Forms of Business Organization in the USA
There exist a number of different business structures that differ in several important aspects. Some of the most common business structures are:
- sole proprietorship
- general partnership
- limited partnership
- limited liability partnership
- corporation (including S corporations)
- professional associations
- limited liability companies
- business trusts
- professional corporations
There are six common issues that distinguish the different business forms: taxation, liability, risk and control, continuity of existence, transferability, expense and formality. Taxation and risk and control are the more significant issues. In addition to these common issues, there are also issues specific to each of them.
A one-person firm generally has only three choices of business form: sole proprietor, corporation or a limited liability company. Multiple people typically have the additional options of general partnership, limited partnership, or a limited liability company.
Liability is a risk that one exposes oneself to when starting a business. Two types of risk are tort risk and contract risk. A tort is unintentional or intentional harm to a person or a property of another. Some examples of tort risk are working injury, product liability and general liability such as when somebody falls on a wet floor. Examples of contract risk are financing risk and risk with vendors and customers. Tort risk can be protected against by using insurance. Most businesses can get an insurance policy against all tort risks. Liabilities associated with the contract can be limited in the contract itself.
Traditionally there was a tradeoff between liability and taxation. However, S corporations and LLCs have changed that tradeoff so that a company can have limited liability and pass-through taxation.
Sole proprietorship As the simplest form of business legal structure the sole proprietorship is viewed as being one and the same as its owner. This characteristic has the advantage of simplicity but also has a disadvantage of personal liability. A sole proprietorship has pass-through taxation; the business itself does not file a tax return; the income is reported on the personal tax return. The owner of a sole proprietorship has unlimited personal liability. However, with insurance of tort risk and contractual limitations for contract risk, the sole proprietor can insure against most risks and operate with nearly the same level of comfort as the owners of the corporation. A sole proprietorship exists only as long as the owner is alive or until the owner decides to close the business. The control belongs entirely to the owner, who also assumes the full risk of the business. Transferring one’s interest in a sole proprietorship is very easy – one simply prepares an asset purchase agreement and sells the assets. The assets of a sole proprietorship are transferred with the estate of the owner upon death. It is the simplest way of doing business. The costs of formation are very low and there is little formality required.
General partnership The general partnership (or simply partnership) is an association of two or more people carrying on a business with the goal of earning profit. A partnership is viewed as being the same as its owners. There is little formality involved in creating a partnership. Like a sole proprietorship, a partnership has only one level of taxation. A partnership is a tax-reporting, not a tax-paying entity. There is latitude in allocating income according to which partners have the best tax rates.
While pass-through taxation is an advantage, owners of a partnership have an unlimited personal liability. Generally, each partner in a partnership is jointly liable for the partnership’s obligations. Joint liability means that partners can be sued as a group. Three rules for liability in a partnership are: 1. Every partner is liable for his or her own actions. 2. Every partner is liable for the actions of the other partners. 3. Every partner is liable for the actions of the employees of the business. Partners are given equal voting rights, even if they contributed different amounts of capital.
Limited partnership (LP) A limited partnership consists of two or more persons, with at least one general partner and one limited partner. While a general partner has unlimited personal liability, a limited partner’s liability is limited to the amount of his or her capital invested in the firm. The limited partnership is a separate entity and must file taxes as a separate entity. LPs are especially useful for raising capital since they permit investors to participate financially in a business without incurring personal liability. A limited partnership normally has pass-through taxation, but must meet certain criteria to avoid being taxed as a corporation. The limited partner interest is considered a security by law. It can be transferred to a third party, but general partners and limited partners have the right of first refusal.
Limited liability partnership (LLP) A limited liability partnership is similar to a limited partnership except that all partners in an LLP enjoy limited liability. LLPs are common among professionals such as attorneys and accountants, who are not allowed to use corporations to limit their liability. LLPs offer both the pass-through taxation of a partnership and the liability protection of a corporation.
