Business Legal Organizational Structures
Choosing the proper legal, organizational structure for your business is one of the most important decisions you will make. While it may not have much impact on the day-to-day operations of a small business, it can have a huge impact come tax time when you want to borrow money or attract investors, or in the unfortunate event that you get taken to court. While it is possible to change your structure at a later date, it can be a difficult and expensive process. Better to make the right decision in the first place.
In the United States, you are not required to have an attorney prepare and file the paperwork to create any of the structures listed below. However, depending on the size and complexity of your business, you may want to consult with an attorney, and you almost certainly should consult with your tax advisor regarding which structure is best for your situation.
There are many choices and many factors to consider when setting up the structure of your business. Many of the advantages of incorporating can be gained in other ways for sole proprietors, such as purchasing liability insurance. Also, the paper legalities are often outweighed by the real-world practicalities.
For example, while a corporation may shield the owners from personal liability for debts, in your first 2-3 years in business, it's unlikely you'll even be able to get business credit without personally co-signing as a guarantor, in which case you forfeit that protection. Educate yourself, talk to a professional, and consider all your options carefully.
The following are the basic forms of business ownership in the United States. There are variants from state to state, so be sure to check with your state's Secretary of State Office for the exact details of your state.
The major advantage of a sole proprietorship is that it is the simplest and least expensive structure, as there is really nothing to set up and maintain, except perhaps a fictitious business name (aka DBA, or Doing Business As). An individual owner of an unincorporated business operates the business as an extension of himself. The profits and losses of the business are reported on the tax return of the owner, and that owner is personally responsible for any liabilities of the business. If someone sues the business for breach of contract, personal injury, or to collect a debt, the court can directly levy the personal bank account and other property of the owner.
An advantage of partnerships is that, like a sole proprietorship, no state filings are required to create the business entity, nor are there any ongoing reporting requirements. In a general partnership, two or more people own the business jointly and share profits and losses of the business as spelled out in the partnership agreement. Each partner is potentially responsible for the full amount of all liabilities of the business. For example, a creditor can collect the full amount of a debt of the partnership from the partner that is the easiest to collect from.
Distribution of profits and losses is determined by the partnership agreement and passes through to the individual partners. It does not have to match the ownership percentages. The partnership itself is not subject to any income or franchise tax. Control of the business is determined by the partnership agreement, but unless stated otherwise, the partners control the business jointly, with each partner having an equal vote.
The basic structure and tax implications are the same as for a general partnership, but the limited partnership allows for one or more limited partners ("silent partners") to own a portion of the business, but not participate in the management of the business. The partnership must also have a general partner who has personal liability for all liabilities of the partnership. This structure allows a partnership to have outside investors without subjecting them to the liabilities of the business.
Limited Liability Partnership (LLP)
The LLP is a fairly new structure that appeared as a result of demand from attorney and accounting firms to be able to limit the liability between partners (attorney and accounting firms were at one time not allowed to incorporate, though they are now). An LLP is taxed like a partnership but limits the liabilities of all partners, much like an LLC. LLP laws vary significantly from state to state.
For example, California and New York only allow this form for attorney and accounting firms. In many other states, partners in an LLP only have a "limited shield," and are not afforded the same protection they would enjoy in an LLC or corporation. These restrictions make the LLP generally only a good choice for attorney and accounting firms, at least in the states with the limited shield law. Check with your Secretary of State for the specifics in your state.
Limited Liability Company (LLC)
An LLC is a hybrid of a corporation and a partnership and is rapidly becoming the most popular structure for small businesses due to its flexibility and its low cost to create and maintain, while still offering most of the advantages of a corporation. The ownership percentages, profit, and loss distributions, and voting powers of each member are determined by the LLC Articles of Organization, rather than by stock ownership.
An LLC can choose to be taxed as a partnership or S Corporation with profits and losses flowing through to the owners’ tax returns, or taxed as a C Corporation, filing its own return. The owners and any officers and directors are protected from the liabilities of the company, as in a corporation. An LLC is generally subject to the franchise tax, though this varies from state to state.
Corporation ("C Corporation")
A corporation is owned by one or more stockholders. It is managed by a board of directors elected by the stockholders, and run day-to-day by officers appointed by the board of directors. A single individual can be the sole stockholder, director, and officer of the company. The stockholders, directors, and officers of the company are protected from the liabilities of the company, including liabilities for their own negligence when acting in their corporate role, except in certain extraordinary circumstances.
In an ordinary corporation, the profits and losses of the corporation are not passed through to the tax returns of the owners. The corporation files its own tax return and pays its own taxes. It may also be subject to state franchise taxes or other annual fees. As for individuals, corporate income tax rates are graduated based upon the taxable income, though the rates and levels of the brackets are different than for individuals.
After the corporation has been formed, the stockholders may elect "S Corporation" status by making a filing with the IRS. An S Corporation is taxed as a partnership, and the profits and losses of S Corporation's flow through to the federal tax returns of the owners in proportion to their stock ownership. They are protected from the liabilities of the business as in a C Corporation. The S-corporation structure is generally preferred over a standard corporation when most of the shareholders are employed by the corporation or otherwise involved in its day-to-day activities, and the corporation distributes most of its income to its shareholders each year. An S Corporation is ideal for small businesses.
A non-profit corporation may be an industry association, a social organization, a research firm, or even a consulting group. It can even sell products or services. The difference is that there are no owners, and any "profits" are simply retained by the corporation to be reinvested for whatever the purpose of the corporation may be. A non-profit can have employees, and those employees can be paid fair market value for their services. There are many restrictions on non-profits that make it a challenging choice, but if you're interested in seeing your vision come to life, it is an option.
Professional Corporations, Professional Associations, and Professional LLCs
These are special entity forms created for lawyers, doctors, CPAs, architects, engineers, and other professionals subject to licensing requirements and malpractice liability. They are similar to the standard forms, except that usually, the appropriate state licensing body must approve the formation documents before they are filed with the Secretary of State.
Business legal structures vary significantly from country to country. The following article refers only to the legal structures within the United States. Here is an overview of Forms of Business Ownership in Canada.