Many different types of business structures exist with different legal and tax aspects for consideration. Starting a business can be as simple as an individual performing freelance work or as complex as a group of investors establishing a large corporation owned by shareholders and managing hundreds of employees. Of course, there are other types of business structures as well; and choosing the best structure can be important to a business’ success. Running a successful business entity involves strategically planning and assessing risk, tax obligations, legal liability, and ownership benefits and responsibilities, among other things.
Many businesses may share some common characteristics. For instance, practically all businesses are required to register the business name with the state where the business is operating and to obtain the relevant business licenses and permits to operate legally. These are business formation issues. Different types of business structures limit or restrict the tax and legal responsibility carried by the owners, other types do not. Likewise, some types of business structures can survive the exit of one of the owners easier or with less disruption than others and may have greater perpetual existence. The U.S. Small Business Administration recommends that anyone interested in starting a business should consult with an attorney and with a tax professional before taking formal steps to establish the business structure so that, among other things, the continuation of the business can be secured, potential legal issues can be addressed, and tax penalties can be avoided.
Here’s some general information about a few differences that distinguish between the most common types of business structures, with some features, legal risks, and tax ramifications of each type of ownership.
- One individual owns the company (and some jurisdictions may not require that the individual registers the business unless a business name other than the individual’s name is used).
- There is no legal separation between the business and the individual owner, meaning that the individual can generally be held personally responsible for all business financial obligations and actions taken by the sole proprietor and employees.
- Taxes are paid by the sole proprietor on his or her individual tax return.
- Partnerships generally exist where more than 1 individual or entity owns the business. In general partnerships, partners regularly share or are involved in various aspects of running the business and also in the profits or losses of the business.
- Sometimes Partnerships are distinguished depending on how the benefits and responsibilities are divided among the Partners:
- General Partnership – there can be equal share of power, and usually equal profit, and risk for each Partner
- Limited Partnership – allows Partners to determine unequal distribution of the benefits and liabilities of the business, sometimes with only 1 Partner being the managing partner
- Joint Ventures – usually for short or definite term, single-project business arrangements and can be conducted on arrangements similar to a General Partnership
- Written Partnership Agreements are recommended to document how details will be handled such as business management and profit distribution and risk of loss.
- Ownership disputes about the meaning or enforcement of terms of the agreements often require attorney involvement to reach a resolution.
- The Limited Partnership can offer some legal separation or protection to the Limited Partners and to limit risk to the partners’ personal assets.
- Taxes are often paid by the partners on their individual tax returns.
Limited Liability Company (LLC)
- This type of business is owned and operated by members and/or managers and can provide the limited liability features of a Corporation and the tax perks and decision-making flexibility of a Partnership. The taxes may only be at the member level on distributions received by the member as opposed to both at the corporate level and at the member level.
- Members can be protected from personal liability for business decisions or actions of the LLC, so if the business goes into debt or is sued, owners’ personal assets may be protected and exempt.
- An LLC may sometimes elect to file a Corporation, Partnership, or Sole Proprietorship tax return; but taxes are paid by the individual members on their personal tax returns.
- An LLC might also request S Corporation status to remain a Limited Liability Company for legal standing, but still be treated as an S Corporation for tax purposes.
- Cooperatives are designed to serve a collective purpose or service and are more common in certain industries such as agriculture, education, restaurant, and healthcare.
- Cooperatives are businesses or organizations owned by and operated for the benefit of their members who are regularly user-owners of the services being provided by the Cooperative.
- Membership applications are required for new members to legally be identified as part of the Cooperative, and members can often easily join or leave the business without affecting the continuity of the business.
- Cooperatives are usually run by an elected board of directors and operated as a Corporation.
- Cooperatives usually are formed by a group of members who have recognized a common need and strategy to meet that need.
- Cooperatives may receive a special designation from the IRS and are not subject to federal income taxes as a business entity, so members of the Cooperative usually pay the taxes on their personal tax returns.
Corporation / S Corporation
- Ownership is purchased through stock offerings by shareholders.
- Before becoming an S Corporation, a regular C Corporation or LLC usually must exist, and the S status is then subsequently elected when appropriate circumstances exist.
- Corporations are considered to be separate legal entities owned by shareholders, which means that the Corporation itself is usually held legally responsible for the business’ actions and debts, rather than the individual shareholders.
- Corporations pay federal, state, and local taxes; sometimes being taxed twice on the same business revenue – paid by the Corporation on the reported business profit and paid by the shareholders on the dividends paid to them from the profits.
- A potential advantage of the S Corporation is that it does not pay taxes as a separate entity and therefore taxes are only paid once by the shareholders on distributions they receive on their personal tax returns.
Choosing the right business structure is one of the first and most important decisions made by business owners. Contact Ilam Smith, Attorney, if you would like to request professional legal guidance in making this important decision for your business.