Types of Business Organization (Updated In 2017)

As a business owner, you face many decisions when it comes to starting, running, and growing your business.

This guide is designed to explain your options and help you decide the correct type of business organization for your business.

If you have any questions, you can email me Sam Mollaei Esq., Business Lawyer, directly at Sam@MollaeiLaw.com

business-types

It explains the advantages and disadvantages of the main business types, including Sole Proprietorship, Partnership, Limited Liability Company, C Corporation, as well as S Corporation.

After I clearly explain each business type in detail and go over the advantages and disadvantages of each, I will explain how you can form your own entity so you can get started with your business and help protect yourself from liability.

Thank you for going on this journey with me. If you have any questions whatsoever, I encourage you to post questions down below in the comment section.

With that, let’s get started...

 

Sole Proprietorship

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The sole proprietorship is the simplest business form and is not a legal entity. Sole proprietorship is the easiest type of business to establish which means that there’s no state filing required.

It is simply an enterprise owned and operated by an individual. By default, once you start selling goods or services, you have created a sole proprietorship.

So there’s no actual filing requirements and you simply report your business’s earnings on your personal taxes.

sole proprietorship is not legally separate from its owner and it offers no personal liability protection. The law does not distinguish between the owner’s personal assets and the business’s obligations.

In fact, a sole proprietor’s assets can be and often are used to satisfy the debts and liabilities of the business. In other words, if your business gets sued, your personal assets (such as your house, car, or any other properties you own) may also be in risk.

Accidents happen, and businesses end all the time. Such circumstances may quickly become a nightmare for a business owner who operates as a sole proprietor.

A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name, such as Benjamin's Hair Shop. The fictitious name is simply a trade name--it does not create a legal entity separate from the sole proprietor owner.

The sole proprietorship is a popular business form due to its simplicity, ease of setup, and nominal cost. A sole proprietor need only register his or her name and secure local licenses, and the sole proprietor is ready for business. 

The owner of a sole proprietorship typically signs contracts in his or her own name, because the sole proprietorship has no separate identity under the law. The sole proprietor owner will typically have customers write checks in the owner's name, even if the business uses a fictitious name. Sole proprietor owners can, and often do, commingle personal and business property and funds, something that partnerships, LLCs and corporations cannot do.

Sole proprietorships often have their bank accounts in the name of the owner. Sole proprietors need not observe formalities such as voting and meetings associated with the more complex business forms.

Sole proprietorships can bring lawsuits (and can be sued) using the name of the sole proprietor owner. Many businesses begin as sole proprietorships and graduate to more complex business forms as the business develops.

Because a sole proprietorship is indistinguishable from its owner, sole proprietorship taxation is actually easy. The income earned by a sole proprietorship is income earned by its owner.

A sole proprietor reports the sole proprietorship income and losses and expenses by filling out and filing a Schedule C, along with the standard Form 1040. Your profits and losses are first recorded on a tax form called Schedule C, which is filed along with your 1040. Then the "bottom-line amount" from Schedule C is transferred to your personal tax return.

This aspect is attractive because business losses you suffer may offset income earned from other sources.

As a sole proprietor, you must also file a Schedule SE with Form 1040. You use Schedule SE to calculate how much self-employment tax you owe. You need not pay unemployment tax on yourself, although you must pay unemployment tax on any employees of the business. Of course, you won't enjoy unemployment benefits should the business suffer.

 

Advantages of Sole Proprietorship

  • Instant, easy & inexpensive
  • No state paperwork is required for creation
  • No separate tax filing is required -- profits or losses are reported on the owner’s tax return
  • The owner may freely mix business and personal assets
  • A sole proprietor need not pay unemployment tax on himself or herself (but must pay employee unemployment tax)
  • Few, if any, ongoing formalities

 

Disadvantages of Sole Proprietorship

  • The owner is subject to unlimited personal liability for business debts, losses and liabilities
  • Obtaining capital, such as a bank loan, can be more difficult -- lenders often require a more formal entity structure
  • Sole proprietorships rarely survive an owner’s death or incapacity, so they do not retain value
  • Sole proprietorships by definition can only have one owner

A distinct disadvantage, however, is that the owner of a sole proprietorship remains personally liable for all the business's debts.

So, if a sole proprietor business runs into financial trouble, creditors can bring lawsuits against the business owner. If such suits are successful, the owner will have to pay the business debts with his or her own money.

