One of the most important and underappreciated decisions you will need to make as you start your business involves the legal structure of your company. Each type of business organization is different and impacts a number of business elements including taxes, paperwork, how you can raise working capital and investment, as well as the amount of personal liability you could be subject to.
Knowing how important this decision is, we’ve researched the most commonly used business organizations and broken out how they could impact you, your partners, earnings, and the legacy of your business. Let’s start with the basics.
The 4 Main Types of Business Organizations
As we’ll see in the next section, there is a myriad of business structures available to entrepreneurs. However, there are 4 main business organization categories:
A sole proprietorship is the simplest form of business organization. It’s a business that has no separate existence from the owner, as all income and losses are taxed against their personal income tax return.
While there are several types of partnerships that we will delve into shortly, in legal terms, a partnership is the formation of a business between two or more people. As partners, these individuals share management of the business as well as any profits and losses.
A corporation operates as a separate, legal body lead by an elected board of directors. The board is elected by shareholders, otherwise known as the owners of the corporation. Aside from the ability to vote and a few other personal rights, corporations have the same legal rights of an individual.
Limited Liability Companies
When it comes to types of business organizations, the limited liability company (better known as 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.
Since each business organization has its own tax considerations, you will want to match your business’s needs wisely and choose the structure that works best for you.
Let’s start with the most straightforward business organization, the sole proprietorship.
As its name would suggest, a sole proprietorship is a business owned by one person.
Compared to the other business organization methods, this option requires the fewest amount of documents to complete and file. Since everything funnels back to the owner, there is no profit-sharing to sort through, making the whole process very simple.
- Easy setup
- Full control
- You receive all of the profits
- Direct access to feedback
- Unlimited liability
- Full responsibility
- High working capital demands
With a sole proprietorship, you do not need to separate the company from yourself as an individual. You are even welcome to use your own name as the name of your business if you so choose. Under this structure, you are required to pay a self-employment tax against your own income. You are also directly responsible for every asset, liability, profit, and loss.
Before deciding to file your company as a sole proprietorship, you need to understand if it’s the best fit for you. Let’s start with companies that would be good candidates for operating under this business organization.
Businesses without much risk in their industry can function as a sole proprietorship without much issue. A good business insurance policy would be able to protect you from most issues. For example, independent consultants, tutors, virtual assistants, and online drop-ship retailers would be excellent candidates to operate as a sole proprietorship.
On the other hand, if your business were to be operating in the healthcare industry, for example, it would not be a good personal or business decision to function as a sole proprietor due to the high-risk nature of the business. Any other business operating in the manufacturing, repair, personal care, or food and hospitality industries would not be the best fits for this business structure.
Your personal assets are directly at stake in a sole proprietorship, so be sure you’re protected in the event of unforeseen circumstance.
There are three forms of partnerships:
- General partnerships
- Limited partnership
- Joint ventures
Each partnership shares similar features, though each has different ownership and liability structures. In any partnership, each partner is required to commit resources like capital, property, or tangible experiences such as skilled work or labor in order to share in the business’s profits and losses.
As we’ll break down for each partnership, at least one partner is tasked with making decisions the business’s day-to-day operations. While it is not required legally, each partnership requires that a formal partnership agreement is drafted. 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.
Now that we have a better understanding of partnerships, let’s learn more about their specific forms.
A business owned by two or more people, with a maximum of 20 owners, who have agreed to share all assets, liabilities, profits, and losses of a company. These 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
To form a general partnership, there are 3 specific standards that need to be met. Let’s take a look at them.
- The partnership needs to include two or more owners
- Each partner must be comfortable with unlimited liability
- Proof that the partnership exists via a formal partnership agreement
Compared to a corporation or an LLC, the costs of establishing a general partnership are minimal and do not 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 a general partnership, 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 that each partner is bound to adhere by. It’s recommended that agreements like these be cleared before being agreed upon, however.
Arriving at these decisions typically occur through majority vote amongst all of the 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.
When a partner passes away, the general partnership is typically dissolved. 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.
Establishing a limited partnership requires two or more individuals agreeing to start a business where one or more of the partners are liable only for the amount they have invested.
Clearly, what separates limited partnerships from other partnerships is that partners can limit their liability. Limited partners, also known as silent partners, have a stake in the company but do not have the ability to 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 between limited and general partners is that they are not 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 an arrangement between two or more parties (often established businesses) who have agreed to combine their resources in order to accomplish a specific project. This 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
- Different visions for the joint venture
- Imbalanced inputs and outputs between parties
- Lack of communication could derail project
An example of a joint venture is the collaboration between Alphabet (Google’s parent company) and Fiat Chrysler Automobiles. In May of 2016, the two companies announced that they would be collaborating in an effort to develop self-driving cars. While each could have certainly done this independently, both partners decided they had a greater opportunity to achieve their goals by working collaboratively.
