Types of Business Organizations

Skyscraper Types of Business Organizations

There are many types of business organizations, but the most common are Proprietorship, Partnership, Limited Liability Partnership (LLP), Limited Liability Company (LLC), and Corporation. Furthermore, there are special tax rules that allows corporations to be taxed only once (as opposed to the typical double-taxation) called S Corporation.

The following is a more detailed explanation of each type of business classification.

Proprietorship

A proprietorship is the most basic of business organizations, being owned by one person and requiring no special formal agreements. Any individual can start a proprietorship business as an entrepreneur. The primary feature of a proprietorship is that the person who owns the business takes complete responsibly for business risk. If the business has unpaid debts due, then the owner is at risk for having his or her assets liquidated in order to pay those debts. This risk associated with owning a business is why many organizations become incorporated, because incorporation makes the business an entity separate from its owners while also dispersing the risk among many owners.

The characteristics of a Proprietorship include:

Easy to Start. Licensure may be required for certain fields, such as requiring a license to practice medicine or requiring a special license to drive a semi-truck. However, it is generally not necessary to file paperwork to start the business. Independent contractors are generally considered to be proprietors.

Taxed Once. Proprietorships are taxed only once as individual revenue, whereas corporations are taxed twice. In a corporation, business earnings are taxed first, and then disbursements to the owners (considered dividends) are taxed a second time as individual income. This double-taxation occurs because the corporation is considered a legal entity separate from the owners. However, conversely, owners of a proprietorship are considered to be self-employed, which results in their income being taxed more via the Self Employed Contributions Act Tax (SECA Tax).

Keep Earnings. As the sole owner of a business, any surplus in earnings go directly to the owner.

Unlimited Personal Liability. The debts of the business are the debts of the owner; so if the business owes a million dollars, then the owner of the business owes a million dollars even if they have only contributed a small portion of that amount to the company.

Limited Life. Unlike corporations, which are entities by themselves and therefore have an unlimited lifespan, proprietorships have a limited lifespan that can last no longer than the owners life. Legally, if a new owner takes over the business, then it becomes an entirely new business even if the company name remains the same.

Limited Financing. Obtaining significant funds to finance growth opportunities is difficult because the financial strength of the business is equal to the financial strength of the owner. This limits the growth rate of proprietorships, which is why generally only corporations become huge companies. In a corporation, the financial strength of the business is separate from the financial strength of its owners.

Partnership

A partnership is essentially the same type of business organization as a proprietorship, with the exception of having numerous owners. All owners still have unlimited personal liability that is shared among them, so if one owner can not pay the business debts then the other owners will be required to pay. Formal contractual agreements can specify the nature of the partnership.

Like with a proprietorship, a partnership has limited financing opportunities. The financial strength of the partnership is equal to the financial strength of the numerous owners. For a business that is growing slowly, this limit to obtaining funds is not a problem. However, quick growth is the primary catalyst for causing a proprietorship or partnership to become incorporated.

Limited Liability Partnership (LLP)

The rules governing a Limited Liability Partnership (LLP) vary from state to state, but the the basic idea is that some partners can be protected from business risk.

With a Corporation, owners establish their ownership through the use of stocks (they buy their share of the company). In the event of bankruptcy, the most that a share-holder can lose is the amount they have invested in the company. Likewise, in a Limited Liability Partnership, one person may take full responsibility for the majority of the business risk, while other partners only risk losing their financial contributions to the business.

However, typically partners with limited liability are restricted from making managerial decisions for the business, just as is often the case for an owner of Preferred Stock of a corporation (no voting rights).

Limited Liability Company (LLC)

The Limited Liability Company (LLC) has become an increasingly popular business style due to its flexibility. LLC's are a hybrid of traditional corporations and partnerships, combining the best benefits of the two business types.

The characteristics of Limited Liability Company (LLC) include:

Flexibility of Ownership. Unlike a partnerships, which requires at least two owners, Limited Liability Corporations (LLC) have the flexibility of having only one owner, yet still receive limited personal liability; or the business can have multiple owners like a partnership with limited liability. It is even possible for another company to be an owner of an LLC.

Flexibility of Taxation. The owners of a LLC can choose to be taxed like a partnership or taxed like a corporation. The benefit of being taxed like a corporation is that the business can claim "S Corporation" status (a special tax status for small corporations) that results in revenue only being taxed once, while simultaneously allowing some individual income to be considered dividends.

The revenue designated as dividends is considered by the government to be "unearned" income rather than being considered self-employed or "earned" income. Self-employed income is taxed extra by the Self Employment Contributions Act Tax (SECA Tax).

Self-employed individuals have to pay about double the amount of Social Security and Medicare tax that employed individuals pay.