Let's examine this more closely because the potential liability can be alarming. Assume that a sole proprietor borrows money to operate but the business loses its major customer, goes out of business, and is unable to repay the loan. The sole proprietor is liable for the amount of the loan, which can potentially consume all her personal assets.

Imagine an even worse scenario: The sole proprietor is involved in a business-related accident in which someone is injured or killed. The resulting negligence case can be brought against the sole proprietor owner and against her personal assets, such as her bank account, her retirement accounts, and even her home.

 

How to Form a Sole Proprietorship

By default, once you start selling goods or services, you have created a sole proprietorship. 

So there’s no actual filing requirements and you simply report your business’s earnings on your personal taxes.

You may need to file a Fictitious Business Name (also known as DBA or Doing Business As) if you’re creating a business that is different from your personal name.

 


Partnership

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A partnership is created automatically when two or more persons engage in a business enterprise for profit. 

By default, a business that begins with a verbal agreement or handshake is considered a general partnership.

All partners share in both the day-to-day management and business profits. However, I highly advise using a written partnership agreement to form a partnership.

A formal, written partnership agreement that lays out all of the partners’ rights and responsibilities is highly recommended as oral partnership agreements are easy ways to set yourself for disputes in the future.

In the partnership agreement, the partners can dictate both the terms of how a partnership is managed and how profits and losses are allocated and distributed. 

A partnership is generally treated as a distinct legal entity separate from its partners. A key attraction of a partnership is that it pays no income tax as income or losses flow through to each partner and are reported on the partner's individual tax return. Each partner contributes to all aspects of the business, including money, property, labor or skill.

In return, each partner shares in the profits and losses of the business. Thus, there's no liability protection for any of the partners as each partner is jointly and severally liable for any liabilities. 

A partnership may be a General Partnership or a Limited Liability Partnership. In a General Partnership, each partner is a general partner, each has unlimited liability for the debts of the partnership, and each has the power to incur obligations on behalf of the partnership within the scope of the partnership's business. 

Limited Liability Partnerships is a business with more than one owner, but unlike general partnerships, Limited Liability Partnerships offer some of their owners limited personal liability for business debts. All of the owners of an LLP have limited personal liability for business debts. 

Limited Liability Partnerships may only be formed by licensed persons for the practices of public accountancy, law, architecture, or engineering. Professionals often prefer LLP's to general partnerships, corporations or LLC's because they don't want to be personally liable for another partner's liabilities, especially those involving malpractice.

An LLP protects each partner from debts against the partnership arising from malpractice lawsuits against another partner. 

 

Advantages of Partnership

  • Owners can start partnerships relatively easily and inexpensively 
  • No state paperwork is required for creation 
  • The partnership pays no income tax as income or losses flow through to each partner and are reported on the partner's individual tax return. 
  • Each partner shares in the profits and losses of the business. Thus, there's no liability protection for any of t he partners as each partner is jointly and severally liable for any liabilities. 

 

Disadvantages of Partnership

  • All owners are subject to unlimited personal liability for business debts, losses and liabilities
  • Individual partners bear responsibility for the actions of other partners
  • Obtaining capital, such as a bank loan, can be more difficult -- lenders often require a more formal entity structure
  • Poorly-organized partnerships and oral partnerships can lead to disputes among owners

 

How to Form a Partnership

If you and your partners don't spell out your rights and responsibilities in a written partnership agreement, you'll be ill-equipped to settle conflicts when they arise, and minor misunderstandings may erupt into full-blown disputes. 

A partnership agreement allows you to structure your relationship with your partners in a way that suits your business.

You and your partners can establish the shares of profits each partner will take, the responsibilities of each partner, what will happen to the business if a partner leaves, and other important guidelines.

 

Questions You Need to Answer to Create a Partnership Agreement:

  • The parties involved in the partnership. Is it a 2 or 3 way partnership? Please provide the names and their corresponding addresses (if known).
  • The name of the partnership — what is the name of the product or service you’re providing.
  • The principal place of business address.
  • Describe in details the activities of your business (what does your business do?)
  • When will the partnership agreement start? when will it end? (if applicable)
  • How much will each partner contribute to the partnership?
  • Who will the partnership be managed by? (Who will have absolutely power and authority to manage and control the partnership and the property and assets of the business?)
  • Where will partnership meetings take place? 
  • “No partner shall buy any goods or enter into any contract exceeding $____ without the prior consent in writing of the other partners."
  • The fiscal year of the partnership will be from ____ to ____ of each year? Please note that this is typically from January 1 to December 31. Also, when will a general accounting be made of all sales, purchases, receipts, payments, etc. of the partnership?
  • Each partner is entitled to what percentage of net profits and losses of the businesses?
  • When will the distribution of profits be made on?
  • In case of dispute between partners, who will be the arbitrator who will settle disputes? Please provide name.

