If you are anything like me, you might be confused about different forms of business entity. Law school students and attorneys frequently stumble when faced with a new or unfamiliar form of business structure, and with the frequency of changes in the law, this situation occurs more often than you might think. Business organizations or associations, depending on where you live, is an area of law that focuses on the rules involved in the formation and operation of different business types. Courses on this subject are taught in many law schools and it is a frequently tested subject on the bar. It is often overlooked by students in law school and by entrepreneurs who do not appreciate the importance of the subject.
To resolve some of that confusion this post will address four very simple types of business. This is by no means an exhaustive description and these businesses differ from state to state, however, these businesses are widely recognized.
As a brief introduction, there are two different ways to form a business. First, an individual or group of people can simply start doing business. Second, an individual or group of people can file documents with a government agency, typically the IRS and their state’s Secretary of State, to form a business. The first way is free, however, it does not protect the owners from common issues like liability, improper actions by employees, tax issues, etc. The second type requires a little more thought and a filing fee or two but allows greater protection because it lets the business owners set the rules of the business. This is a huge benefit because courts examining a business entity will often rely on old inflexible rules that may run contrary to what the business owners wanted or intended. Let’s jump into the four main groups shall we?
- Sole Proprietorship
The Sole Proprietorship is one of the simplest business organization. The sole requirement, (no pun intended) is that an individual begins doing business. This could be complicated web development, the opposite of what I do, or the individual may start selling things at the local flea market. The essential component is that they are the sole owner of the business and they are doing business. The IRS has a slightly different definition, but one that for all intents and purposes is the same. It reads: “A sole proprietor is someone who owns an unincorporated business by himself or herself.”
Sole proprietors are liable for almost everything. Because there is no separation between the owner and the business the owner is responsible for any violation of law, or harm that he or she causes. Individuals who sue the business may collect from the business and if the business doesn’t have enough money then the individuals can collect from the business owner. This means that business owner is also responsible for their employees, and are liable for the taxes and fees associated with those employees.
The sole proprietorship is very good for individuals who don’t want to go through the hassle of filing multiple tax returns. All of the profit and loss of the sole proprietorship is passed on to the business owner.
2. Partnership
Partnerships are the multi-person compliment to the sole proprietorship. A general partnership is formed when two or more people start a business together, so long as ownership is shared between them. However, people may form limited partnerships by agreeing to certain rules that govern the relationship between the partners. Ownership is split proportionate to the number of partners, so if there are two partners then ownership is 50/50.
In a general partnership every member is liable. This means that creditors, like the IRS or people who have sued the partnership, can collect from the assets of the partnership and if there is not enough money in the assets, they can then collect from the partners as well. To prevent this result a lot of partnerships choose to file as limited partnerships (lp) of limited liability partnerships (llp) because they can limit their liability to the assets of the partnership. Put simply, the partners will only lose what they have put in.
Partnerships pass their income to the partners. So the partnership does not pay any tax instead the partners pay their income tax on their portion of the partnership income. However, partnerships can choose to be taxed like corporations which means the partnership pays tax on what it has made and then the individual partners pay additional tax on what they are paid by the partnership.
3. LLC (Limited Liability Company)
The LLC is a fairly new business organization. Unlike the previous two, it has existed for the past 43 years. LLC stands for Limited Liability Company, if you mistakenly say corporation you will receive odd looks and a few eye rolls. The LLC is created by filing paperwork with the state. This differs from state to state however most states require that the business owners file with the state’s secretary of state. Along with basic information about the business including its purpose, name, and some contact information, the business must also have articles/certificate of organization, this is essentially the founding document.
LLCs limit the liability of the owners. The owners are usually liable up to the amount of the LLC’s assets. This is very useful especially for businesses that operate in riskier areas, where they are more likely to be sued.
LLCs may be taxed as a corporation or as a partnership, however, the default rule is that they will be taxed as partnerships. So, the LLC’s owners pay the taxes for the LLC through their personal income tax. The LLC’s profit passes through to the owners, is treated as a wage or salary.
4. Corporations
Corporations are well known and both hated and loved. People love to own stock of corporations but hate what corporations do. Corporations function similarly to an LLC. They are formed by filing specific paperwork. These documents include the article of incorporation (aka the founding document), Bylaws (the rules), and other agreements or documents as necessary. At the same time as the filing of the articles of incorporation with the Secretary of State, the corporation must sell its stock. Stock is ownership in the business. Stock is often referred to as shares or securities, and it represents a right to vote and be paid for that ownership.
The owners, or shareholders, of a corporation have limited liability. They cannot be required to pay more than the what they have already contributed to the company. For example, corporations like Purdue pharmaceutical have been sued repeatedly for their part in the opioid crisis and those companies have lost a lot of money. However, the creditors, or the people suing, are limited in the amount of money they can get, they cannot collect from the owners of the stock after they have exhausted all of the companies money.
Corporations are subject to double taxation. The corporation is taxed on its profits, and then the shareholders are taxed on the money they receive from the corporation as their share of those profits.
Conclusion:
Each of these business organizations has its own advantages and disadvantages. Sole Proprietorships give the owner absolute control over their business but they are liable for all debts or actions against the business. Partnerships allow a lot of control but are also liable for almost everything. LLCs limit liability but cost more to make and have limitations on the owners’ ability to control the business. Corporations provide a lot of liability protection however control is as centralized.