Business Structure
A business structure is the form an organization must be registered in to conduct its daily operations.
What Is A Business Structure?
A business structure is the legal form within which an organization operates to carry out its daily activities.
Before registering your business, you must choose the appropriate business structure. The decision to adopt a particular business structure is influenced by its inherent advantages and disadvantages.
A business owner should also decide their motives and missions for establishing a business in advance. Their preferences determine a person's best choice based on the following characteristics:
- Ownership
- Liability
- Formation costs and process
- Ability to Raise Capital
- Taxation and other regulations
The ownership creates a concern for individuals as different business structures have different requirements for the minimum and the maximum number of members they can hold.
Liability refers to the legal responsibility or obligation to pay debts or fulfill financial commitments. The business assets are used to repay the liabilities as they come due.
Owners' liability can range from unlimited to limited for different business structures. The primary difference between limited and unlimited liability is the extent of the owner's liability.
With limited liability, business owners are protected from being personally liable to meet the amount due. The business assets and the personal assets are detached. The owner does not have to satisfy the liability if insufficient invested capital exists.
On the other hand, the business owners' assets are fused with the business in an unlimited liability. The business owner is responsible for paying the dues when the business's assets are insufficient.
The Internal Revenue Service (IRS) recognizes the following business structures in the United States:
- Sole Proprietorship
- Partnerships
- Corporations (C Corp)
- S Corporations
- Limited Liability Company (LLC)
Key Takeaways
- A business structure is the form an organization must be registered in to conduct its daily operations.
- The Internal Revenue Service recognizes sole proprietors, partnerships, C Corporations, S Corporations, and Limited Liability Companies (LLC) as business structures.
- Each business structure differs based on ownership, owners' liability, formation costs, processes, ability to raise capital, and tax implications.
- The choice of the business structure depends on the owner's preferences. It also depends on the missions and visions for its formation.
- A sole proprietorship is a famous business structure with only one owner. “Sole” refers to a single individual, and “proprietor” means the owner.
- A partnership is a business structure whereby two or more people come together to trade or conduct a business to generate profits.
- A limited liability company (LLC) combines the features of two business structures: partnerships and corporations.
Sole Proprietorship business structure
A sole proprietorship is a famous business structure with only one owner. “Sole” refers to a single individual, and “proprietor” means the owner.
This business structure is most suitable for small-scale businesses. The owner is responsible for managing its daily operations. In this manner, the sole owner controls and manages the business and receives all profits while bearing all the risks.
For example, a small-scale local grocery store, beauty parlor, or garment store could be classified as a sole proprietorship. Additionally, freelancers are considered to be sole proprietors as they work independently.
A sole proprietorship is the only business structure with highly concentrated controllable and decision-making power. As there is just one owner, they have direct control over the business operations.
Consequently, they can make quicker decisions since they do not need approval or advice from others, enabling them to seize opportunities more quickly.
Since the business is not separate from the individual, the owner can pocket all the profits that the business creates. This incentivizes the owner to grow their business, so the profit multiplies, and the owner reaps all the benefits.
The owner provides the business funds, including its assets, and is personally liable for debts with insufficient capital. They are burdened with unlimited liability.
Due to this, if a debtor demands a payment of $50,000 from the owner and the assets can only suffice up to $35,000, the owner is personally liable to meet their commitment of $15,000. The owner is responsible for collecting funds by selling personal properties or undertaking further debt.
A sole proprietorship is the most uncomplicated business structure, as minimal procedures are required to register with the federal, state, or local governments. The business owner must obtain a business license to practice based on the jurisdiction requirement.
A disadvantage, however, of setting up a sole proprietorship is that the owner cannot raise funds through the public - from a share issue. The sole owner must generate capital. They can do so by undertaking a bank loan or borrowing from family or friends.
Due to its limited resources, the business usually finds it demanding to cease many growth opportunities. Additionally, the owner may not be fully skilled in marketing, accounting, and selling, making managing all tasks challenging.
