Business law is a broad term referring to federal, state, and local laws governing the formation and daily operation of all business entities, from sole proprietorships to corporations. Understanding the basics of each structure is essential to determining the best structure for your business. Additionally, it is useful when determining whether to alter your existing business to a new structure or selling a business to another party.
What Is a Business Structure?
Business structure is a term used to describe the way a business is organized in terms of leadership, direction and rights/liability. Additionally, how you structure your business is an important decision to make as it can affect the following areas:
- The amount of taxes that you are required to pay;
- The amount of personal liability you will have; and,
- The amount of paperwork required to establish and maintain your business.
- Each type of business structure carries with it advantages and disadvantages which should be analyzed carefully to ensure that one chooses the correct type of business structure for their business. There are some factors to consider when choosing a business structure including:
- The potential risks and liabilities inherent to the business;
- Type of costs incurred to establish and maintain the business structure;
- Potential investments required;
- How will federal and state governments tax the business.
Common business structures include:
- Sole Proprietorships. A sole proprietorship has only one owner and does not need to be registered with the state. These types of businesses are easy to set up and maintain. Owner of the sole proprietorship makes all management decisions for the business and all profits and liabilities of the business belong solely to the sole proprietor. A sole proprietorship structure is simple and easy to maintain, however, it still requires the owner to ensure that the business stays legitimate in the community where it operates by keeping up to date with local registration, business licenses and other permit laws required to run your business. The major disadvantage to a sole proprietorship is that the owner has no protection in the event they are sued or have liabilities.
- Partnerships. Partnerships or general partnerships do not require any formalities to be formed. A general partnership is defined as an arrangement by which two or more people are engaged in a business for profit. These partners agree to share the profits and financial losses of the partnership. Additionally, in terms of liability, each partner is individually liable for the business debts of the partnership if the business itself cannot pay the bills. Furthermore, if a contract, tort, or criminal liability suit is brought against one partner, it is brought against all the other partners as well. In a general partnership, all partners are considered agents for the other. Partners therefore have a fiduciary duty to act in the best interest of the partnership. In the event a partner breaches this fiduciary duty, the other partner(s) can sue the breaching party for damages resulting from that breach.
- Limited Partnership. A limited partnership exists where there are one or more general partners and one or more limited partners within a partnership. In a limited partnership, one partner must be the general partner. The general partner makes the management decisions of the business, while the limited partners do not. However, the general partner also assumes 100% of the risk for liabilities and debts of the limited partnership. Limited partners, on the other hand, only risk the financial contributions they originally made to the limited partnership. Despite this, all the partners in a limited partnership, whether general or limited, share in the profits of the business.
- Limited Liability Partnerships (LLP). A Limited Liability Partnership, or LLP, is a partnership where one or all partners have limited liability for the partnership. An LLP is unusual in that is exhibits elements of a partnership and a corporation. A trademark characteristic of an LLP is that one partner is not responsible or liable for another partner’s misconduct or negligence.
- Corporations. A corporation is a legal entity owned by shareholders within the corporation. The corporation itself, not the shareholders, are legally liable for the actions and debts the corporation incurs. A corporation enjoys most of the rights and responsibilities that an individual possesses, specifically that the corporation may enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets, and pay taxes.
There are four different types of corporations including C Corporations, S Corporations, Professional and Nonprofit Corporations.
- C Corporations. A traditional corporation is referred to as a C corporation. A C Corporation has a business structure that is created as a separate, distinct legal entity from its owners. Advantages of a C Corporation aside from the limited liability for owners include: tax benefits and the ability to raise capital and attract investors.
- S Corporations. An S corporation is structured in a manner as to provide a pass-through entity for tax purposes. The term “pass-through” means that the corporation’s income or losses pass through to the individual shareholder’s tax returns. The S corporation however has the same limited liability of traditional corporations.
- Professional Corporation. A professional corporation is a corporation that certain groups of professionals can form. These types of professionals include accountants, engineers, lawyers, physicians, and other health care professionals. The list of professionals that can form a professional corporation vary from state to state, so it is important to make sure that your specific type of corporation can be classified this way in the state in which it is formed.
