4 Major Business Formation Types
Choosing the right business structure is crucial as it lays the foundation for operations, taxation, liability, and growth prospects. Understanding the four primary types of business formations can significantly impact the trajectory of a company. Understanding these 4 major business formation types enables entrepreneurs to choose structures aligned with their goals, risk tolerance, and growth strategies. Each type carries its benefits and trade-offs, making it imperative to weigh the options carefully before establishing a business.
When establishing a “business entity”, there are four different ways to do it. Depending on the circumstances and nature of the proposed business, each choice presents advantages and disadvantages. Rather than take the advice of friends or family members, it is always best to discuss your options with a qualified and experienced business law attorney. Doing so will give you the piece of mind that comes with covering all the bases, for both your own legal protection and possible tax benefits as well!
Anyone who has ever contemplated setting up a business was likely overwhelmed by the vast number of decisions such a venture demands. Perhaps more than or equal to considerations such as a business plan, identification of measurable objectives, location, and name, how the business is structured is of utmost importance.
The four ways in which a business may be set up are: Sole Proprietorship, Partnership, Corporation, and Limited Liability Company or LLC.
1. Sole Proprietorship
This is the most simple business entity there is. As the name implies, the establishment has just one owner. That owner may choose to use his or her own name or “d/b/a”, which means, “doing business as”. The requirements are minimal – just a social security number and the necessary permits and licenses.
These are often a top choice for small businesses because they are so economical to start up. Benefits include the fact that income is taxed once, instead of twice as a company and then personal source of revenue. Sole proprietorships are not subjected to as much government involvement and taxation as some other business types. Since only one person is involved, conflicts with partners, their associates or family members are nonexistent. Also, it is very easy to dissolve.
A major point to be aware of is that under the law, there is no distinction between the individual and the business. That can sometimes jeopardize the owner’s personal assets should the business go through financial problems. The same is true in the reverse, should the business owner experience hardships, such as divorce, illness, or some other personal difficulty, the business may be negatively affected.
It takes an astute individual to successfully operate this type of business. They are 100 percent responsible for all of the decisions and raising capital. There are also certain employee benefits that can not be fully deducted from the firm’s income. Owners should realize that some costs could only be partially deducted later as an adjustment.
Example: A freelance graphic designer working independently, assuming full control over their business affairs and responsibilities.
Examples: A freelance writer, a plumber, or a small retail shop owner may operate as sole proprietors.
The owner faces unlimited liability; meaning, the creditors of the business may go after the personal assets of the owner if the business cannot pay them. The sole proprietorship form is usually adopted by small business entities.
This formation type takes place when two or more individuals form a written agreement to operate a business together. Partnerships can also be established between other businesses and among one or more businesses and one or more individuals. This choice is also fairly simple and inexpensive to establish. However, partnerships have their own unique set of tax and liability issues.
In general partnerships, all partners have unlimited liability. In limited partnerships, creditors cannot go after the personal assets of the limited partners.
Of course, this type of business allows for shared responsibilities when it comes to raising capital, making important decisions, and managing operations. On the flip side, when conflicts arise, no matter how large or small, unresolved issues can endanger the business. Those considering a partnership need to proceed with caution, because if one partner makes a financial or legal misstep, it can spell disaster for the company as a whole.
Example: Two lawyers collaborating to establish a law firm, sharing responsibilities, and profits as partners.
Examples: A law firm, a medical practice, or a real estate investment partnership may operate as partnerships.
Going through the process known as “incorporation” sets up the most flexible type of company. Corporations are state-chartered and have a number of legal rights. Its owners have limited liability because the corporation has separate legal standing. The owners are thereby protected from personal legal action, should the business be sued. However, corporations undergo a great deal of scrutiny and are held accountable for their actions at a higher level.
For example, the government oversees the operations of a corporation and requires them to appoint a board of directors, hold regular meetings, record and publish meeting minutes. Income is also subject to taxation as both personal and business revenue. Another point to keep in mind is that ownership can be transferred through the sale of stock or transfer of a controlling interest within the corporation.
The owners (stockholders) enjoy limited liability but have limited involvement in the company’s operations. The board of directors, an elected group from the stockholders, controls the activities of the corporation.
Example: A multinational manufacturing company issuing shares of stock to shareholders and enjoying separate legal standing.
Examples: Google, Apple, and Microsoft are all publicly traded corporations.
4. Limited Liability Company-LLC
These types of businesses have many of the same built-in advantages as corporations. Along with their limited liability, LLCs can be owned by a variety of entities, including individuals, trusts, other LLCs, and corporations. When it is set up under the proper guidelines, an LLC can be taxed like a partnership, which is an advantage. However, there is quite a bit of paperwork required to form and operate an LLC to ensure that it will not be taxed as a corporation.
A company Private limited (LLC in the U.S., GmbH in Germany, Perseroan Terbatas in Indonesia, Privat Aktiebolag in Sweden, Besloten Vennootschap in the Netherlands).
Although all four of theses common business entities are fairly straight forward, there are slight differences that govern their creation and operation, which can vary from state to state. That’s why it is always a very good idea to retain the services of an experienced business lawyer. Wilmington attorney Wes Jones is well-versed in these matters. Please make an appointment with Wes so he may assist you in exploring options and deciding which approach is best for your next business venture.
Limited liability companies (LLCs) in the USA, are hybrid forms of business that have characteristics of both a corporation and a partnership. An LLC is not incorporated; hence, it is not considered a corporation. Nonetheless, the owners enjoy limited liability like in a corporation. An LLC may elect to be taxed as a sole proprietorship, a partnership, or a corporation.
Example: A small software development company formed by a group of tech enthusiasts who seek limited liability and operational flexibility.
Examples: An online store, a consulting firm, or a local restaurant may operate as LLCs.
Considerations for Choosing the Right Structure
The choice of business structure depends on various factors, including:
- Personal Asset Protection: If you want limited liability protection for your personal assets, a corporation or LLC may be a good option.
- Ease of Formation and Management: Sole proprietorships and partnerships are relatively easy to form and manage, while corporations may require more legal and administrative complexities.
- Taxation: The taxation structure of each option varies. Sole proprietorships and partnerships are generally “pass-through” entities, while corporations may have separate tax liabilities.
- Fundraising and Ownership Structure: Corporations may be better suited for raising capital through stock offerings, while partnerships and sole proprietorships may have simpler ownership structures.
When selecting a business structure from one of the 4 major business formation types, it is advisable to consult with an attorney and accountant to understand the legal and tax implications of each option. They can guide you in making the best decision for your specific business needs and risk tolerance.
Photo credit: via Pixabay
Ready to get started?
Are you a consultant? If you are a consultant and wish to contact us for any reason, we invite you to click the ‘Let’s Get in Touch’ button to connect with our team and receive the necessary assistance.
Are you seeking appropriate and objective advice? If so, please click the ‘Request for Proposal’ button to get in touch with us and find out how we can assist you today.