In the previously mentioned business types, all revenue would be taxed extra by the SECA tax. However, being taxed like a S Corporation avoids all income requiring the extra tax, overall allowing owners to reduce their tax expense. A company who regularly earns a substantial amount of revenue may consider being taxed like a corporation to avoid the SECA tax on part of the generated revenue. However, LLC's with a single owner are almost always taxed as a sole proprietorship and generally cannot claim S Corporation status.

Note: The IRS looks more closely at companies that claim S Corporation status, in order to avoid abuse of the system, because the salary/dividend split is somewhat subjective. For example, if an owner of a LLC reports $20,000 as salary (subject to SECA Tax) and reports $180,000 as dividends, then this owner will likely face major problems with IRS. Conversely, $140,000 as salary and $60,000 as dividends is a more reasonable split. The IRS considers illegal tax evasion to be very serious, so it is better to be conservative to avoid significant consequences.

Less Government Regulation. One of the downsides of corporations is high government regulation, which can complicate management of the company due to numerous forms and rules. While LLC's are still regulated, the level of regulation is significantly less than for traditional corporations.

Unlimited Life. Like a corporation, a Limited Liability Company is considered to be a separate entity from the owners, which means that the company can continue to exist beyond the lives of the owners. However, redistributing ownership of an LLC is not as easy as it is for a corporation. Owners will need to fill out special documents to redistribute ownership, whereas in a corporation ownership is redistributed easily through the use of buying and selling company stocks.

Note: For tax purposes, the government does not consider an LLC to be a separate entity, which is why it is possible to be taxed like a partnership.

Corporation

Corporations are legally established entities that are separate from their owners. Transferring ownership is extremely easy through the use of buying and selling shares of stock (i.e. shares of ownership). The primary benefit for a business to become a corporation is to meet the financial needs of rapid growth by acquiring significant financing.

Financial Strength. Whereas the financial strength of a partnership is the financial strength of its owners, a corporation's financial strength is completely separate from its owners. Revenue earned can be partly distributed as dividends, but it is not uncommon for businesses to retain earnings for future growth. This financial strength is one of the characteristics of a corporation that allows for significant funds to be raised much easier than for partnerships.

Limited Liability. Corporations also have limited personal liability to the owners, which was a unique benefit prior to the existence of LLP's and LLC's. The most that an owner can lose is the money he or she has invested into the company, even if the company's debts exceed the invested amount in the event of bankruptcy. For example, in a partnership, if the company owes a million dollars, then the owners are responsible for repaying that amount even if the owners have not contributed that much capital to the business. However, in a corporation, if an owner has invested $10,000 in the company, then the most he or she can lose is that investment: this is the power of limited personal liability vs unlimited personal liability.

Double-Taxation. Revenue is taxed as if the corporation is an individual; and revenue can be used to reinvest in the business for further growth, or it can be disbursed to business owners as dividends. This taxation method results in revenue being taxed twice when it is disbursed as dividends (the business entity is taxed and then the dividends are taxed as individual income), which is one of the drawbacks of corporations.

S Corporation

A S Corporation (Small Business Corporation) is a special tax classification for any Corporation or Limited Liability Company (LLC) that meets special characteristics, including having less than one-hundred shareholders. This tax classification allows revenue to be treated as it would in a partnership, thereby avoiding the double-taxation of corporation revenue. Money is viewed as passing directly to the owners, who then report gains or losses on their individual tax returns.

However, money that is received from the company can be classified as either salary income (i.e. "earned" income subject to the SECA tax) or dividend income (i.e. "unearned" income). The benefit of this strategy is to avoid double-taxation while simultaneously reduce Self-Employment taxes (SECA Tax) since "unearned" dividend income is not subject to SECA tax.

Note: Companies claiming S Corporation status are scrutinized more heavily by the IRS, since the salary/dividend split is subjective. As mentioned, an individual claiming $20,000 salary and $180,000 dividends would likely face major consequences by the IRS. The salary/dividend split is expected to be "reasonable;" and since the IRS considers illegal tax evasion to be very serious, it is better to error on the side of caution.

Further qualifications for the S Corporation status are: a shareholding cannot be another company or organization (except in certain cases), a shareholding cannot be foreign, and the company cannot have more than one type of stock (meaning there cannot be more than one way to define ownership).

Which is Better: Corporation or LLC?

With the flexibility of a LLC, one may wonder why any company would still choose to become a corporation. The primary reasons why are:

  1. Corporations find it much easier to obtain large amounts of financing,
  2. Personal liability is reduced with more shareholders,
  3. Ownership is transferred more easily than in LLC's, and
  4. Being taxed as a corporation is typically better when revenue earned is significant due to avoidance of the Self-Employment SECA tax on all income.

Furthermore, for tax purposes, any LLC with more than 100 shareholders is automatically considered to be a corporation, even if the company is legally an LLC. So if the owners of a company intend to grow their business into a significant enterprise, then a corporation is likely the best business classification to pursue.

Read more about Which is Better: Corporation or LLC?


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