Business can operate in any one of a number of different forms. Each of the business forms has advantages and disadvantages and no one form is “right” or “wrong” for everyone. In this section, we will briefly discuss the various business forms that a businessperson can choose when starting or operating a business. It is important to note that choosing a business form is critical for a new company, as a “bad” decision as to which business form to use can cost lots of money in the forms of extra taxes, legal expenses and troubles, personal liability for the business operator, difficulty in raising money for the business, etc.
A sole proprietorship simply means that the person forming the business is doing so by him or herself. Sole proprietorships constitute the vast bulk of companies in the United States. Essentially, there is no legal distinction between the people who own sole proprietorships and the companies themselves. The business profits or liabilities are treated exactly as though they were personal profits or liabilities of the owner.
A partnership is a business form whose organizational structure originates from the laws of agency and agency relationships. The typical partnership is made up of two or more individuals who operate the business as co-owners.
The partnership is, in some instances, considered an entity unto itself. For example, the partnership may own land in its own name and may be sued as an independent entity. However, certain liabilities of the partnership, such as its debts, obligations and tax burdens, are attributed solely to the owners of the partnership. Thus, all partnership assets and debts are considered the assets and debts of the partners themselves. This, of course, means that partners are personally liable for all partnership debts. Thus, if the partnership is sued, the partners might lose their own personal money and possessions because of the suit. This is sometimes called “unlimited liability” and is the main drawback of the partnership form. It is possible to form a partnership without a formal written document. While some states require or prefer the creation and/or filing of a "partnership agreement," it is often the case that simply acting in concert with a combined business objective will result in a partnership being implied by the law.
The IRS has a fairly complicated system of taxation for garnering revenues from a partnership. At its most basic level, however, taxation of a partnership is straightforward. Essentially, the partnership does not incur a tax liability separate from that of its members. In other words, taxes on profits and other business transactions accrue to the individual partners rather than the partnership. In the end, this means that the tax rates and other tax attributes of the individual, and not the partnership, control the rate and timing of taxation on the partnership's operations.
Limited Partnership (also sometimes called “limited liability partnerships”)
The limited partnership is characterized principally by two factors. Unlike in a general partnership, there are two specific subsets of partners: limited partners and general partners. An LP (or “LLP”) is formed by at least one general partner and at least one limited partner. The second major trait, as described in the name, is the difference in the nature of liability of the partners. The general partners in an LP retain the unlimited liability characteristic of the general partnership, while the limited partners obtain the benefit of “limited liability.” This means that they are not personally liable for debts or liabilities incurred by the partnership. In essence, the most money that the limited partners can lose is the amount of money that he or she invested in the business (if the business goes bankrupt, he or she loses the entire investment).
The creation of an LP is a state regulated process where formal creation and filing of documents with the state is required. Ownership of the LP is split between the general partners and limited partners. However, an important rule is that the management of the partnership must be done by the general partners and NOT by the limited partners. If a limited partner is too much involved with the operation of the company, a court may remove the liability shield and hold the limited partners liable for partnership debts.
Taxation of an LP is generally identical to that of a general partnership. This means that profits and losses are passed through to the general and limited partners based on their ownership percentages in the partnership.
A corporation is the business form chosen by many larger companies, although there is no size requirement for the formation of a corporation. Unlike some of the other forms of business, the corporation can be expensive and complicated to form, depending on the state and the type of corporation. All states require some kind of filing by the business with the state in order for the corporation to be formed.
The main advantages of the corporation are ability to raise capital (money for operations) quickly and efficiently and limited liability for the corporate owners.
A corporation’s owners are called “shareholders” because they own “shares” in the company. Shares are easily transferable because they can be sold from person to person. This makes it easy for corporations to raise capital because the corporation can sell parts of itself to any investor at any time it needs money.
A corporation also features the advantage of “limited liability”. This means that the owners of a corporation (the shareholders) are not personally liable for debts or liabilities of the corporation. As with limited partners in a limited partnership, the most money that the corporate shareholder can lose is the amount of money that he or she invested in the corporation.
The main drawback of the corporation is in the area of taxation. Unlike the other business forms, the company is itself taxed on funds that it receives from transactions. That is to say, the company pays taxes on its earnings just like an individual pays taxes on his or her wages. The problem is that after taxes are paid, the remaining income that goes into the company must eventually come back out again. In other words, over time, as the company pays dividends, sells assets or ultimately liquidates, the value of the company is paid out to its shareholders. The government now takes a second bite at the apple, taxing these dividends and distributions as they enter the hands of the shareholders. This phenomenon is sometimes known as “double taxation”.
A corporation is governed by a “board of directors” which makes the “big” decisions on behalf of the company, such as which officers to hire, whether to go into a new line of business, etc. The day to day operations of the company are handled by the company’s “officers.” Corporate officers can include the President, the Chief Executive Officer (CEO), the Chief Financial Officer (CFO), etc. Some really major decisions, such as whether to dissolve the company, however, are reserved for the shareholders.
Corporations and their management are discussed in much greater detail in the course on Business Law.
Limited Liability Company
The limited liability company (LLC) is a more recent invention of the business law community. The LLC is a hybrid entity, as it shares some features with the corporation while having some features that are more typical of partnerships. The goal of the LLC's originators was to create a business form that shared some of the best aspects of both of these two divergent business forms, combining them into one relatively flexible entity.
An LLC is made up of "members" - the LLC equivalent of a shareholder (in a corporation) or a partner (in a partnership). An LLC is formed by filing "Articles of Organization" (or similar documents known by various names in different states) describing the purpose, management, and organization of the firm.
The LLC is not subject to a tax at the organizational level. This means that taxation of the LLC occurs solely on the basis of profits and losses as allocated to each member's capital account. Thus, the LLC avoids the problem of “double taxation” that afflicts the corporation.
The LLC also has the advantage of limited liability for its members. Members of the LLC are not personally liable for the debts and obligations of the firm. Thus, while taxation of the firm has the benefit of partnership-style flexibility, the operation and liability for the LLC has more in common with the corporation.
The LLC is a very popular business form these days, especially for smaller business, because of its combination of limited liability for its members and its avoidance of double taxation.
The S Corporation
The S corporation, like the LLC, is a hybrid business form that was created with the intention of balancing the benefits and detriments of the corporation and partnership into a single business entity. However, the S corporation has seen a large number of its potential users elect either the LLC or LP business form over the S corporation form. The reason for this is while the S corporation does offer pass-through taxation and limited liability, the requirements that must be met to qualify for S corporation status are extremely stringent. These requirements include a limit on the number of shareholders and a limitation that only American residents may be shareholders in an S corporation.