There are many different types of small businesses in the United States. How you choose to legally structure and set up the ownership of your business might be one of the first decisions that you will have to make as a business owner. There is no one-size-fits all approach when it comes to legal entities.
"Business Structure" Gale Business: Entrepreneurship, Gale, 2020. Originally published in Encyclopedia of Management, 8th ed., Gale, 2019.
One of the first critical decisions to be made when forming a new company is determining the formal structure of the organization. The formal structure of the business impacts issues such as liability, ownership, operating strategy, and taxation. Four different business structures are discussed below: partnership, corporation, subchapter S, and limited liability corporation (LLC).
A partnership is a business association in which two or more individuals (or partners) share equally in profits and losses. As is the case with a sole proprietorship, partners have full legal responsibility for the business including debts against the business. Persons entering into this type of business need a partnership agreement detailing how much each partner owns of the business, how much capital each person will contribute, and the percentage of profits to which each partner is entitled; how company decisions will be made; if the company is open to new/additional partners, and how they can join; and under what circumstances and how the company would be dissolved.
In a general partnership, all partners are liable for actions made on the company's behalf, including decisions made and actions taken by other partners. Profits and losses are shared by all partners, as are company assets and authority.
A limited partnership is a similar business arrangement with one significant difference. In a limited partnership, one or more partners are not involved in the management of the business and are not personally liable for the partnership's obligations. The extent to which the limited partner is liable is thus limited to his or her capital investment in the partnership.
In a limited partnership agreement, several conditions must be met, the most important of which is that a limited partner (or partners) has no control or management over the daily operations of the organization. At least two partners, and one or more of the general partners, must manage the business and they are liable for firm debts and financial responsibilities. If a limited partner becomes involved in the operation of the partnership, he or she stands to lose protection against liability. In addition, a limited partnership agreement, certificate, or registration has to be filed, usually with the secretary of state, but this varies by state. Such an agreement generally includes the names of general and limited partners, the nature of the business, and the term of the limited partnership or the date of dissolution. Since limited partnerships are often used to raise capital, the agreement has a set term of duration. Individual states may also have additional requirements governing limited partnerships.
The most frequent use of the limited partnership agreement has been as an investment, removing the limited partner from financial liability but raising capital through his or her investments or contributions. Limited partnerships are common in the film industry, real estate investments, and other ventures that are focused on a single or short-term project in which one or more financial backers contribute funding or resources to the project while the other partner or partners perform the actual work. Limited partnership may also be attractive to businesses seeking to provide shares to multiple individuals without the tax liabilities of a corporation and families seeking to transfer wealth without contending with the wealth tax.
Partnerships are not required to file tax returns for the company, but individual partners do have to claim their share of the company's income or loss on personal tax returns. The Internal Revenue Service (IRS) governs limited partnerships for tax purposes. IRS guidelines restrict limited partnership investments to 80 percent of the total partnership interests. Limited partnerships are also taxable under state revenue regulations.
The major difference between a partnership and a corporation is that the corporation exists as a unique and separate entity from its owners, or shareholders. A corporation must be chartered by the state in which it is headquartered. It can be taxed, sued, or entered into contractual agreements, and it is responsible for its own debts. The shareholders own the corporation, and they elect a board of directors to make major decisions and oversee corporate policy. The corporation files its own tax return and pays taxes on its income from operations. Unlike partnerships, which often dissolve when a partner leaves, a corporation can continue despite turnover in shareholders/ownership. For this reason, a corporate structure is more stable and reliable than a partnership.
Incorporating offers several major advantages over partnership. Sale of stock can help raise large amounts of capital significantly faster, and shareholders are only responsible for their personal financial investment in the company. That means that shareholders have only limited liability for debts and judgments made against the company. Moreover, the corporation can deduct the cost of benefits paid to employees from corporate tax returns.
Forming a corporation costs more money than forming a partnership, including legal and regulatory fees, which vary depending on the state in which the business is incorporated. Corporations are subject to monitoring by federal and state agencies and by some local agencies. More paperwork related to taxes and regulatory compliance is required. Taxes are higher for a corporation, particularly if it pays dividends, which are taxed twice, once as corporation income, then again as shareholder income.
Many major corporations in the United States are incorporated in Delaware. The state has very corporation-friendly rules for forming and conducting business, including no requirement that multiple individuals serve as officers of the corporation and no residency requirement. Delaware also has well-established laws governing transactions between corporate entities, and the courts have extensive experience litigating corporate disputes.
Some small businesses are able to take advantage of the corporate structure and avoid double taxation by filing IRS form 2553. These companies must be small, domestic firms with 100 shareholders or less and only one class of stock, and all shareholders must meet eligibility requirements. If a company meets these requirements, it can treat company profits as distributions through shareholders' personal tax returns. This way the income is taxed to shareholders instead of the corporation, and income taxes are only paid once. Subchapter S corporations are also known as small-business corporations, S-corps, S corporations, or tax-option corporations.
The limited liability corporation structure combines the benefits of ownership with the personal protection that a corporation offers against debts and judgments. One or more people can form an LLC, and the business owner(s) can either choose to file taxes as a sole proprietorship/partnership or as a corporation. The process of forming an LLC is more extensive than a partnership agreement but still involves less regulatory paperwork than incorporation.
Major advantages offered by the LLC structure are:
Still, some may choose to file taxes as a corporate entity, particularly if owners want to keep corporate income within the business to aid its growth. According to the Small Business Administration, an LLC cannot file partnership tax forms if it meets more than two of the following four qualifications that would classify it as a corporation: (1) limited liability to the extent of assets; (2) continuity of life; (3) centralization of management; and (4) free transferability of ownership to interests. If more than two of these apply, the LLC must file corporation tax forms.
An LLC that chooses to be taxed as an S corporation can also do the following, which the traditional S corporation cannot:
Companies may change their business structure during the course of operations. Consider HP (formerly Hewlett-Packard). The company was formed as a general partnership between two individuals in 1939. Eight years later, in 1947, the partners incorporated the enterprise. After a decade of incorporation, the company went public in 1957. Often, it is changes to tax filings—and associated tax payments—that prompt many businesses to make decisions about restructuring their operations. Owners may opt for a new structure due to changes in tax laws or in the business itself. In order to anticipate what changes in structure might be beneficial, companies should schedule an annual discussion about long-term business plans with an accountant or tax advisor.
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