The basic foundation of business is to establish a product or service that consumers want and then structure a group of people into an organization that meets that demand in the most profitable manner possible. It sounds simple when reduced to these basic elements, but piecing together the puzzle of the correct business structure is one of the most challenging aspects of creating a business. It is the key that can make all the difference in the success or failure of the enterprise.
Choosing the proper business structure provides the organization with the solid base necessary to conduct business operations in the most productive manner possible. There are four different structural types a business can be formed as:
Some of these structures even have substructures that can offer a business more options when it comes to the details of their organization.
This type of business is the most popular small business structure formed in the United States due mainly to its lack of formal registration requirements and ease of set-up. For the most part, all that is required to start a sole proprietorship is to file a fictitious name statement with the county recorder.
There are no formal state or federal filing requirements or fees which makes this type of business very quick and easy to set up. Sole proprietorships are not taxed as a separate entity as the individual is responsible for all taxes. The main benefit of a sole proprietorship is that it allows the individual owner to maintain complete control over the business operations and management.
The main drawback is that there are no limits to the liability the owner assumes for the operation of the business, but this is mitigated by the fact that the owner is solely responsible for the actions of themselves and the business and can control their own liability.
This type of business structure is used when two or more individuals form an agreement to conduct business operations together. There are several types of partnership agreements that can be formed and each has its own specific value to the partners.
There are general partnerships, limited liability partnerships, and limited partnerships, all of which assume similar structures regarding how the business is formed and managed by the individual partners. Each type of partnership differs according to how it is individually structured in the actual partnership agreement, where details such as ownership percentages and management responsibilities are documented.
Much like a sole proprietorship, the partnership is very easy to set up and there are no formal state or federal requirements or fees for formulation. Partnerships are also taxed similarly to a sole proprietorship as the individual partners are responsible for their own taxes.
The benefit of the partnership is that it provides for additional investment capital from each member and management flexibility within the various partners. They also have the benefit of limiting liability to the partners in limited and limited liability partnership structures. The main disadvantage to a partnership is that partners, unless limited, will have a say in how the business is conducted and compromises have to be made.
The LLC is a business structure that is formed by one or more individuals and includes a written agreement between all the members on how the business will conduct itself. LLCs are more complex to form than sole proprietorships or partnerships in that they must be registered with the secretary of state and there are fees and legal documents that must be completed. LLCs have flexibility when it comes to taxation because they can elect to be taxed as a corporation, a partnership, or a sole proprietorship. This gives the LLC the ability to shape its tax structure according to the needs of its members.
Limited liability companies have the benefit of limiting the liability exposure of its members to the debts of the company, and there are very few administrative requirements pertaining to the operation of the company. LLC members can also choose whether they wish to operate the company themselves or hire employees to perform day-to-day management tasks. The main disadvantage of the LLC is that it is more complex and expensive to form and requires articles to be filed with the state.
Corporations are structured in two different formats:
Both corporate types must file with the state and pay the proper fees of incorporation, but they must also follow strict administrative rules.
Corporations are more complex to form and operate than other business structures because the shareholders must elect a board of directors and these individuals must appoint officers to manage the corporation's day-to-day operations under the supervision of the board of directors. They must also file specific annual reports as well as conduct regular shareholder meetings and board meetings and keep accurate corporate minutes of these events.
C and S corporations differ mainly in the manner in which they are taxed. C corporations are taxed as an entity at the corporate tax rate and dividends paid out to shareholders are taxed at the individual level. This creates a double taxation scenario that does not exist in an S corporation because it is not taxed as an entity and income that is passed through to the shareholders is taxed individually. Additionally, shareholder distributions are not subject to self-employment tax although, like C corporations, S corporation salaries are subject to self-employment tax.
Corporations have the benefit of having many layers of liability protection for their shareholders and assets. It is much easier for corporations to raise capital than other business structures because they can sell shares of stock or make use of favorable corporate loans. The main disadvantage of corporations is that they are difficult and expensive to form and are a complex entity to run and manage on a day-to-day basis.
Each type of business structure has benefits and disadvantages that need to be researched prior to the formation of the business. The decision on which business structure to pursue can only be made by the individual seeking to form the business and it must be done according to how that individual will be most comfortable conducting business. The ultimate choice might depend on the type of product or service being offered and what types of liability the individual becomes open to as a result of that business.
Generally, individuals must choose between the ease of set-up and operation of a sole proprietorship or the protections and flexibility of an LLC. Groups of individuals must decide between the ease and flexibility of a partnership or the protective layers and structure of a corporation. Using proper planning and foresight in this stage of business formulation will go a very long way toward reducing organizational and expansion problems that might arise in the future of the business.
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