Business Structure

Choosing your Business Structure

One of the most important decisions you will make when starting your business is deciding on a legal structure for your company.  The business structure you choose will have legal and tax implications, but furthermore, it can affect your personal liability and perhaps your company’s ability to raise money. You should seek advice before establishing a business structure and you can seek advice by hiring a consultant like Vanguard Global Solutions.  There are no cost options where advice is also available like your local small business development center.

The business structure you choose will depend on three primary factors including liability, taxation and record-keeping.  Here is a brief overview of the most common forms of business entities and their differences.

Sole Proprietorship

The simplest form of a business organization is a sole proprietorship.  A sole proprietorship means the owner of the business becomes the business and uses their tax identification number or their social security number for tax purposes; there is no separate legal business entity.  This type of business organization is the most common and also the simplest to set up.  There are several advantages for this type of organization including easy setup, low formation cost, the sole proprietor owner makes all management decisions, and all business profits flow directly to the sole proprietor and the sole proprietorship can be easily transferred or sold.  There are also disadvantages including unlimited personal liability and limited access to capital.  The unlimited personal liability is the most important disadvantage to understand when contemplating a sole proprietorship form of business.  The sole proprietor can be held personally liable for the debts and obligations of the business. This risk extends to any acts committed by employees of the company.  Additionally, all responsibilities and business decisions fall on the shoulders of the sole proprietor which can be a double edge sword.  A sole proprietorship is not a separate legal entity, so a sole proprietor pays only personal taxes and the profits or loss from the sole proprietorship are included in the individual federal tax return.

General Partnership

General partnerships are made up of two or more partners and each partner participates in the management of the business and they are all responsible for the business’s debts and operations.  Each partner contributes skills, money, and time, and each shares in the company’s profits and losses.  The name of the business can be any of the general partners name or a fictitious business name.  In order to form a partnership, the prospective partners must create an agreement.  This agreement can be oral, written, or implied from the conduct of the parties. Although no formal agreement is required it is highly recommended to have a written form of the agreement to ensure all partners understand the details of the agreement.

Limited Liability Partnership

A major difference between a general partnership and a limited liability partnership (LLP) is that in an LLP there are two types of partners.  The LLP has general partners and limited partners.  General partners invest capital, manage the day-to-day business operations, and can be personally liable for partnership debts.  Limited partners can also invest capital into the organization but do not participate in management decisions and are not personally liable for partnership debts beyond their capital contributions.   The creation of an LLP is a formal process and requires public disclosure.  The partnership must comply with the statutory requirements of the Revised Uniform Limited Partnership Act and any other applicable state statutes.  The partners are required to sign a document called a certificate of limited partnership.  The name of an LLP cannot resemble the surname of a limited partner unless it is also the name of a general partner.  Also the name must contain, without abbreviation, the words limited partnership.  An example of where a limited partnership would be a good business organization would be a small film production company.

Limited Liability Company

A Limited Liability Company (LLC) is a recent development in the case of business organizations.  An LLC blends the advantages of the previous mentioned business organizations together.  An LLC is an unincorporated business entity that combines the most favorable attributes of general partnerships, limited partnerships, and corporations.  The formation of an LLC is more formal than the previous types of business organizations discussed.  An LLC is formed by creating articles of organization and sending them to the state where the LLC is filing.  Liability is a major decision point in the selection of a business organization type.  An LLC is liable for any loss or injury caused to anyone as a result of a wrongful act owner, employee, or any other representative while in the normal course of their duties as associated with the LLC.

Corporations 

Corporations are the most common form of business organization in the United States, and range in size from one owner to thousands of owners. Owners of corporations are called Shareholders and they are usually shielded from the debts of the corporation.  Officers of the Corporation may be subject to liability in cases of fraud or severe mismanagement.   This form of business is characterized by the limited liability of its owners, the issuance of stock shares, and continuity of the business.  In order to become a corporation, a business entity must incorporate which provides separate legal standing for the company from its owners.  Owners are also protected against personal liability.  Incorporation provides companies with a more flexible way to manage their ownership structure and provides a variation of tax implications which can be seen as both advantageous and disadvantageous.

Creating a corporate entity is fairly straightforward.  Generally, a corporation files articles of incorporation with the government, laying out the general nature of the corporation, the amount of stock it is authorized to issue, and the names and addresses of directors. Once the articles are approved, the corporation’s directors meet to create bylaws or rules that govern the internal functions of the corporation, such as meeting procedures and officer positions.  There are two types of corporations a C corporation and an S Corporation. The singular main difference in these two types of corporation is the taxation rules.

If a corporation elects to be taxed as an S-Corporation, it pays no federal income tax at the corporate level.  Similar to a partnership, the organizations income or loss flows to the individual shareholders income tax returns.  This type of corporation is advantageous if the corporation is expected to have losses that can be offset against other income of the shareholders or the organization is expected to make profits, and the shareholders’ income tax brackets are lower than the corporation’s.  Both types of corporations can sell stock to raise capital from investors for the growth of the organization.

The ideal choice for a large publicly held corporation would be the C-Corporation.  The C-Corporation completely separates the individual shareholder taxation from the corporation.  A C-Corporation is the only business structure that is not a pass through entity, which means your net income is taxed at the corporate level before it is distributed to the owners or shareholders, who must also pay tax on the income.