- Nonprofit Corporation. A nonprofit corporation is formed in order to conduct activities and transactions for purposes other than shareholder financial gain. While a nonprofit is permitted to make a profit, the profit must be used to forward the goals of the organization, rather than to provide income to the shareholders.
- Limited Liability Companies (LLC). Limited liability companies shares the limited liability of a corporation but is not held to the same strict management requirements of a corporation. Similarities to a corporation include that one can only create an LLC by following the state laws in which the LLC is formed. An LLC is generally defined as a business entity somewhere between a corporation and a partnership that consists of one or more persons. An LLC combines the pass through taxation of a partnership with the limited liability of a corporation. An LLC has managers, members, and sometimes employees. The owners or member of a LLC participate in the management of the business. Members, managers, and employees are not held personally liable for the debts of the business as they would in a general partnership or sole proprietorship.
What Are the Advantages of Sole Proprietorships?
There are many advantages to a sole proprietorship, the majority of which include:
- Simple Formation. A sole proprietorship can be created without any actual registration with the state or federal governments. A sole proprietorship is less complicated and expensive than forming a LLC or a corporation.
- Tax Benefits. The owner of a sole proprietorship is not required to file separate taxes, but can simply file as an individual, just as they would have otherwise. This can save costs that are often incurred in employing an accountant and tax filings for a corporation or LLC. The business is taxed at the rate applied to personal income, not corporate tax rates.
- Employment. Sole proprietorships are able to hire employees which can afford them tax breaks when they file their taxes. Spouses of the business owner can also employed without ever having to declare that they are an employee. Married couples can form a sole proprietorship, though the liability is only assumed by one party.
Control. Control of the sole proprietorship lies solely in the owner.
What Are the Disadvantages of a Sole Proprietorship?
There are disadvantages to a forming a sole proprietorship including:
- Liability. A sole proprietorship is not protected the same way that a corporation or LLC is. A business owner assumes all losses, debts, violations, and other liabilities assumed by the business. For example, the owner can be sued for any unlawful acts committed by the employees.
- Taxes. While not paying taxes at a corporate tax rate and filing as an individual has it's benefits, a sole proprietor must pay self-employment taxes. Additionally, some tax benefits are not deductible, such as health insurance premiums.
- Life of the Proprietorship. If the owner of a sole proprietorship dies or becomes incapacitated, the business does not continue. The business is liquidated on the owner's death and becomes part of the owner's personal estate and is distributed to the beneficiaries. This can result in heavy tax consequences on the beneficiaries due to inheritance taxes and estate taxes.
- Raising Capital. Initial funds are usually provided by the owner of the sole proprietorship and yet can be difficult to raise capital. Sole proprietorships do not issue stock or other money-generating investments like corporations.
What Are The Advantages of a Partnership?
There are many advantages to a partnership which make it an attractive option when determining a business structure. These advantages include:
- Control: Partnerships allow for greater control by the partners than would be possible in different business forms such as a corporation – where decisions must be made by a majority of the board of directors, and can be affected by shareholders.
- Taxes: A partnership does not usually file taxes, but each individual files their own taxes as they would as an individual. This can be an attractive element of a partnership, especially for those with smaller business who do not wish to have a complicated tax process.
- Survival of the Partnership: Partnerships terminate or dissolve when a partner within the partnership becomes deceased or incapacitated.
- Creation: Partnerships are easy to create and require less paperwork and annual maintenance when compared to other types of business structures.
What Are the Disadvantages of a Partnership?
Despite these advantages, there are a few important disadvantages to a partnership which should be considered in depth. For example, a partnership will not extend beyond the life of a partner. If one hopes that their business have longevity, a partnership may not be the best option as it will dissolve upon any partners' death.
Additionally, partnerships have less restrictions on the manner in which the business is controlled. While some may view this as an advantage, for those working with other partners may prefer to have a more strict structure, such as in a corporation. A corporation's structure may ensure that no one acts in a manner that may endanger the corporation.