 


Limited Liability Company (LLC)

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Slowly becoming more as a standard for businesses, a Limited Liability Company (or LLC) is a hybrid business form which combines the liability protection of a corporation with the tax treatment and ease of administration of a partnership.

The LLC is America’s newest form of business organization and is the most popular form of business.

The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single person, two or more people, corporations or other LLCs.

Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.

In other words, in the eyes of the government, an LLC is not a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC's members and are paid through their personal income tax. While the federal government does not tax income on an LLC, some states do, so make sure to check with your state's income tax agency.

Since the federal government does not recognize LLC as a business entity for taxation purposes, all LLCs must file as a corporation, partnership, or sole proprietorship tax return. 

LLCs that are not automatically classified as a corporation can choose their business entity classification. To elect a classification, an LLC must file Form 8832. This form is also used if an LLC wishes to change its classification status. 

 

Advantages of Limited Liability Company (LLC)

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Limited Liability -- Owners  are not personally responsible for business debts and liabilities. Limited Liability means that members are protected from personal liability for business decisions or actions of the LLC.

This means that if the LLC incurs debt or is sued, members' personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means "limited" liability - members are not necessarily shielded from wrongful acts, including those of their employees.

Pass-through taxation means that LLCs are not taxed as a separate business entity. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.

No restrictions on the number of members allowed.

Members have flexibility in structuring the company management

Does not require as much annual paperwork or have as many formalities as corporations. 

 

Disadvantages of Limited Liability Company (LLC)

  • More expensive to form than sole proprietorships and general partnerships
  • Ownership is typically harder to transfer than with a corporation.
  • Limited Life - In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave the business.
  • Also, because the LLC is a newer business type, there is not as much case law to rely on for determining precedent.

 

How to Form a Limited Liability Company (LLC)

The basic requirement for setting up an LLC are:

 

Step #1: Search your business name

Before you form an LLC, you should check that your proposed business name is not too similar to another LLC registered with your state's Secretary of State

 

Step #2: File Articles of Organization

The first formal paper you will need file with your state's Secretary of State to form an LLC. This is a necessary document for setting up an LLC in many states. 

 

Step #3: Create an Operating Agreement

Operating Agreement is an agreement among LLC members governing the LLC's business, and member's financial and managerial rights and duties. Think of this as a contract that governs the rules for the people who own the LLC. 

 

Step #4: Get an Employer Identification Number (EIN)

EIN is a number assigned by the IRS and used to identify taxpayers that are required to file various business tax returns.

You can easily file for an EIN online if you have a social security number here: https://sa.www4.irs.gov/modiein/individual/index.jsp

If you do NOT have a social security number or if you live outsides of United States, ask a business lawyer  to help you get one.

 

Step #5: File Statement of Information

Statement of Information includes fairly basic information about the LLC that you need to file with your state’s Secretary of State every 2 years. Think of it as a company census you must complete every 2 years.

 

Step #6: Search and Apply for Business Licenses and Permits

Once your business is registered, you should look and apply for necessary licenses and permits you will need from the county and city where you will do business. Every business has their own business licenses and permits so either do a Google search of your business along with the words "permits and licenses" or talk to a business lawyer to guide you with this.

 

Step #7: Talk to a Business Lawyer

If you have any other questions, talk to a business lawyer who will clarify and help you with all 6 above steps or answer any other question you may have about starting your business.

 


C-Corporation

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A corporation is the most common business structure. A corporation is an independent legal entity owned by its shareholders.

This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.

Corporations are more complex than other business structures because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are generally suggested for established, larger companies with multiple employees.

For businesses in that position, corporations offer the ability to sell ownership shares in the business through stock offerings. “Going public” through an initial public offering (IPO) is a major selling point in attracting investment capital and high quality employees.

A corporation’s shareholders, directors, and officers must observe particular formalities in a corporation’s operation and administration.