Technically, a joint venture is not a partnership. Since the term partnership is used to describe a single body of business formed by one or more individuals, a joint venture may not formally fall into the same category.
With a joint venture, each party is responsible for the costs of the project and will be associated with any profits or losses. It should be noted that while each partner 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. The agreement will indicate how much each partner contributed, where day-to-day responsibilities lie, and how profits and losses will be handled.
Ideally, the partners should establish a new entity when forming a joint venture. This will allow for the partners to have a clear sense of how taxes will be paid. Through the joint venture agreement, the partners are able to declare how the joint venture will pay its taxes.
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?
The direct definition of a corporation is a group of people united in one body for a specific purpose. There are two distinct variations of a corporation that we’ll get to in a moment, but first, let’s review the basics of a corporation.
In the eyes of the law, a corporation is a legal person. As strange as that may seem, it’s true. 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.
A corporation is owned by its shareholders and is operated by elected officers. These officers are elected by the largest shareholders through a group of individuals known as the board of directors. Depending on the size of the company, one person can be an officer, director, and shareholder simultaneously.
Unlike an actual person, a corporation can live on in perpetuity, as long it is profitable. Shareholders are able to either sell or transfer their shares enabling the corporation to live in the event of a cashout or death.
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 is able to, within reason, protect its owners from being held personally responsible for business debts and obligations.
Now that we’ve established the basics, let’s compare C Corporations to S Corporations.
Every corporation begins as a C Corporation. To form a C Corporation, business leaders need to choose and register with an unregistered business name. The articles of incorporation will be filed with the Secretary of State within the state you’re filing within. 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 taxed independently. 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 that there is a double taxation situation occurring 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. A corporation 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 15th of that year.
Many states require owners to pay annual reporting fees, franchise taxes, and other miscellaneous fees. These fees are not very expensive, fortunately, 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 to an S Corporation would be to save on taxes. Let’s quickly break down the differences between Federal and State taxes.
An S Corporation is taxed similarly to a sole proprietorship or partnership as long there are 100 shareholders or less. Any profit or loss are passed directly through to the shareholders and are taxed and reported on their personal tax returns.
With S Corporations, states often times pass profits and losses through to the owners, with some states even taxing these owners double.
Choosing to establish an S corporation may show the owner’s formal commitment to the company, which in turn could help build credibility amongst employees, suppliers, and investors. Another advantage of an S Corporation includes the transfer of interests. S Corporations do not face the same issues with tax consequences, adjusting property basis, or complying with complex accounting rules that a C Corporation would be subject to.
- 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.
S Corporations are watched very closely by the IRS since 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 in order to avoid any 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
More commonly known and referred to as an LLC, a limited liability company is a business organizational structure that protects the owner’s personal assets in the event of a business fault or accident.
Having your business structured as an LLC won’t fully prevent you from being personally liable if it is determined that the owner has taken action that is illegal, reckless, or fraudulent. Owners can also be held responsible if they have not properly distinguished the activities of their company from 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 rules of an LLC are established by each state, meaning the rules for each owner will differ depending on their location. You will need to file the name of your LLC along with your articles of organization, with the state in which you’ll operate.
It’s also possible that you will be asked to prepare an LLC operating agreement stating each owner’s percentage of ownership in the company. This operating agreement will also indicate each owner’s distribution of shares, responsibilities, voting power, and the protocol in the event that the owner wants to sell their stake in the business.
The state in which you’re filing may require you to publish the establishment of your LLC in your local newspaper as a statement of public record. Each state has their own LLC fee structure, ranging from $100 to $800 which is paid during the initial filing. Because an LLC is a state structure, there are no specific tax forms at the federal level. LLC also have the choice of being taxed as a corporation, partnership, or as an individual. Work with a CPA to determine which tax election is most advantageous for you.
Choosing the Right Type of Business Organization for You
Now that we’ve gone through the advantages and disadvantages of each type of business organization, you should feel much more comfortable making your decision. Be sure to keep in mind that business organization laws and regulations will differ from state to state and will certainly have an impact on any structure you choose.
Change is a constant in business. Even after settling on a form of business organization, things evolve and require you to adjust. You can reassess your needs at any time and reorganize your company if you ever need to with the help of a lawyer and an accountant. One type of business organization never fits all, but there is one that’s just right for you.