefits, including the flexibility to form the business as partners see fit. This flexibility can include the opportunity to closely oversee its operations.
In this ownership structure, each partner possesses agency powers, enabling them to participate directly in the management of the business. Agency powers allow partners to establish binding agreements, deals and contracts with other organizations and individuals; each partner must adhere to these agreements. However, it’s recommended that these arrangements be cleared before commitments are made.
Arriving at these decisions typically occurs through majority vote amongst all partners. Each partner’s vote holds the same weight, though voting privileges can be awarded to specific voters in the absence of a specific partner. It’s crucial for each member of the organization to have their vote be recognized, as every partner is held responsible in the event of inappropriate or illegal activities.
In this type of business, the general partnership is dissolved when a partner dies. The same occurs when one partner becomes unable to meet their obligations or leaves the organization. Specifics can be written into the partnership agreement that would allow the general partnership to continue through the transfer or succession of ownership.
What separates limited partnerships from other partnerships is that partners can limit their liability. Establishing a limited partnership requires 2 or more individuals agreeing to start a business where 1 or more of the partners are liable only for the amount they invested.
Limited partners, also known as silent partners, have a stake in the company in this type of business arrangement, but they can’t make management decisions. The remaining partners, known still as general partners, are responsible for day-to-day operations and any financial obligations beyond their initial investment.
Limited partners receive dividends based on the amount they’ve invested in the business. Another difference in these forms of business ownership is that limited partners aren’t considered self-employed. As long as they remain outside of the business’s operations, limited partners will not be subjected to self-employment tax.
- Share in profits and losses without needing to be involved in the business
- Limited personal financial risks for limited partners
- Taxed via your own income tax returns
- Easier to attract new investors
- General partner(s) fully liable
- Limited partner(s) can assume general partner liability if they become active in the business
- State taxes and fees
A joint venture is a type of business arrangement between 2 or more parties (often established businesses) that agree to combine their resources in order to accomplish a specific project. This is different from a pure partnership, because the original companies remain separate entities.
Ideally, however, the partners should establish a new entity when forming a joint venture. This allows for the participants to have a clear sense of how taxes will be paid. This business organization arrangement remains valid until the completion of a project — or a certain period elapses.
- Increased capacity and access to resources
- Shared liability with parties
- Access to new markets
- Potential different visions for the joint venture
- Imbalanced inputs and outputs between parties
- Lack of communication could derail project
As an example, Alphabet (Google’s parent company) and Fiat Chrysler Automobiles formed a joint venture in 2016, announcing that they would collaborate to develop self-driving cars. While these companies could have worked independently, both businesses decided they had a greater opportunity to achieve their goals by working together.
With a joint venture, each party is responsible for the costs of the project and will be associated with any profits or losses. However, note that while each participant is responsible for the joint venture’s expenses, these costs remain separate from their (and their partner’s) other business interests.
A joint venture agreement will establish the rights, obligations and objectives for the partnership and its members. It will also indicate how much each partner contributed, where day-to-day responsibilities lie and how profits and losses will be handled.
Before forming a joint venture, it’s important to answer the following questions:
- How many parties will be involved? What specific, essential skill does each provide?
- What and how much is each party contributing? Who owns what?
- What is the scope of the joint venture (Where will you operate? What will you solve? How will you accomplish this?)
- How will the joint venture be structured? Who is controlling and managing?
- How will we operate once we’ve accomplished our initial goals?
- Who will work for the joint venture?
A corporation is a group of people united in one body for a specific purpose.
A corporation operates as a separate, legal body led by an elected board of directors. The board is elected by shareholders, otherwise known as the owners of the corporation. Depending on the size of the company, one person can simultaneously be an officer, director and shareholder. Aside from the ability to vote and a few other personal rights, corporations have the same legal rights of an individual.
In the United States, a number of high-profile Supreme Court cases (Burwell v. Hobby Lobby, Goldberg v. Kelly) have enabled corporations to continue operating and protecting their assets as if they were private citizens.
Unlike an actual person, a corporation can live on in perpetuity, as long it is profitable. Shareholders can either sell or transfer their shares, enabling the corporation to live in the event of a cashout or death.
In these types of companies, the shareholders, officers and directors are required to make decisions about the direction and execution of business operations via formal votes. These votes and meetings occur regularly and must be properly recorded in corporate minutes.
All of these meetings must abide by the reporting requirements set forth by the state in which the company is incorporated as well as in other states where a considerable amount of business is done. A corporation can, within reason, protect its owners from being held personally responsible for business debts and obligations.
Now that we’ve established the basics of a corporation, we’ll look at its 2 variants — C corporations and S corporations.
