Types of Business Organizations

Abstract

This article will focus on different forms of business. There are a number of ways to structure a business—these include sole proprietorships, different types of partnerships, limited liability companies, and corporations. Each form of business organization has advantages and disadvantages and these are largely influenced by the purpose of the enterprise as well as a number of other factors. Each type of organization poses different legal ramifications and income tax considerations. This article will provide an analysis of the different types of business organization as well as a brief discussion of the advantages and disadvantages of each structure.

Overview

There are a number of ways to structure a business, and the factors involved in choosing the appropriate legal structure include: the purpose of the organization; the size of the entity; the costs involved in starting the entity; state, federal and local laws and rules governing the business; and tax considerations. Essentially, there are four types of legal structures for business:

• Sole Proprietorship
• Partnership
• Limited Liability Company
• Corporation

There are advantages and disadvantages to each type of business organization and these are driven by a number of factors. The following is an analysis of the four legal structures.

Sole Proprietorship. A sole proprietorship is the most basic business form and is frequently utilized by a single person owning or running a business on his or her own. Such business enterprises are often run from the person's home. Owners pay taxes on the business profits and this is reflected on individual tax returns (Form 1040 and Schedules C and E). In some states, the costs of a business that is being operated from an individual's home may be deducted from income taxes. However, at the same time, certain counties and states may require a sole proprietor to pay property taxes on the value of any office equipment used for the business. In addition to tax liabilities, sole proprietors are also responsible for the debts of the business (Butow, 2004).

Partnership. A partnership is the legal structure for a business enterprise when two or more people start a business. There are different types of partnerships, and these include general partnerships, limited partnerships, and limited liability partnerships. In order to set forth how the business will operate, the partners should enter into a partnership agreement. The partnership agreement should specify who the partners are, what their roles and responsibilities are, and most importantly spell out how the profits will be divided between or among the partners.

A general partnership is a business structure where each partner is liable beyond what he or she has invested in the enterprise. Also, each partner can take actions that may bind the entire partnership. A general partnership is not a taxable entity because the income and losses pass to each partner who, in turn, reports the profit and loss on individual tax returns. Because the income and losses pass to each partner, these entities are also referred to as "pass-through" enterprises. In a general partnership, the profits and losses are normally distributed equally between or among the partners. At the same time, each partner is jointly and severally liable for all the obligations of the partnership. That means a person suing the partnership can choose to collect from any partner and does not have to collect an equal amount from each partner (Rianda, 2011).

On the other hand, a limited partnership (LP) is one where two or more partners agree to operate a business jointly. In this structure, each partner is liable only to the extent of the amount each has invested in the business. This entity is also pass-through enterprise. A limited partnership can also include both general and limited partners. In these cases, the general partners usually are responsible for running the operations of the business while the limited partners are essentially investors. Further, each partner shares the profits and losses according to the partnership agreement (Butow, 2004).

Another type of partnership is a limited liability partnership, or LLP. These structures are normally used by professional organizations such as law firms and accounting companies. An LLP has similar features to a partnership, but the partnership as a business entity is responsible for any debts and the individual partners are shielded from these liabilities. Some US states also recognize limited liability limited partnerships (LLLPs), which mix features of limited partnerships and limited liability partnerships.

Limited Liability Companies (LLC). A limited liability company is a cross between a corporation and a partnership. This type of business organization offers more protection from creditors' claims than a partnership. In this way, it is similar to a corporation, but it is also a pass-through entity so it shares the features of a partnership. However, LLCs have distinct features and requirements. In an LLC, the owners are called members. Members, in turn, can be individuals or corporations. However, unlike a partnership where profits and losses are evenly distributed according to the partnership agreement, there is greater flexibility in this regard for a limited liability company.

Further, in order to establish an LLC, it is necessary to file articles of organization with the secretary of state. Another way that LLCs are similar to partnerships is that a limited liability company is required to have an operating agreement. The operating agreement should specify who the members are, what the role and responsibility of each member will be, and how profits will be shared between or among the members. The operating agreement should also contemplate changes in ownership if other members are invited to join the enterprise or if an existing member decides to sell his or her interest. Finally, because this is also a pass-through structure, members report income and losses on personal income tax returns.

Some states require that certain types of professionals that provide special types of services, such as doctors, lawyers, or architects, do not form normal LLCs; this ensures that their liability for their services is not limited in way that could potentially harm consumers. Instead, these professionals may register as a professional limited liability company (PLLC), which restricts the limitations on liability to business matters.

