There are several different types of business structures. Each one offers certain advantages and disadvantages in terms of management control, taxes, and potential liability on the part of individual owners or shareholders. If a person or group of people is setting up a business, they should familiarize themselves with the advantages and disadvantages of each kind of business entity.
It is important to keep in mind that the types of business structures are governed by state law, so each one might have slightly different features in different states. It is important, when considering which structure to adopt for any particular business venture, to consult the law of the state in which the business is to be located.
There is one exception and this is in the area of federal taxation. Of course, how a business is taxed for federal tax purposes is governed by federal tax law. State taxation will be governed by state tax law. Taxation under state law is another factor that should be considered.
Sole proprietorships are businesses owned by a single individual, who takes on all the risks of the business, including the risk of incurring debt and legal liability on behalf of the business.
There is no legal distinction between the sole proprietor and the business when it comes to liability for the owner. The sole proprietor also maintains full control over the business and realizes all of the profit.
A corporation is an entity that is legally distinct and separate from the corporation’s owners. The shareholders are the owners of the corporation, while members of the board of directors and officers, such as the chief executive officer, are responsible for its management. A corporation may enter into contracts, sell and buy property, sue and be sued.
A corporation is created when a group of shareholders who want to share ownership of their corporate business form a corporation under the laws of the state which they want to serve as the location of their corporate home. The owners of a corporation hold shares in the corporation. .
Corporations can only be created by complying with a state’s requirements for the formation of a corporation. For example, the people involved in forming the corporation must prepare and file articles of incorporation, usually with the secretary of state of state in which the corporation is being formed. The guidelines are defined by statutes in each state that address corporate governance. The shareholders of a corporation are not responsible for the debt or legal liabilities of the corporation. Corporations must have a board of directors, conduct annual meetings, and adopt bylaws.
A group of people can form a general corporation or they might be able to choose to form a number of alternative types. Two common structures are C corporations and S corporations. The main difference between them is that C corporations are taxed separately from their owners while S corporations are not. Instead, an S corporation’s income is passed through to the owners of the S corporation who then pay taxes on the income on an individual basis. S corporations are subject to limitations from which C corporations are exempt.
Such limitations include:
- The number of shareholders is limited to no more than 100;
- Only 1 class of stock is permitted;
- All of the shareholders must be residents of the state in which the S corporation is formed..
Limited Liability Companies
A limited liability company (LLC) is generally defined as a business entity consisting of one or more people. An LLC combines features of a corporation and features of a partnership. An LLC, like a corporation, has limited liability under the law. However, LLCs are not held to the same strict management requirements as corporations are. Limited liability companies consist of managers, members, and employees. LLCs, like corporations, are legal entities separate from their owners. They also have a choice in how they are taxed.
An LLC can choose among different tax treatments. They can choose to be taxed in the same manner as a sole proprietorship, which would mean that each member is taxed personally on their share of the LLC’s income. Or, an LLC can choose to be taxed in the same manner as a partnership. So, again, as with a sole proprietorship, each member would be taxed on their share of the LLC’s income.
Another option is for the LLC to be taxed in the same manner as an S corporation. Again, as a practical matter, this means that the LLCs income, deductions and credits flow through to the members and each member pays personal income taxes on their share.
Finally, an LLC can choose to be taxed in the same manner as a C corporation. A C corporation is completely separate from its owners when it comes to paying taxes. The earnings of a C corporation’s earnings are taxed at the corporate level. Dividends distributed to shareholders are also taxed at the personal level of the shareholder. Remember that if shares of stock are held in a retirement account, stock dividends are not taxed as they are earned. If stock dividends are distributed to a shareholder’s non-retirement account, they are taxable in the year received at 15 percent for most shareholders who fall within certain income brackets..
Many small businesses have converted from C corporations to S corporations to avoid the taxation of both corporate income and dividend income. However, the most recent changes to the Internal Revenue Code (IRC) significantly reduce the tax burden on C corporations. Under the recently revised tax code, the corporate tax rate was reduced from 35 percent to 21 percent, which is lower than the personal tax rate on pass-through income.
Individual tax rates were reduced as well, so even income that is passed-through to individual shareholders is now taxed at a lower rate. Taken together, this means there is no longer as significant a tax advantage to taxation as an S corporation as compared to a C corporation.
An LLC’s structure is usually less rigidly organized than that of a corporation, making investors wary of investing in them. An LLC is run according to its operating agreement, which is the LLC version of articles of incorporation. This document governs the day-to-day operation of the company including such issues as finances, organization, structure, and operations. Unlike corporations, which are required to appoint officers and a board of directors, an LLC is more flexible with its management structures. This, too, is stated in the operating agreement.
- General Partnership: A general partnership consists of two or more partners who come together to engage in a common business. A partnership can be formed with or without an agreement. All partners share the profits, debts and liabilities of the partnership and can be held personally liable for the debts and legal liabilities of the partnership;
- Limited Partnership: A limited partnership consists of one or more limited partners and one or more general partners. The role of the general partners is to make the management decisions for the business, while that of the limited partners is limited to investing capital in the partnership. All of the risk is assumed by the general partners, who also assume all debts and any legal liabilities and of the limited partnership. Conversely, the limited partners only risk their financial contribution. In most cases, all partners in a limited partnership share the profits of the business.
- Limited Liability Partnership: A limited liability partnership (LLP) is a partnership with limited liability for all partners. Some states reserve this structure for certain professions. Partners in an LLP are shielded from legal liability for the negligence or misconduct of the other partners.
Should I Consult an Attorney to Form a Business Entity?
Choosing an entity for your business can be a challenging task given the various options. If you are looking to create a business or change the structure of your business entity, consider consulting an experienced corporate lawyer who can help you evaluate your options.
There are a number of implications, including tax implications, to the choice of business structure. Each state has different laws, so you need to know the law in your state. There can be state tax law consequences as well to consider. A business lawyer can provide complete information about the implications of each type of business and help you find the one that best fits your needs.