When forming a new company, one of the first critical decisions is the formal structure that business will take. Issues such as liability, ownership, operating strategy, and taxation are all impacted by the formal structure of the business. Four different business structures are discussed below: partnership, corporation, Subchapter S, and limited liability corporation (LLC).
A partnership is a business association where two or more individuals (or partners) share equally in profits and losses. As is the case with a sole proprietorship, partners have full legal responsibility for the business (including debts against the business). Persons entering into this type of business need a partnership agreement detailing how much each partner owns of the business, how much capital each person will contribute, and the percentage of profits to which they are entitled; how company decisions will be made; if the company is open to new/additional partners, and how they can join; and in what cases and how the company would be dissolved.
In a general partnership, all partners are liable for actions made on the company's behalf, including decisions make and actions taken by other partners. Profits (and loss) are shared by all partners, as are company assets and authority.
A limited partnership is a similar business arrangement with one significant difference. In a limited partnership, one or more partners are not involved in the management of the business and are not personally liable for the partnership's obligations. The extent to which the limited partner is liable is thus "limited" to his or her capital investment in the partnership.
In a limited partnership agreement, several conditions have to be met, the most important of which is that a limited partner or partners have no control or management over the daily operations of the organization. There must be at least two partners and one or more of these general partners manage the business and are liable for firm debts and financial responsibilities. If a limited partner becomes involved in the operation of the partnership, he or she stands to lose protection against liability. In addition, a limited partnership agreement, certificate, or registration has to be filed, usually with the secretary of state, but this varies by state. Such an agreement generally includes the names of general and limited partners, the nature of the business, and the term of the limited partnership or the date of dissolution. Since limited partnerships are often used to raise capital, there is a set term of duration for the agreement. Individual states may also have additional limited partnership requirements.
The most frequent use of the limited partnership agreement has been as an investment, removing the limited partner from financial liability but raising capital through his or her investments or contributions. Limited partnerships are common in real estate investments and, more recently, in entertainment business ventures.
Partnerships are not required to file tax returns for the company, but individual partners do have to claim their share of the company's income or loss on personal tax returns. The Internal Revenue Service (IRS) governs limited partnerships for tax purposes. IRS guidelines restrict limited partnership investments to 80 percent of the total partnership interests (see IRS Revenue Procedure 92-88 for information governing limited partnerships). Limited partnerships are also taxable under state revenue regulations.
The major difference between a partnership and a corporation is that the corporation exists as a unique and separate entity from its owners, or shareholders. A corporation must be chartered by the state in which it is headquartered, and it can be taxed, sued, enter into contractual agreements, and is responsible for its own debts. The shareholders own the corporation, and they elect a board of directors to make major decisions and oversee corporate policy. The corporation files its own tax return and pays taxes on its income from operations. Unlike partnerships, which often dissolve when a partner leaves, a corporation can continue despite turnover in shareholders/ownership. For this reason, a corporate structure is more stable and reliable than a partnership.
There are several major advantages to choosing incorporation over partnership. Sale of stock can help raise large amounts of capital significantly faster and shareholders are only responsible for their personal financial investment in the company. Shareholders have only limited liability for debts and judgments made against the company. And the corporation can deduct the cost of benefits paid to employees from corporate tax returns.
Forming a corporation costs more money than a partnership, including legal and regulatory fees, which vary depending on the state in which the business is incorporated. Corporations are subject to monitoring by federal and state agencies, and some local agencies as well. More paperwork related to taxes and regulatory compliance is required. Taxes are higher for corporations, particularly if it pays dividends, which are taxed twice (once as corporation income, then again as shareholder income).
Some small businesses are able to take advantage of the corporate structure and avoid double taxation. These companies must be small, domestic firms with seventy-five shareholders or less and only one class of stock, and all shareholders must meet eligibility requirements. If a company meets these requirements, they can treat company profits as distributions through shareholders' personal tax returns. This way the income is taxed to shareholders instead of the corporation, and income taxes are only paid once. Subchapter S corporations are also known as small business corporations, S-corps, S corporations, or tax-option corporations.
The limited liability corporation (LLC) structure combines the benefits of ownership with the personal protection a corporation offers against debts and judgments. One or more people can form an LLC, and business owner(s) can either choose to file taxes as a sole proprietorship/partnership or as a corporation. The process of forming an LLC is more extensive than a partnership agreement but still involves less regulatory paperwork than incorporation.
Major advantages offered by the LLC structure are that the business does not have to incorporate (or pay corporate taxes); one person alone can create an LLC; owners can be compensated through company profits; and business losses can be reported against personal income. Still, some may choose to file taxes as a corporate entity, particularly if owners want to keep corporate income within the business to aid its growth. According to the Small Business Administration, an LLC cannot file partnership tax forms if it meets more than two of the following four qualities that would classify it as a corporation: (1) limited liability to the extent of assets; (2) continuity of life; (3) centralization of management; and (4) free transferability of ownership to interests. If more than two of these apply, the LLC must file corporation tax forms.
An LLC that chooses to be taxed as an S corporation can also do the following, which the tradition S corporation cannot, according to David Meier in Entrepreneur:
Revised by Wendy H. Mason
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Meier, David. "The Many Benefits of Forming an LLC: A Closer Look at Why This Legal Structure Can Be Good for Business." Entrepreneur, 16 August 2004. Available from < http://www.entrepreneur.com/article/0,4621,316656,00.html >.
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