Corporation The corporation is the most common form of business entity among larger firms. Unlike sole proprietorships and partnerships, corporations are separate and distinct from their owners in the eyes of the law. The owners’ liability is limited to the amount of capital invested in the corporation. It is a legal entity which has the rights and duties of an individual: it can be sued, taxed, taken to court, etc.
The corporate business form was well-developed under Roman law. In the second and third centuries the corporate form was used by the early Christian church to hold and transfer church property. The corporate form was brought to the American colonies by the British.
A venture does not need to incorporate in its very early stages. The need for incorporation usually arises from a specific event such as a need for external financing or selling a product opening up potential liability, etc. To form a corporation, an incorporator performs a name check. The incorporator then files the articles of incorporation which include: the name, the address of the corporation’s registered office and the name of the registered agent in the office (the legal office is not the same as the corporation’s business office), the length of time that the corporation is to exist, the capital structure (common stock and preferred stock), the name and the address of the incorporator. Up to this point in the incorporation process, one has spent no more than a few hundred dollars in fees for filing the articles of incorporation. The incorporator then elects the board of directors and goes away as the board of directors takes over. The directors then issue shares and elect the officers.
C corporation For a corporation organized under subchapter C of the 1986 IRS code (known as C corporation), the federal tax ranges from a minimum of 15% to a maximum of 35%, depending on the corporation’s level of taxable income. Double taxation may be the issue with C corporations since profits paid out as dividends are taxed a second time at the personal level. To reduce the tax burden the corporation can include debt in its capital structure, but at a certain level of leverage the IRS will reclassify the debt as equity. A more common way of reducing the tax burden is to pay year-end bonuses so that the corporate income is reduced to near zero. However, there is a limit to what the IRS considers reasonable compensation.
S corporation For a corporation organized under subchapter S of the Internal Revenue Code (S stands for small business corporation) there is a pass-through taxation. The S corporation must be a domestic corporation with the maximum number of shareholders of 75 which include individuals or certain estates and trusts who are not non-resident aliens. Besides, S corporations must have one class of stock.
Limited liability company (LLC) A Limited Liability Company is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation. Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
Business trusts These trusts are unincorporated and are typically created as alternatives to corporations or partnerships. The business trust can conduct a wide variety of business, including investing, buying, and selling, yet offers beneficiaries a limited level of liability; a business trust may even invest in stocks, bonds, and similar investment instruments. Unlike corporations, business trusts do not receive charters from the states in which they are formed. Instead, they are formed through the creation of declarations of trust, which their grantors voluntarily sign.
Professional corporation A professional corporation is a variation of the corporate form of business organization that is available to entrepreneurs who provide professional services—such as doctors, lawyers, accountants, consultants, and architects. "Professionals," Frederick W. Dailey explained in his book Tax Savvy for Small Business, "are treated as small businesses under the tax code. Most of them operate as sole proprietorships or partnerships, and are subject to the same tax rules as other similar businesses. However, certain professionals who offer services may form and operate a special type of entity, called a professional corporation." Some states require professionals to form this type of entity if they wish to incorporate. In a professional corporation, the owners perform services for the business as employees.
Comprehension
1.4.1 Answer the questions using the active vocabulary and Unit 1 Glossary.
1. What are the six common issues that distinguish the different business forms?
2. Why do you think taxation and risk and control are the more significant issues?
3. What are the choices of business form for a one-owner firm?
4. What are the choices of business form for multiple people?
5. What are the two types of risk that one exposes oneself to when starting a business?
6. What is the tradeoff between liability and taxation?
7. How have S corporations and LLCs changed that tradeoff?
8. What are the major characteristics of a sole proprietorship?
9. What are the major characteristics of a partnership?
10. What are the major characteristics of a corporation?
11. What types of partnership do you know?
12. What types of corporation do you know?
13. What are the advantages of a limited liability company over other legal types?
14. What is the major difference between a business trust and a corporation?
15. What is the variation of the corporate form of business organization that is available to entrepreneurs who provide professional services?