A low-profit limited liability company (L3C) is a form of LLC with a dual mission: generate profit and provide a social benefit. Because of this distinction, these organizations are typically treated like not-for-profit organizations under the tax code (Hogg, 2016).

Corporations. A corporation is essentially an entity that exists separate and apart from its owners. Corporations are required to have at least one owner, and owners are called shareholders or stockholders; ownership interests are referred to as stock. Because a corporation exists separate and apart from the owners, the owners are protected from debts and liabilities. The corporation itself assumes liability for the debts and obligations of the business, putting aside the issue of personal guarantees (Rianda, 2011).

A corporation is established when articles of incorporation are filed with the secretary of state. This document establishes the reason for the enterprise and in some states it is referred to as a certificate of incorporation or a company's charter. The articles should clearly state the business purpose, but at the same time that description should also allow the business flexibility to grow and evolve. The basic information that should be stated in the articles includes the business' name and address, the name of the incorporators, the intended duration of the business entity (either perpetual or of limited duration) and the purpose of the business (Arend, 1999).

An incorporator is the responsible individual for filing the articles with the secretary of state. In many states, the incorporator cannot be an owner, officer or director of the business entity. A legal agent is a third party who is not affiliated with the business entity who will be responsible for accepting any legal process papers filed against the business. A legal agent can be a law firm, but there are also professional organizations that perform these duties.

Corporations are also required to have written by-laws. This is the governing document of the business and it establishes the operating procedures for the entity. By-laws describe the management structure and what the roles and responsibilities of the officers and directors will be. Generally, directors are senior executives or managers who are responsible for the day-to-day operations of the business while officers are the individuals appointed to implement the policies and procedures established by the directors. Officers report to the directors who are ultimately accountable to the owners, that is, the shareholders. By-laws should also specify the voting procedures, notice requirements, proxy, and the minimum number of people who must be present for a vote to be effective—this is referred to as a quorum.

Corporations are required to have an annual meeting, but meetings can also be held once every quarter, once a month, or at any time an action is taken that affects the operations of the business. Such action includes mergers, establishing new business ventures and promoting or terminating officers and directors. Minutes, or a written record of the meeting, must be prepared and the actions taken during these meetings are often memorialized in a written resolution. Resolutions, minutes and notices are required to be maintained with the company's books and records along with the articles of incorporation and by-laws.

There are three types of corporations: C corporations, S corporations, and benefit corporations. The former refers to a business that meets the minimum requirements for the definition of a corporation established by the Internal Revenue Service tax code while the latter is a designation for a business that is established pursuant to subchapter S of the code. A subchapter S designation allows a business to be taxed like a partnership where the profits and losses are passed through to the shareholders. At the same time, owners are provided with protection from debt liability. Finally to qualify as an S corporation there must be one or more, but fewer than seventy-five owners.

On the other hand, a C corporation does not have a limit to the number of owners; however, these businesses are not pass-through entities and the corporation's profits are taxed. Because of this, C corporations are subject to what has been termed "double taxation." In addition to the profits being taxed, shareholders are taxed on the dividends that are paid on the stock that they own. Further, shareholders are also taxed on any profits they receive on shares of stock that they sell. This is known as a capital gains tax. Corporations are required to pay salaries to the directors, officers and employees, who are also required to pay taxes on that income (Barney, 1997). Finally, unlike pass-through entities, C corporations do not separately state income or loss items. These are instead taken together to arrive at total taxable income, with the same tax rates applying to ordinary income and capital gains. Since income does not retain its original character in a corporation, many of the benefits available at the individual level are unavailable when the corporate form is chosen (Wong & Zambrano, 2012).

Finally, like an L3C, a benefit corporation serves the public interest socially and environmentally as well as seeking profit. Benefit corporations must not only adhere to the regulations for other types of corporations and pay taxes in the same way, but also produce a benefit report each year. First adopted as a legal designation in Maryland in 2010, by mid-2016 thirty states had laws allowing the formation of benefit corporations (Pippin & Weber, 2016).

Cooperatives (co-ops), run by and for shareholder-clients, may also be corporations. To corporate, they must submit articles of incorporation to the state, write by-laws, hold member meetings, and elect directors. As in an LLC or LLP, an incorporated co-op is a pass-through entity, meaning that the shareholder-clients are responsible for filing any income from the co-op on their individual income taxes (SBA, n.d.).

Corporations may also be subdivided, combined, and controlled in various ways. Holding companies are often formed as the owner of a corporation's stock in order to reduce ownership risk. Corporations may merge into one larger entity, sometimes requiring government approval due to antitrust measures. Corporations may also be considered conglomerates, in that they own and run many smaller, often seemingly unrelated businesses.