For example, management decisions must often be made by formal vote and recorded in corporate minutes. Director and shareholder meetings must be properly noticed and documented.

Finally, corporations must meet annual reporting requirements and pay ongoing fees in their state of incorporation and in states where they are registered to transact business.

Taxation is a significant consideration when choosing a business type, and a C corporation is taxed as a separate legal entity (which means no pass-through taxation like a partnership). A business tax return is filed and taxes are paid on the corporation’s profits.

If the corporation distributes profits to the shareholders in the form of dividends, shareholders pay income tax on those distributions. This creates a double taxation of corporate profits. 

As with any business type that offers liability protection to owners, a corporation must be created at the state level. Articles of Incorporation (sometimes called a Certificate of Incorporation) in the appropriate state must be filed and filing fees paid. 

 

Advantages of C-Corporation

  • Limited Liability - owners are typically not personally responsible for business debts and liabilities. When it comes to taking responsibility for business debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in stock of the company.
  • Corporate Tax Treatment - corporations file taxes separately from their owners. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.
  • Unlimited number of shareholders
  • Ownership is easily transferable through the sale of stock
  • Unlimited life, extending beyond owner illness or death
  • Some business expenses may be tax-deductible
  • Additional capital can be raised by selling shares of corporate stock
  • Attractive to Potential Employees - Corporations are generally able to attract and hire high-quality and motivated employees because they offer competitive benefits and the potential for partial ownership through stock options.
  • Ability to Generate Capital - Corporations have an advantage when it comes to raising capital for their business - the ability to raise funds through the sale of stock.

 

Disadvantages of C-Corporation

  • Time and Money - More expensive to form than sole proprietorships and partnerships. Corporations are costly and time-consuming ventures to start and operate. Incorporating requires start-up, operating and tax costs that most other structures do not require.
  • Double Taxing - In some cases, corporations are taxed twice - first, when the company makes a profit, and again when dividends are paid to shareholders.
  • Additional Paperwork - face ongoing state-imposed filing requirements and fees. Because corporations are highly regulated by federal, state, and in some cases local agencies, there are increased paperwork and record keeping burdens associated with this entity.
  • Face ongoing formalities - holding and properly documenting annual meetings of directors and shareholders

 

How to Form a C-Corporation

  1. File a DBA
  2. File Articles of Incorporation with Secretary of State
  3. Create Bylaws
  4. Get Employer Identification Number
  5. File Statement of Information
  6. Apply for Business Licenses and Permits
  7. Talk to a business lawyer if you have any other questions

A corporation is formed under the laws of the state in which it is registered. To form a corporation you’ll need to establish your business name and register your legal name with your state government.

If you choose to operate under a name different than the officially registered name, you’ll most likely have to file a fictitious name (also known as an assumed name, trade name, or DBA name, short for "doing business as").

State laws vary, but generally corporations must include a corporate designation (Corporation, Incorporated, Limited) at the end of the business name.

To register your business as a corporation, you need to file certain documents, typically articles of incorporation, with your state’s Secretary of State office. Some states require corporations to establish directors and issue stock certificates to initial shareholders in the registration process.

Contact your state business entity registration office to find out about specific filing requirements in the state where you form your business.

Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state and locality. Use our Licensing & Permits tool to find a listing of federal, state and local permits, licenses and registrations you'll need to run a business.

 


S-Corporation

An S corporation is a special type of corporation created through an IRS tax election which we will discuss shortly. An eligible domestic corporation can avoid double taxation by electing to be treated as an S corporation.

To be considered an S corp, you must first form a business as a C-corporation in the state where it is headquartered. S corporations are "considered by law to be a unique entity, separate and apart from those who own it."

This limits the financial liability for which you (the owner, or "shareholder") are responsible. Nevertheless, liability protection is limited - which means that S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.

What makes the S corp different from a traditional c-corporation is that profits and losses can pass through to your personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. There is an important factor.

However, any shareholder who works for the company must pay him or herself "reasonable compensation." Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as "wages."

