Choosing a business structure has implications for every aspect of a business, including how a business is managed, how the business pays taxes, how the business makes money, and how the business handles profits and losses. Starting a business can be as simple as filing for a business license and beginning operation as a sole proprietor. However, the process becomes more complicated where business owners opt for a partnership or corporation.
This article discusses the main types of business structures, the steps necessary to start each type, and their pros and cons in terms of liabilities, operation, and taxation.
Sole proprietorships are the most common form of business structure due to how easy they are to start. Any person operating a business under his or her name is automatically considered a sole proprietorship if he/she does not file paperwork with the Secretary of State to form a different kind of business. To form a sole proprietorship, a person simply starts a business, files for a business license with their city or local municipality, and usually opens a separate business bank account. Sole proprietorships operate under the owner’s social security number for tax and other registration purposes. After those steps, the business is ready to operate.
Sole proprietorships are ideal for someone with a business idea or a skilled trade who wants to start a business quickly with minimal investment since there is no state or federal fee necessary to start a sole proprietorship. Sole proprietorships are managed by the individual owner, which is beneficial for someone who wats full control over the business.
The sole proprietor is, for all intents and purposes, the same as the business. Because sole proprietorships do not operate as a separate business entity, the person and the business are treated the same. Thus, the assets of the business are owned by the sole proprietor. Likewise, the debts and liabilities are personally owed by the sole proprietor as well. If the business suffers a major liability or goes into debt, the owner’s personal assets can be used to pay for them. Thus, although they are easy to start, sole proprietorships are not ideal for high-risk businesses or for people with substantial personal assets.
A partnership is a simple business structure where two or more people own a business together. There are different types of partnerships, but the main types are general partnerships, limited partnerships (LP), and limited liability partnerships (LLPs). A partnership is governed by the partnership agreement, which defines the roles of the partners, how the partnership will be managed, and how the partnership will dissolve. Partnerships can be managed by all the partners or have one or more silent partners who are not involved in the day-to-day business. The structure depends on the terms of the partnership agreement.
In a general partnership, all partners share in the profits and liabilities of the company equally. The partners take on personally liable for the debts of the company and are not personally protected from liability.
A limited partnership combines aspects of the general partnership and an LLP. An LP has one general partner who has unlimited liability, while the other partners have limited liability. The partners with limited liability have less control over the business than the partner who takes on the liability. Often, one or more partners is a silent partner with no control over the management of the partnership. This structure is ideal for a business where one or more partners wants to manage the business and the others invest with the goal of making passive income.
In a limited liability partnership, all partners enjoy limited liability and are not responsible for the debts of the business or the actions of the other partners. LLPs are popular among professionals like lawyers and accountants because of the flexibility in designating some partners as equity partners and some as salaried partners, as well as the limited liability.
Partnerships are recognized by every state, and most states adopted their form of the Uniform Partnership Act, which provides a uniform set of rules for governing partnerships. In terms of taxation, the partnership itself does not pay income tax. Rather, taxes pass through to the partners who then pay individual taxes on profits and losses. Partnerships are desirable in that they avoid the double taxation of corporate entities. Partnerships are also flexible because the partners can decide how control and liability are spread amongst the partners.
Limited Liability Company (LLC)
An LLC is an unincorporated business owned by one or more people who are called members. The members own the LLC, and operate the LLC according to an agreement. The LLC entity is a separate entity from the members. The most advantageous aspects of the LLC are its flexibility and limited liability. Members have contractual limited liability for the business’ liabilities because the LLC protects the owner’s personal assets from liability. However, there are exceptions to limited liability in situations where the LLC members co-mingle their business and personal affairs. In those situations, members of a closely-held company can be held personally liable for liabilities.
The LLC is flexible because the owners can choose how to manage the LLC. The LLC can either be managed by one or more members, or the members can appoint a manager to run the LLC. Members who also manage the LLC are called member-managers. Unlike a corporation, the LLC does not have to be managed by a board of directors, and the members do not have to comply with the same formalities as corporations.