Applications

The type of legal structure that is appropriate for individuals starting a business depends on a number of factors. The following is a comparative analysis of the advantages and disadvantages of each form of business organization.

The most basic form of business, the sole proprietorship, is the best option for a single owner of a business. These entities are relatively easy to establish since they do not require extensive documents to be filed. At the same time, some states require certain business enterprises to be licensed. This includes, but is not limited to, electricians, plumbers, home-improvement contractors, real estate brokers, mortgage brokers, financial planners and even hairdressers. Some of the advantages of a sole proprietorship are that individuals can start these businesses without significant initial costs. Further, taxes are not paid by the business, but rather by the owner, and any profits are reported on individual tax returns. Therefore there is no need for extensive financial statements to be prepared.

The main disadvantage to this form of business organization is that the individual is responsible for any debts incurred by the business as well as other legal claims that can be initiated in the courts. This is especially relevant if the sole proprietor is a homeowner or owns other residential property. If the individual running the business does not pay debts or if a lawsuit is commenced against the business, a judgment can subsequently attach these debts to the person's dwelling. In short, a sole proprietor exposes their real property and other assets to debt and legal liabilities.

Another form of business organization that has been discussed is the partnership. This legal structure is frequently used by family businesses. Other than the possible licensing requirements, there is no need for extensive documentation and filings. Moreover, the profits of the business are not taxed since these are passed through to the individual partners. One disadvantage to this type of legal structure is that each partner is subject to a certain amount of liability for debts. Further, unless the partnership agreement states what should occur in the event of the death of a partner, partnerships do not provide for continuity of life. So if one of the partners dies, the partnership agreement may need to be renegotiated, and the surviving partner can find him- or herself doing business with people who were not originally part of the business.

A hybrid of partnerships and corporations is what is commonly known as a limited liability company, and this type of business draws on the advantages of partnerships and corporations. The main advantage is that the operating agreement can establish a flexible means for the members to share the profits and losses. Some of the factors in making this determination include the financial investment of each member as well as his or her role and responsibilities. Like a corporation, members of limited liability companies are protected from debts. Thus members can protect their assets from claims arising from creditors or lawsuits. However, this legal structure does not provide the flexibility that is available to a corporation with respect to arranging for financing the business operations.

Finally, there are a number of advantages for establishing a corporation. An "S" corporation is probably the best option for a business with one owner or where few people are involved in the business. The main benefit is that the profits are not subject to double taxation. More importantly, an "S" corporation enables owners to protect their private property and other assets. This designation is well suited for a small business, and as stated above, is only available to business entities that have seventy-five or fewer owners. A "C" corporation has a great deal of flexibility to finance its operations. Corporations can sell more stock, issue debt, and obtain lines of credit from a variety of financial institutions. Another benefit of such corporations is that they provide continuity of life. This means that the business entity will continue in the event of the death of an owner or if an owner decides to sell his or her ownership interest (Barney, 1997).

As mentioned above, however, the main disadvantage of a corporate structure is that the entity is subject to double taxation. At the same time, corporations have a number of means at their disposal to mitigate tax consequences. Many of the expenses associated with running the business can be deducted from income taxes, and an array of financial and accounting mechanisms enable corporations to mitigate tax liabilities. Further, many states offer corporations tax relief in order to attract these entities to do business in the state. If a corporation is large, generates sufficient revenue, and offers employment opportunities to a number of people, such incentives ultimately benefit a state's economy. Oklahoma, for example, offers a tax incentive that exempts horizontally drilled oil and gas wells from the state's 7% production tax for a limited period of time (Watts, 2013).

Another way for a corporation to mitigate its tax liability is to incorporate in a state in which it is not actually located. For instance, many Fortune 500 companies incorporate in the state of Delaware. This is so because this state has procedures in place that enable business entities to establish themselves quickly. Further, Delaware does not tax the profits of the corporation if business is not actually conducted in the state (Vinzant, 1999). Such states, or even other countries, with favorable tax laws that attract many businesses are often referred to as corporate havens. Some regulators see these and other tax loopholes as unfair, however, and some jurisdictions have penalties for businesses that seek to exploit them.

Conclusion

In the final analysis, the type of legal structure business people choose depends on a number of variables that have been discussed herein. There are numerous legal and tax implications to consider, as well as federal, state and local laws that may apply to a particular business. This is an important point because some types of business are subject to a great deal of oversight. Moreover, for corporations that are also publicly traded entities, that is, a company whose shares of stock are bought and sold on one of the stock exchanges or other trading outlet, there are substantial financial and reporting requirements that stem from the Sarbanes-Oxley Act of 2002. Further if deficiencies are discovered in a corporation's financial statements, the business and the responsible individuals (chief executives and the like) are subject to felony prosecution.