 

Advantages of S-Corporation

  • Tax Savings - only the wages of the shareholder who is an employee is subject to employment tax. One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a "distribution," which is taxed at a lower rate, if at all.
  • Business Expense Tax Credits - Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, then benefits like health and life insurance are deemed taxable income.
  • Independent Life - An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.
  • Shareholders are typically not personally responsible for business debts and liabilities
  • Unlimited life extending beyond owner illness or death
  • Additional capital can be raised by selling shares of the corporation’s stock.
  • Pass-through taxation

 

Disadvantages of S-Corporation

1. The IRS imposes restrictions on S corporation shareholders: 

  • Be a domestic corporation
  • Less than 100 shareholders
  • Be Individuals, certain trusts and estates 
  • Cannot be non-resident aliens
  • Have only one class of stock

2. More expensive to form than sole proprietorships and general partnerships, and face ongoing, state-imposed filing requirements and fees.

3. S corporations face ongoing corporate formalities, such as holding and properly documenting annual director and shareholder meetings. 

 

Deciding Between C-Corporation vs. S-Corporation

Ask yourself the following questions:

1. Do you have more than 100 shareholders? If so, you can only have a C-Corporation

2. Do you want your profits and losses to be reported on your individual tax returns? If so, form an S-Corporation

Decide between filing as a C corporation and an S corporation. The standard is usually to file as a C corporation if you have a sizable operation. An S corporation is more appropriate if you intend on having fewer than 100 shareholders.

C corporations are individually taxable, file a corporate tax return and pay taxes at the corporate level. Double taxation is a possibility for C corporations if the company's income is distributed as income, resulting in taxation at different levels based on the number of shareholders. C corporations can also have multiple classes of stock, such as preferred and common.

S corporations are available to companies that intend on having fewer than 100 shareholders. S corporations file an informational federal return, but do not pay tax at the corporate level. Profits and losses are reported on the business owner’s individual tax returns. An S corporation has pass-through taxation (which means that you can pass business losses to your personal taxes) and is only eligible for one class of stock.

 

How to Form an S-Corporation

If you want to form an S-Corporation, you must first file an Articles of Incorporation with your state’s Secretary of State to create a C-Corporation.

Once you have done that, you have to file Form 2553, Election by a Small Business Corporation, with the IRS to make it into an S-Corporation. All shareholders must sign and file FOrm 2553 to elect your corporation to become an S Corporation. 

 

However, you need to meet a couple of criteria if you want to create an S-Corporation:

  1. First, the entity must be domestic — meaning that it has to a corporation created in United States.
  2. Second, it can’t have more than 100 shareholders. 
  3. Third, the shareholders can only be individuals, estates, or certain trusts. 
  4. Fourth, the S-Corporation cannot have any non-resident alien shareholders — meaning that all shareholders must be from United States. 
  5. And fifth, the S-Corporation can only have one stock of stock. 

If you meet all of that criteria, then you may want to form an S-Corporation instead of a C-Corporation by filing Form 2553, Election by a Small Business Corporation. I have attached the form to this course. 

Once your business is registered, you must obtain business licenses and permits. Note that regulations vary by industry, state and locality. Feel free to use the Licensing & Permits tool I attached to this course to find a listing of federal, state and local permits, licenses, and registrations you'll need to run your business.

 


Guide Summary

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Sole Proprietorship - Simplest business structure, no filing requirements, but no personal liability protection

Partnership - Created automatically when 2 more persons engage in a business. By default, a business that begins with a verbal agreement or handshake is considered a general partnership. All partners share in both the day-to-day management and business profits. However, I highly advise using a written partnership agreement to form a partnership.

Limited Liability Company - A standard for most small businesses and online businesses. Features limited liability which means the owners of an LLC have no personal liability for the obligations of the LLC. An LLC is the entity of choice for a businesses seeking to flow through losses to its investors because an LLC offers complete liability protection to all its members. 

C-Corporation - A corporation is an independent legal entity owned by its shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs. Also feature Corporate Tax Treatment meaning that corporations file taxes separately from their owners

S-Corporation - Pretty much the same as a C-Corporation + some tax benefits. Also, Profits and losses can pass through to your personal tax return. This means that the business is not taxed itself, only the shareholders are taxed.

 

Starting a Business?

My name is Sam Mollaei, Esq., and I'm a business lawyer.

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Over the past 5 years, I have helped numerous entrepreneurs decide on which business type to form for their business.

I made this guide to help business-owners and entrepreneurs just like you decide on the correct business structure for your specific business. 

Need to form a Limited Liability Company or Corporation? Contact me via email at sam@mollaeilaw.com or via phone (818) 925-0002.