Partnerships also tend to limit the growth of a business because control is localized to a few individuals rather than members of a board. Partnerships are likely more suitable for start-up ventures and temporary projects as opposed to long-term businesses.
What Are the Advantages of a Limited Liability Company?
One of the major benefits of a Limited Liability Company or LLC, is that the single member can be the sole owner of the business. As a single member LLC, that member/owner can make their own business decisions regarding their business without having to consult or receive majority approval from other partners or board of directors. Similar to a sole proprietor, the sole member owns, manages, and operates their business the way they want to without liability issues related to a sole proprietorship. Additionally, if there is more than one member in an LLC, the Operating Agreement for the LLC can specifically spell out the respective roles of each member within the LLC. This can make it easy to manage as each member has their own respective tasks and responsibilities.
Another major advantage of an LLC is the limited liability characteristic. An LLC, similar to a corporation, is a separate entity from its individual members or owners. Members of an LLC are not personally liable for the debts and liabilities of the LLC. There are instances however when members of an LLC can be held personally liable for their actions, for example, if a member personally guarantees a business debt or fails to use due care resulting in harm to a third party or breach of duties to the LLC.
In contrast to a corporation, an LLC is considerably easier to manage than a corporation. Although an LLC requires registration with the state by filing Articles of Organization for the LLC with the Secretary of State, this can often be the extent of management for the organization. LLC's are not required to hold meetings and report their meetings to the state, however, LLCs do require annual fee and filing obligations.
LLCs permit the members to determine how profits of the business will be allocated under the terms of their operating agreement. LLC members are also not limited to only be permitted profit sharing to the proportion of ownership of the LLC, but can decide to divide up the profits in a different manner.
What Are the Disadvantages to a LLC?
Some disadvantages to a LLC include the following:
- Taxes. Members of a LLC are responsible for paying self-employment taxes. Contrasted with a Corporation that has made an S-election which eliminates the self-employment tax because profits flow through and are not treated as self-employment income. A LLC can choose whether it will be treated as a partnership or corporation when filing federal tax returns.
- Owners. LLC's do not have specific roles like a corporation where there are directors, managers, and employees. Often this can make it difficult for decisions to be made and who should make them. Therefore, these issues can be resolved by specifying the role of each member in the Operating Agreement.
While an LLC offers many of the advantages of a partnership and a corporation, it has definite downsides which should be considered prior to moving forward with this option.
What Are the Advantages of a Corporation?
A corporation must file Articles of Incorporation in the state in which they are incorporated. Additionally, corporations must hold organizational meetings in which they elect corporate officers, to determine authorized classes of shares, and to draft and enact bylaws which provide for the corporation's internal structure. Board of directors of a corporation are directed to hold meetings regularly to discuss, vote and finalize business strategies, finances, and internal policies. Annual shareholders meetings are also required. Like LLC's corporations must file annual reports and pay yearly fees to retain their corporate status.
Other advantages include the fact that a corporation can outlive its founders and owners. Ownership is easy to transfer and consumers and investors are guaranteed that the business will remain stable. This makes a corporation an attractive investment opportunity which can aid in business growth. In addition to the longevity of a corporation, through the sale of stock, a corporation can also attract additional investors which in turn help the business grow.
Corporations maintain credibility and reputation that other businesses have difficulty growing or maintaining. Corporations can be expenses and time consuming to create and maintain, therefore, if a corporation has a great reputation, the public is assured that the corporate is stable and a contributing member of the surrounding communities.
What Are the Disadvantages of a Corporation?
A major disadvantage in the creation of a corporation is that the creation and maintenance of a corporation can be expensive. There are a myriad of fees which are required at the onset of the creation of a corporation and multiple fees required to maintain a corporation in good standing on an annual basis.
There is also a tax liability for corporations that outweigh that of other business structures. Corporations are considered separate legal entities that require a separate tax return and corporations are also subject to double taxation.