LLCs are formed by filing an application with the Secretary of State and paying the associated fee. Some states limit the life of the LLC. In states where LLC’s have a limited life, the owners can dissolve it and re-form a new LLC.
LLCs are also flexible in regards to taxation. LLC member can choose how to pay taxes. For example, a single-member LLC can file as a sole proprietorship and pay taxes as an individual, or an LLC with multiple members can file as a partnership or corporation. However, single-member LLC owners will also have to pay quarterly self-employment taxes to the IRS.
LLCs are advisable for one or more people who want to start a business and ensure their personal assets are protected from liability.
Corporations played a huge role in the industrial development of the United States, and continue to occupy a predominant place in almost every aspect of American society. A corporation is a legal entity separate from its owners created in order to operate some kind of business. The modern corporation has its roots in British “joint-stock” companies, which formed in the 1600s. The British Crown granted monopolies to merchant investors and created joint-stock companies to allow merchants to aggregate capital and resources. This made it easier for merchants undertake ventures es too large or expensive for any one person to handle.
One example of a prominent joint-stock company was the East India Company. The East India Company formed as a British joint-stock company and was granted a monopoly over the spice trade with India. The East India Company became so large and powerful, it helped Britain to slowly control and take over India. In the United States, Britain’s joint-stock companies, like the Virginia Company, helped Britain colonize and control North America. After the American Revolution, the United States’ government continued the tradition of joint-stock companies by chartering corporations like the Union Pacific Railroad in order to build infrastructure.
Private corporations emerged in the late 1800s when states like New Jersey passed laws allowing corporations to define the scope of their charters without a government charter. This led to widespread monopolies in industries like oil and railroads, and prompted the government to regulate corporate monopolies through the Sherman Antitrust Act and the Supreme Court’s decision in the Northern Securities Case.
Today, forming a corporation entails filing an application and Articles of Incorporation with the state of the corporation’s choosing. Some businesses incorporate in a state that is different from their principal place of business in order to take advantage of certain protections provided by a particular state’s laws. For example, many companies incorporate in Delaware because of its business-friendly atmosphere. Delaware has a separate court that only adjudicates business-related issues using judges instead of juries, which is advantageous for businesses.
A distinctive feature of the corporation is its ability to sell stocks. Corporations raise funds by offering shares of its corporation to prospective shareholders in exchange for money. This is advantageous because it allows corporations to fund expansions, research and development, or production with shareholder money.
Corporations must abide by certain corporate formalities in order to keep their corporate status. Formalities include registering stock with the government, appointing a board of directors, which oversees business operations, and holding annual board and shareholder meetings where minutes are kept. Corporations must also keep a variety of records, including every time stock is sold or transferred. Keeping up with corporate formalities can be burdensome and require a lot of resources.
One drawback of corporations is the fact that they are double-taxed. This means a corporation pays taxes on profits, and shareholders are personally taxed when the corporation distributes dividends. Like LLCs, corporations shield the shareholders and board of directors from personal liability for debts and liabilities in most situations.
Overall, corporations are desirable for medium to high-risk ventures, or companies that need to raise capital.
An S-Corporation is a type of corporation meant that avoids the double taxation faced by regular corporations, so named because it is formed under Subchapter S of the IRS Code. S-Corp’s enjoy pass-through taxation, meaning corporate income and losses pass through to the shareholders for tax purposes. The shareholders pay personal taxes at individual tax rates.
S-Corps enjoy the same limited liability as LLCs and Corporations. The owners of S-Corps generally pay themselves a salary, unlike LLCs which pass all profits through to the individual members.
Creating an S-Corp requires filing an application with the IRS rather than the state. However, only certain corporations can qualify as an S-Corp. For example, only corporations with one class of stock and 100 shareholders or less can register as an S-Corp. S-Corps also require the same burdensome corporate formalities as other types of corporations, which must be followed at all times. Overall, a S-Corp may be a good alternative to those businesses that can quality to a traditional corporation in order to avoid double-taxation.
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