Forms of Business Organization

Choosing a business structure is one of the first steps to consider when starting a business. The business structure you choose will impact everything from day-to-day operations, how much you pay in taxes, your ability to engage and attract investors and the paperwork you need to file. The type of business structure will also greatly influence business and personal liabilities. Since your choice is so impactful, it’s a good idea to consult with an attorney or accountant before making this important decision.

Below is an overview of the most common forms of business organization. After you have settled on the structure that’s right for your business, remember you’ll also need to apply for applicable business permits, licenses and a tax ID.

Sole Proprietorship

The default form of business organization is a sole proprietorship, and that’s how most businesses start out. A sole proprietorship is the business activity of an individual. Your business will automatically be considered a sole proprietorship if you are engaging in business activities but have not created another type of business organization.

Sole proprietorships are simple to start, simple to operate and simple to shut down because the individual business owner makes all of the decisions. Since there is no separate entity, the business owner personally owns all assets and profits of the business and is responsible for all losses. Profits and losses flow through to the owner’s personal income tax return.

The business owner is also personally responsible for all debts, obligations and losses of the business, without any limit. This means the business owner’s personal assets are at risk for debts and obligations of the sole proprietorship. A sole proprietorship cannot take investments from others to help the business grow because there are no ownership interests to sell to others. Business loans to a sole proprietorship are usually personal loans to the owner. Some tax advantages, such as deductibility of the owner’s medical insurance costs, are not available to sole proprietorships.

Partnerships

Partnerships are the most basic business structure where ownership is held by two or more individuals. Like sole proprietorships, general partnerships do not limit the liability to the owner partners. General partners can be held personally liable for debts and obligations of the business, as well as the actions of their partners. While partnerships are generally easy to establish, and will be presumed to exist in some situations even without formal written agreements, partners should have legal agreements in place to describe how profits will be shared, how disputes will be resolved, how future partners may be admitted, steps for dissolution and how decisions will be made. Profits and losses are passed through to the partners for income tax purposes.

Partnerships may take many forms, including general partnerships, limited partnerships and limited liability partnerships and joint ventures.

  • General Partnerships – Profit and responsibility for management and liability are divided among the partners (generally in equal shares unless a written agreement provides otherwise). Since there is no separate legal entity, there is no protection from personal liability afforded to the partners.
  • Limited Partnerships and Limited Liability Partnerships – These are business entities created by statute and have specific requirements. Unlike general partnerships, these types of partnerships feature limited personal liability for some or all of the partners.
    • Limited partnerships – They often are used to attract investment for real estate or other specific projects. Limited partnerships have a general partner with unlimited liability and most of the control, and additional partners hold limited liability and limited control.
    • Limited liability partnerships (LLPs) – These are similar to limited partnerships, but every partner has limited liability. These types of partnerships are often used by professional groups, such as law firms or medical practices. Others often choose a limited liability company (LLC), a structure which has emerged as an attractive choice within the last couple of decades.
  • Joint Ventures – A joint venture is another name sometimes used for a Joint ventures are often created between businesses to address a single project and are treated like general partnerships.

Corporations

A corporation is a legal entity that is separate from its owners (shareholders). State laws establish the rules for the creation, registration, operation and dissolution of corporations. These state laws create a higher degree of certainty concerning governance and ownership rights of shareholders, and are one reason that some investors prefer a corporate form of organization.

The policies and direction of a corporation are set by its board of directors, the members of which are elected by the corporation’s shareholders. Unlike sole proprietorships or general partnerships, corporations offer protection to their shareholders from personal liability. In the worst case, shareholders can lose all of their investments in a corporation, but they cannot be held personally liable for losses or liabilities beyond their investments in the corporation.

Corporations are subject to income taxes separately from their shareholders, creating the prospect for taxation of the same income both at the corporate level and when distributed to shareholders through dividends. Recent reductions in corporate tax rates have minimized the impact of this “double taxation”. Closely held businesses may find a corporate form of organization favorable because health insurance and certain other benefits for the business owners can be tax deductible at the corporate level.

Corporations are generally a good choice for medium- to high-risk businesses, which often need to raise significant amounts of capital from numerous shareholders or operate in or plan to seek investment from investors in multiple states.

Certain corporations may choose to be taxed similarly to a partnership and avoid double taxation by making a tax election to be an “S corporation”. After making this election, profits and some losses are passed through directly to shareholders without being subject to tax at the corporate level. There are special limits on S corporations, including a limitation of no more than 100 shareholders. Additionally, partnerships, corporations and nonresident aliens do not qualify as shareholders in an S corporation.

Limited Liability Company (LLC)

An LLC is a relatively recent form of business organization that combines the liability protection of a corporation and the tax and flexible operational benefits of a partnership. LLCs offer a more flexible alternative to a corporation. LLCs can be tailored to a variety of business types and sizes.

The owners of an LLC are referred to as “members,” and each member’s equity in the company is its membership interest. An LLC must be registered with the state in which it was formed, but the details of its governance, the allocation of profits and losses and the allocation of ownership equity can all be set up in an operating agreement entered into by the members.

An LLC is not subject to separate income taxation. Instead, similar to partnerships, the profits and losses of an LLC are passed through to its owners for tax purposes. In Tennessee, an LLC can be managed by its members, managed by a designated manager, or managed by a board of directors. LLCs organized in other states may be subject to different requirements.

Nonprofit Corporations

Some ventures are intended to operate for the benefit of the public instead of for the benefit of their owners. In such a case, a nonprofit corporation may be the right choice for organization of the business.

Even if a nonprofit corporation is designed to benefit the public instead of private owners, it can still be subject to tax on its net income and its property unless it has demonstrated that it qualifies for tax-exempt status. To qualify for tax-exempt status, a nonprofit corporation must show the IRS that it has been organized and will be operated for charitable, religious, educational, scientific or literary purposes. The qualification procedure requires submission of a detailed application with supporting documents. If the IRS approves the nonprofit corporation’s tax-exempt status, it will issue a certification granting it an exemption from payment of federal income taxes. Depending on state and local laws, a federal tax exemption may also permit the nonprofit corporation to establish exemption from many state and local taxes.

Directors and executives of nonprofit corporations must follow strict rules governing the operation of nonprofit corporations and the continued availability of its tax-exempt status. These rules are generally designed to ensure that the nonprofit corporation is primarily benefitting the public instead of its members or employees.

For more information on business organization and to get started on establishing your business entity, contact a member of Chambliss Startup Group or an attorney or accountant of your choice.

Source: Chambliss Startup Group, Chambliss, Bahner & Stophel, P.C.