Another matter to consider is the potential for lawsuits. Sole proprietors who fail to fulfill their obligations in a business transaction expose themselves to legal actions and if the person suing them prevails, the business person's real property and other assets will not be protected. In this regard, business enterprises can also be exposed to product liability lawsuits. A partnership or small business that makes toys for children, for example, can be sued if those toys cause harm or injury to a consumer. While the owners of corporations can protect their real property and assets from such legal claims, large corporations that generate a lot of profit are invariably the targets of class action lawsuits — and whether or not these lawsuits have merit, such legal actions can be costly.

Ultimately, the appropriate form of business organization depends on the purpose of the business, the number of people who will have an ownership interest, the amount of profit or revenue that will be generated, and finally the number of people that the business will employ. At the end of the day, the final factor that needs to be considered is that any type of business consists of people and the success of the enterprise will be significantly affected by the roles and responsibilities of these individuals, and the relationships that they create. In short, business people should carefully consider all of these variables and, moreover, rely on the advice of financial advisers and legal counsel. In this regard, the matters discussed in this article are for informational purposes only and should not be construed as financial or legal advice.

Terms & Concepts

Articles of Incorporation: Governing document of a corporation that establishes the reason for a corporation's existence; must be filed with the secretary of state.

Business Organization: The legal structure of a business enterprise — sole proprietorship, partnership, limited liability company and corporation.

By-Laws: Governing document of a corporation that spells out the operating procedures and describes the role and responsibilities of the officers and directors.

Capital Gains Tax: Tax paid on the profit generated from the sale of an asset such as stock, or from dividends paid to stockholders by a corporation.

Corporation: A legal business entity that is created under and governed by the laws of the state of incorporation.

Form 1040: Individual tax form that must be filed by a sole proprietor or partners who receive profits.

General Partnership: A business partnership with two or more partners who are each liable for any debts and who also share in the administration, profits and losses of the operation.

Incorporator: Responsible individual who files articles of incorporation with the secretary of state.

Limited Liability Company: A business organization that has features of a partnership and a corporation.

Limited Liability Partnership: A form of business partnership normally utilized by law firms and accounting companies. The partners are shielded from the debts incurred by the partnership.

Limited Partnership: A business partnership consisting of one or more partners who manage the business and are liable for its debts.

Members: The owners in a limited liability company.

Owners: In the context of a corporation, the stock holders or shareholders.

Partnership: A business enterprise where two or more partners are each liable for any debts and share in the administration, profits and losses of the operation.

Partnership Agreement: The governing document of the partnership that spells out the roles and responsibilities for the partners.

Pass-Through: In the context of partnerships, profits and losses are passed to each partner who then files this income on individual tax returns.

Proxy: In the context of corporations, the assignment of a voting right by one owner, officer or director to another.

Quorum: The minimum number of people who must be available to have a valid corporate meeting.

Resolutions: Document prepared by an officer or director of a company that memorializes action taken at a meeting.

Sole Proprietorship: Business organization usually formed when one person operates the business.

Stock: A unit of ownership interest in a corporation.

Stock Holders: Owners of a corporation.

Bibliography

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Suggested Reading

Hillman, R. W., & Loewenstein, M. J. Research handbook on partnerships, LLCs and alternative forms of business organizations. Cheltenham, UK: Edward Elgar Publishing.

Hogg, S. (2016). Do well with do-gooder investors. Entrepreneur, 44(4), 64. Retrieved December 28, 2016, from EBSCO online database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=113500668&site=ehost-live&scope=site

McCahery, J.A. (2001). Comparative perspectives on the evolution of the unincorporated firm: An introduction. Journal of Corporation Law, 26, 803–818. Retrieved January 2, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6093915&site=ehost-live

Olson, E.G. (2005). Strategically managing risk in the information age: A holistic approach. Journal of Business Strategy, 26, 45–54. Retrieved January 2, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19329863&site=ehost-live

Slemrod, J.L. (2005). What corporations say they do and what they really do: Implications for tax policy and tax research. Journal of American Taxation Association, 27, 91–99. Retrieved January 2, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=17041924&site=ehost-live

Yu, X. (2013). Securities fraud and corporate finance: Recent developments. Managerial & Decision Economics, 34(7/8), 439–450. Retrieved November 3, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90469319&site=ehost-live