From a single musician with his own record label to a multinational conglomerate with thousands of employees, all businesses must choose an organizational structure whose complexity and form meet the company's needs. Choosing the appropriate structure for you requires a thorough analysis of your business.
Important factors include: How many owners will the business have and will all the owners be active participants? Will any of the owners be other businesses? Will the owners of the business or the business entity itself hold business assets? Who will be liable for the debts of the business? What are the capital requirements of the business? The answer to these and many other questions will bear on the appropriate choice of organizational structure for your business.
The two major categories of business organizations are corporations and partnerships. In the past many business planners were faced with a dilemma in choosing between these two forms. Partnerships offer certain tax benefits, but the partners themselves are responsible for the debts and obligations of the other partners. Corporations, on the other hand, tend to have additional tax burdens, but afford the corporation's officers, directors and shareholders complete protection from liability. Today, however, there are a number of additional organizational forms, many of which address this predicament.
A sole proprietorship is the business form most commonly used when a business has only one owner. In a sole proprietorship, a single individual owns all the business assets and is liable for any business debts. Proprietorships are usually small, with capital demands being met by the owner and with little or no need for outside investors.
A general partnership is the simplest form for a business to take when two or more people own the business. A partnership exists whenever two or more people co-own a business for profit and share in the profits and losses of the business. A partnership arises automatically whenever this arrangement exists, and no further formalities are necessary. Partners can agree to organize the business in whatever manner they please and frequently partners construct an agreement between themselves, which sets the ground rules for the partnership. Importantly, all the partners are liable for debts and obligations resulting from the wrongful acts of another partner, if that partner acted in the ordinary course of partnership business, or acted with the authority of the other partners.
When we think of a generic corporation, the structure that probably comes to mind is what is known as a C corporation. The name "C corporation" is derived from the fact that regular corporations are taxed by the Internal Revenue Service under subchapter C of the Internal Revenue Code. A defining attribute of any corporation is that it is considered to be a separate legal entity, which gives rise to one of the greatest advantages to incorporation: the corporation itself, not the shareholders, is liable for the corporation's debts. Furthermore, absent wrongdoing on their part, officers and directors are not personally liable for corporate debts.
An S corporation is organized and operated just like a regular corporation except for the special treatment afforded it under subsection S of the federal Internal Revenue Code. With some limited exceptions the S corporation is not taxed at the corporate level. Instead it is permitted to pass income and losses through to its shareholders who report the income on their federal tax returns. A business must meet certain eligibility requirements to qualify for incorporation as an S corporation. S corporation status is established under federal income tax law and, therefore, is not necessarily available for purposes of state income tax law.
Limited Liability Partnership
The limited liability partnership is one of several variations on the basic partnership model that have evolved mainly in response to the exposure to personal liability for the obligations of the partnership. The limited liability partnership resembles a regular partnership in all respects except the allocation of liability. In a limited liability partnership, each partner is protected from personal liability arising from negligence, malpractice or improper conduct of other partners, agents or employees of the partnership, but not from his or her own actions of negligence, malpractice or improper conduct.
The limited partnership is another variation of the general partnership. In a limited partnership there are two types of partners: general partners and limited partners. The general partners are the partners who manage the business and have the power to bind the partnership. Only the general partners are personally liable for the partnership debts. The limited partners are essentially passive investors. They do not participate in the management of the partnership, they may not bind the partnership and are not personally liable for the debts of the partnership. The formation of both the limited liability partnership and the limited partnership requires special formalities, such as filing with the appropriate state official.
Limited Liability Company
A limited liability company is another type of business formation designed to protect its owners from personal liability for the debts of the business. Like the limited liability partnership and the limited partnership, it is also created by filing formal papers with the state. Aside from this formality, the limited liability company can be structured to operate much like a general partnership, a limited partnership, or a corporation, depending upon the wishes of its members.
Pros and Cons of Various Entities
Each one of the organizational forms described above has advantages and disadvantages to be considered when choosing the appropriate organizational form. For one, certain structures are more expensive to set up and maintain than others, and more formal steps may be required to establish them. Corporations, limited liability companies and limited partnerships must comply with strict statutory formalities regarding their creation and continued existence. For example, failure to continually meet the requirements for S corporation eligibility will result in termination of S corporation status and thus potentially serious tax consequences. On the other end of the spectrum, general partnerships require no formalities whatsoever.
Management and Control
The management and control of the business is another big consideration. Corporations are not actually operated by the owners of the business, the shareholders. Instead, the shareholders elect a board of directors and officers to manage and control the business. By contrast, the partners in a general partnership have complete control over business operations, as does the sole proprietor. The general partners manage a limited partnership, and in most states, a limited liability company may be managed either by its members or by managers selected by the members.
Personal Liability Protection
Personal liability for the obligations of the business is often on the mind of the business planner. The insulation of personal assets from the claims of business creditors is generally available to shareholders of C corporations, S corporations and limited partners in a limited partnership and to members of a limited liability company. However, a general partner in a limited partnership, all partners in a general partnership and the owner of a sole proprietorship are all subject to unlimited personal liability for the debts of the business.
Because different organizational forms are taxed differently, the tax consequences of the chosen organizational form should be explored. As a separate entity, the C corporation pays income tax on its earnings. Then, if the corporation chooses to distribute its after-tax income to the shareholders in the form of dividends, the shareholders must pay tax on that income as well. The same income is taxed twice at the corporate and at the shareholder level. This is commonly referred to as "double taxation." Money passing through partnerships, limited partnerships, limited liability companies and S corporations are not taxed as separate legal entities and, instead, the profits and losses flow through to the owners themselves. Tax considerations are complicated and extend to many detailed aspects of the business operations.
Continuity of Existence
Continuity of existence is another attribute that varies depending on the organizational form. Generally, corporations have a perpetual existence. This means that the death, withdrawal or bankruptcy of a shareholder will not interfere with the legal existence of the corporation. By contrast, the death or withdrawal of a partner from a general partnership will automatically dissolve the partnership, unless the partnership agreement states otherwise. Continuity of existence for limited liability companies and limited partnerships vary from state to state, but generally, the withdrawal of a limited partner from a limited partnership does not dissolve the partnership, while the withdrawal of a general partner does.
This is by no means a thorough analysis of the pros and cons of each organizational form. There are many other factors to be considered, such as, how the owners will be compensated, whether benefits will be offered to owners and employees, whether there will be more than one class of stock, and, whether there will be restrictions on the transferability of ownership. Certain organizational forms, such as the limited liability company are better suited for joint venture possibilities. Finally, when examining the various aspects of the business planning process, it is important to remember that the rules governing the formation and operation of certain organizational forms vary from state to state.
The decision as to which organizational form to use depends on numerous factors, including the need to limit potential individual liability, tax consequences, and the relationships and roles of the various owners. An experienced business attorney can help you decide which business structure is right for you in light of your specific business needs.