Every corporation begins as a C corporation. When forming a C corporation, business leaders need to choose and then register with an unregistered business name. The articles of incorporation will be filed with your commonwealth or state’s secretary of state. Once registered, the C corporation will be able to offer stock. Those who purchase this stock become owners of the business and will be issued stock certificates.
- Greater access to capital
- Better for raising additional capital compared to an S corporation
- Shareholders are not personally liable for corporation’s debts
- Shareholders can be both U.S. citizens and international individuals
- Double taxation
- Majority shareholders hold a dominant vote in management decisions
C corporations are types of business organizations where the shareholders are independently taxed. To obtain an employer identification number (EIN), C corporations need to file IRS Form SS-4. C corporations are required to pay state, payroll, income, unemployment and disability taxes. The business is also subject to corporate income tax, meaning a double taxation situation occurs overall.
Corporations pay taxes against their earnings before disbursing the remaining funds in the form of dividends to their shareholders. Individual shareholders are then taxed against their dividends on their own personal tax returns. While double taxation is not an ideal scenario, C corporations are able to reinvest their profits at a lower corporate tax rate.
An S corporation derives its name from a tax law in Subchapter S of Chapter 1 of the Internal Revenue Code. An organization can become an S corporation by filing IRS Form 2553, also known as the Election by a Small Business Corporation form, no later than March 15 of that year.
Many states require owners to pay annual reporting fees, franchise taxes and other miscellaneous fees. These fees are not very expensive and could be filed on your corporate taxes as a cost of doing business.
One of the main reasons business owners would want to convert from a C corporation legal forms of business to an S corporation would be to save on taxes. Here are the differences between federal and state taxes for S corporations.
- Federal Tax
An S corporation is taxed similarly to a sole proprietorship or partnership as long as there are 100 shareholders or fewer. Any profit or loss are passed directly through to the shareholders and are taxed and reported on their personal tax returns.
- State Tax
With S corporations, states often pass profits and losses through to the owners, with some states even double-taxing these owners.
Choosing to establish a business organization as an S corporation could show the owner’s formal commitment to the company, which could help build credibility among employees, suppliers and investors. Another advantage of an S corporation includes the transfer of interests. S corporations don’t face the same tax consequences, adjusting property basis or complying with complex accounting rules that can be applied to a C corporation.
- Avoids double taxation seen in C corporations
- Shareholders are not personally liable for corporation’s debts
- Majority shareholders hold the dominant vote in management decisions
- Shareholders can only be U.S. citizens or residents
Employees of an S corporation are able to be shareholders, earn salaries and receive corporate dividends. These dividends are tax-free if they do not exceed their stock basis. However, if the stock basis is exceeded by the dividends, a capital gains tax will be assessed.
The IRS closely watches S corporations because dividend payments can be used to disguise salaries in an effort to avoid paying payroll taxes. Reasonable salaries commensurate to the employee’s role and experience must be paid to avoid charges of non-compliance. Other non-compliance issues stemming around elections, consent, filing requirements or other similar business activities could result in the termination of the S corporation.
Limited Liability Company
A limited liability company (LLC) is a type of ownership structure that protects the owner’s personal assets in the event of a business fault or accident.
When it comes to types of business organizations, the LLC is the newest business classification around, combining some of the best features of the other structures. An LLC provides the liability protection of a corporation while still offering tax advantages and flexibilities of a partnership.
However, structuring your business as an LLC won’t fully prevent you from being personally liable if it’s determined the owner has acted in an illegal, reckless or fraudulent manner. Owners can also be held responsible if they have not properly distinguished the activities of their company from their own personal interests.
- Owner’s liability limited to their amount invested
- No minimum or maximum on the number of owners
- Owners can operate fully in the company
- Operating management flexibility
- Increased organizational complexity
- Multiple tax classifications
The legal forms of structuring your business as an LLC are established by each state —meaning the rules for each owner will differ depending on their location. You’ll file the name of your LLC and your articles of organization with the state in which you’ll operate.
You also might have to prepare an LLC operating agreement stating each owner’s percentage of ownership in the company. This operating agreement will indicate each owner’s distribution of shares, responsibilities, voting power and the protocol if the owner wants to sell their stake in the business.
Your state might require you to publish the establishment of your LLC in your local newspaper as a statement of public record. Each state has its own LLC fee structure, ranging from $100 to $500 paid during the initial filing. States might also require an annual or biennial fee for renewals.
Because an LLC is a state structure, there are no specific tax forms at the federal level. These types of businesses can also choose whether to be taxed as a corporation, partnership or as an individual. Work with a CPA to determine which tax election is most advantageous for you.