Types of Business Structures
There are many different types of business structures for carrying on your business. This will provide a brief overview of some of these structures, with some details about why one structure may be better for your type of business than another. In many cases, the choice will be obvious, but entrepreneurs frequently make mistakes that can be costly to fix. Partnering with a skilled business attorney can make all the difference. Contact us today with your questions.
Sole Proprietorship
This is the most basic type of business structure. Think of the little girl selling cups of lemonade from her front lawn. She’s a sole proprietor. A sole proprietorship is just you carrying on your business, without filing any kind of formation document with the state. It’s simple and easy, and you find many people doing this to provide all kinds of services – gardeners, consultants, handymen, nannies, tutors, and so on. Any profits, losses, and expenses from the business are reported on your individual 1040 tax return. The downside, however, is that you have no shield protecting your personal assets from the liabilities that your business may create. This puts personal assets like your home, your car, and your savings accounts at risk.
General Partnership
The simplest way to understand a general partnership is that it’s like a sole proprietorship, but with more than one person. For example, if you and your friend are providing lawn care services together, sharing expenses and splitting the proceeds, you are in a partnership. You don’t have to file any formation document with the state, although some states do allow for this. Unlike corporations, there are no formal meeting requirements. A partnership is a “pass-through entity” – the partnership itself does not pay tax on profits, but instead passes those through to the partners. You record your share of the profits, losses, and expenses on your personal tax return. It’s important to have a written agreement between the partners, outlining what the ownership shares are, how the profits and losses will be split between the partners, how decisions will be made, whether there are any restrictions on the transfer of someone’s partnership interest to another person, etc. And as with sole proprietorships, with a typical general partnership there is no liability shield, and the partners’ personal assets are at risk.
Limited Partnership
This is a variation on the partnership, where you will have a general partner that manages the partnership, and limited partners who are essentially passive investors. Because the limited partners are passive, and do not play a role in the management, they get a liability shield. Their risk is limited to the money they have invested in the company. The general partner, on the other hand, has unlimited risk. Also, any losses passed through to the limited partners can only be used to offset passive income.
Limited Liability Company
The LLC is a hybrid entity. If there is only one owner (called a member), then it’s like a sole proprietorship but with a liability shield. If there are two or more members, then it’s like a partnership with a liability shield. To form an LLC, you must file formation documents, usually called articles of organization, with the state where the LLC is being formed.
LLCs are a relatively new creation. Although Wyoming first authorized LLCs in 1977, other states didn’t begin to adopt LLCs until the late 1980s, and by the mid-1990s every state had adopted LLCs. Since then, LLCs have largely supplanted the use of partnerships due to the liability shield that LLCs provide, and have become the business structure of choice for most types of businesses. LLCs provide a tremendous amount of flexibility in how they are managed, although it’s important, particularly with multi-member LLCs, to have a written operating agreement detailing ownership percentages, how decisions will be made, management responsibilities, how profits and losses will be allocated, and how profit distributions will be made. It’s also recommended to include restrictions on transfer, and provisions to deal with involuntary transfers (for example, because of divorce, death, or bankruptcy).
LLCs are pass-through entities. If the LLC is a single-member LLC, the IRS treats it as a “disregarded entity,” and the LLC and its sole owner are taxed like a sole proprietorship. The LLC itself does not pay taxes, and all revenues, expenses, profits, and losses are reported on the owner’s tax return, and taxed at that level. If the LLC has more than one member, the LLC and members are taxed like a partnership.
For Profit Corporations
Prior to the widespread adoption of LLCs, the primary alternative to the partnership was a for-profit corporation. Corporations require much more structured governance than LLCs, with the need for a board of directors and officers, and with annual shareholder meetings and regular board meetings. Failure to observe these corporate governance rules can jeopardize the liability shield that protects the personal assets of shareholders from corporate liabilities. In general, though, shareholders of a corporation are only at risk to the extent of their investment in the corporation. The corporation itself pays taxes on its profits, rather than passing the profits and losses through to the shareholders. Shareholders are only taxed on dividends that the corporation pays to them. This is often called “double taxation” because the money paid out as dividends is taxed at two levels – first at the corporate level, then at the shareholder level.
Now that LLCs are the entity of choice for most businesses, corporations are used primarily for tech startups. These companies need to raise money from venture capital investors, operate stock option plans, and potentially go public, and for these reasons, the corporate structure is more appropriate than the LLC structure. In addition, because of certain tax advantages available only to corporations, it is often a big mistake for a tech startup to form as an LLC rather than a corporation.
The other situation where a corporation is used is for providers of certain professional services, such as doctors, dentists, lawyers, accountants, etc. Some states require that these types of professionals form professional corporations, rather than any other type of entity.
To Learn More About Types of Business Structures
Contact Attorney Paul Spitz
This is only a general overview of the most common types of business entities. Of course, in any particular situation, it’s important for an entrepreneur to talk with his or her lawyer and accountant, to determine the best choice for that business.
At Kinetic Law, we’re here to help you discuss types of business structures to identify what is best for your business. With offices in Cincinnati, we also serve clients throughout California, like San Diego, Los Angeles, San Fransisco, and Silicon Valley. Schedule a consultation today.
