Types of Business Structures

21 Jul, 2009  General Business

There are seven types of business structures allowed under the law in most states.  These are sole proprietorship, general partnership, limited partnership,  “C” corporation, “S” corporation, limited liability company, and limited liability partnership.  There is no perfect business structure.  Each structure has its own advantages and disadvantages.  The requirements for doing business in each state and city may vary from state to state and city to city.  So you should always check with your local city clerks office.  They should be able to tell you what is required and the order in which each requirement must be met.

Sole proprietorship

A sole proprietorship is an individual person engaged in a trade or business.  The business is owned by the individual who takes full responsibility (and risk) for the day to day operation of the business.  The business may or may not have any employees, but the still has full responsibility.

Advantages – Proprietorship’s are easy to set up usually only requiring fictitious name certificate and, if you are a reseller, a sales tax permit.  The sales tax permit allows the business to collect sales tax in the state where the business is located.  A fictitious business name certificate may also be called business license or DBA certificate (Doing Business As).  You usually do not need a fictitious name certificate if you are doing business under your own name.  Taxes are relatively easy.  You fill out Schedule C to deduct your business expenses from your income taxes.

Disadvantages – Taxes are paid at your individual tax rates.  Individual tax rates are typically higher than business tax rates so you may end up paying more taxes.  The owner of a sole proprietorship has unlimited liability for every business mistake.

General partnership

A general partnership is formed when two or more “sole proprietors” decide to pool their resources and share profits and loses from the business.  The key factor that makes the business a partnership is that the profits and loses are shared.

Advantages – General partnerships are easy to set up.  You don’t need a formal written partnership agreement, a simple  “gentleman’s agreement” is usually enough.  A detailed partnership agreement is highly recommended.  The agreement should specify how the profits and loses are shared and how conflicts between the partners are supposed to be handled.  Taxes are easy.  The partnership files an information return on Form 1065.  Each partner pays taxes on their “pro rata share” of the profits at their individual tax rates.

Disadvantages – Taxes are paid at your individual tax rates.  All partners have unlimited liability for every business mistake.  If partner A hurts someone while on partnership business, all partners are liable even though they were not involved.  Partnerships have what is called a “phantom income” problem.  This is when the partners have to pay taxes on their “pro rata share” of the partnership’s profits even though the partnership did not pay them cash to cover the taxes.

Limited partnership

A limited partnership is a partnership with two classes (or tiers) of partners:  general partners who have unlimited liability for the actions of the partnership and “limited partners” who are liable only up to the cash value they’ve contributed to the partnership.  Limited partners are also sometimes known as “silent partners”.  The key distinction between general and limited partners is that general partners are responsible for the management and operation of the partnership.  Limited partners cannot participate in the management or operation of the partnership.  If they do then they are considered general partners and lose their limited liability status.

Advantages – Only general partners have unlimited liability.  Limited partnerships also have the same advantages as a general partnership.

Disadvantages – Limited partners cannot participate in the management and operation of the partnership without becoming general partners.  Limited partnerships are more complex, requiring additional paperwork to maintain the business structure.  Limited partnerships also have the same disadvantages as a general partnership.

“C” corporation

A corporation is a separate legal and taxable entity from its owners, or shareholder.  It’s called a “C” corporation because it is taxed under Subchapter C of the Internal Revenue Code.  Corporations issue shares which represent a part ownership in the corporation.  Directors and officers are chosen to oversee operations and manage the corporation.

Advantages – The shareholders of a corporation on liable only up to the amount of their individual contributions as capital to the corporation.  The shareholder’s personal assets are protected from liability by the corporation.  Corporate tax rates are typically less than individual tax rates.

Disadvantages- Corporations can be expensive to form often requiring the help of an experienced attorney.  Start up legal expenses and filing fees can easily reach $1,000 or more.  A corporation may have to register as a “foreign corporation” in all states, other than its home state, in which the corporation has a physical presence.  Corporations can be expensive to keep alive.  Each state has specific reporting and documentation requirements that must be met for the corporation to maintain its legal status.  Some states also require a minimum tax payment from the corporation whether the corporation makes any money or not.  California requires a minimum tax payment of $800 per calendar year for corporations.  If you don’t use and treat the corporation with respect the corporation could lose its limited liability protection allowing others who sue the corporation access to your assets as well as the corporation’s assets.  This is called “piercing the corporate veil”.  Corporations require a lot of paperwork.  When you have a corporation, you don’t do anything; the corporation does everything.  For a corporation to do anything the shareholders have to prepare written documents (called resolutions or “minutes”) authorizing the directors of the corporation to do the thing, and the directors have to prepare written documents authorizing the officers of the corporation to do the thing.  Corporate dividends are double taxed.  The corporations pays taxes on all of its profits.  The corporation may distribute a portion of the after tax profits to its shareholders as a dividends.  The shareholders receive their dividend but must pay personal income taxes on the amount received.  A “C” corporation typically requires three or more individual and separate directors and officers to manage the corporation.  An individual may be both a director and an officer and may hold more than one office within the corporation at the same time (such as CEO and COO) as long there are at least three directors and offices held by separate individuals.

“S” corporation

Also known as a “Subchapter S corporation”.  A “S” corporation is the same as a “C” corporation except that it is not taxed by the federal government.  The shareholders are taxed like a general partnership while enjoying the limited liability of a corporation.  “S” corporations issue shares just like “C” corporations.  The shareholder’s pro rata portion of shares are used to determine the shareholder’s portion of taxable profits.

Advantages – In some states a “S” corporation can be formed by a single individual.  “S” corporations have the same advantages as “C” corporations.

Disadvantages- Some states and cities do not recognize “S” corporations so the corporation may be subject to double taxation at the state or local level.  “S” corporations have the same “phantom income” problem as general partnerships.  There are a lot of extra rules a “S” corporation must follow to not be taxed as a “C” corporation.  “S” corporations have different IRS reporting requirements than “C” corporations and must report certain items of income differently.  It can be difficult to operate a “S” corporation without a good accountant.

Limited liability company (LLC)

A limited liability company is basically a “S” corporation without the many rules that make them unattractive to many business owners.

Advantages – Owners of LLCs have limited liability.  LLCs are easy to run.  There is no need to prepare minutes or resolutions to authorize people to do things;  they just do them.  LLCs are tax like a partnership.  Overseas companies are more familiar with LLC style companies.  So being an LLC may give the company and advantage in overseas markets.

Disadvantages- LLCs have the same “phantom income” problem as partnerships.  There are restriction on what an LLC can and cannot do if it has employees.  Many investors view LLCs are small time business so may avoid LLCs that are trying to raise capital.  Some cities has burdensome requirements for LLC making doing business difficult.  Some states have minimum tax requirements for LLCs.  California requires a minimum tax payment of $800 per calendar year for LLCs.

Limited liability partnerships (LLPs)

An LLP is a general partnership where the partners have limited liability for the acts and omissions of the other LLP partners.  LLP partners also have limited liability for the contracts they sign on behalf of the LLP.

Advantages – LLPs have the same advantages as general partnerships.

Disadvantages- LLPs have the same disadvantages as general partnerships.

Related Blogs

Share and Enjoy:
  • Print
  • Digg
  • del.icio.us
  • Facebook
  • Google Bookmarks
  • Technorati
  • StumbleUpon
  • Twitter

No related posts.

Comments

Comments are closed.