The owners pocket the profits from a sole proprietorship. Legally, the owner and the business are treated as the same individual. Similarly, the IRS specifies that the income should be taxed when transferred to the owner's accounts at the personal income tax rates.
Partnerships business structure
A partnership is a business structure whereby two or more people come together to trade or conduct a business to generate profits. The partners share the profits created. There must be a minimum of two persons or partners to incorporate a partnership.
Usually, the partners make their business official by incorporating a partnership agreement that governs the capital and profit contribution. The partnership agreement could also specify other features depending on what is agreed upon by the partners.
The partners could also agree on the aftereffects when a partner leaves. More often, when a partner leaves, the initial partnership agreement ceases. The remaining partners can continue the business by drafting a renewed partnership agreement.
The decision-making power in a partnership lies with all the partners. All decisions must be mutually agreed on. The partners also have equal control over the business. A partnership is similar to a sole proprietorship as they are not separate legal entities, i.e., the owners and the business are different. Partners are personally liable for debts when the business’s assets are insufficient to meet its dues.
Types of Partnerships
There could be an agreement among the partners to have limited liability. This also depends on the type of partnership that is incorporated.
1. General Partnership Agreement: Here, every partner must provide the assets for the business and be personally liable for the debts. They have unlimited liability whereby their personal assets may be used to settle the debt.
2. Limited Liability Partnership (LLP): In this, every partner is endowed with less risk than in a general partnership, as their liabilities are capped to the amount they have invested, i.e., their contributed capital.
3. Limited Partnership: It combines the two features of the general and limited liability partnerships. In this structure, there is one general and one silent partner. The general partner has unlimited liability, whereas the silent partner has limited liability.
Note
The silent partner is not allowed to conduct any day-to-day operations.
The formation process of a partnership is more straightforward than setting up a corporation but more tedious than a sole proprietorship. The partners would primarily be required to select the best type of partnership they prefer based on their liability obligations.
After selecting the appropriate choice, the partners must draft a partnership deed and choose a trade name. These documents must be submitted to the state government to obtain a license to practice.
More funds can be contributed to the business as more partners are in a partnership. It is also much easier to raise capital for a partnership than for a sole proprietorship.
After the incorporation, the partnership business does not have to pay taxes directly. The taxes are levied on the partner's income after the distribution of profits. It is paid at the personal income tax rates and passed on to the partners.
Corporations
A corporate/company is a separate legal entity created by individuals to conduct business activities. A company's crucial and unique feature is that it exists independently and is not attached to its owners.
A company exists legally similar to a person and can own assets, liabilities, etc., under its name. It can also undertake and lend debt by engaging in contracts directly. However, since a company is not a physical person, it is considered artificial.
A company can have many owners who contribute capital to the organization. The business uses this capital to provide for day-to-day activities and growth opportunities. The owners of the company are collectively known as shareholders.
The company can raise further capital by issuing shares. A shareholder can buy the company’s shares at an amount specified in the offer agreement. The company gains money by this, and the shareholder owns a part of its stake.
A corporation is characterized by a limited liability whereby the owners are not liable to repay the company’s debts. As the company exists independently, all its assets can be used to repay the debts.
Additionally, the shareholder’s liability will only exist for the amount outstanding on their shares. The company can demand the unpaid portion when the shareholder does not pay the total amount. They can do this by issuing a call notice to the shareholder.
Forming a company is the most hectic and time-consuming. Inherently many more laws and regulations govern the incorporation of a company. Additionally, after incorporation, the company must adhere to many rules while practicing.
Different Types Of Corporations
A corporation can be of 4 types. They are as follows.
1. C Corp
A C Corporation is the most common corporate form where the company is treated as a legal entity and taxed separately from the owners. The structure of a C Corp matches the definition of a public company.
A public company is not restricted to raising capital from the public. They can openly invite the public to subscribe to their shares or debentures. Furthermore, they can issue more than one stock (common or preferred).
The company profits are taxed at corporate rates. As there are many owners or shareholders of the company, the profits are also shared with the owners. The owners are subsequently taxed at personal income tax rates.
2. S Corp
An S Corp is a Small Business Corporation and resembles a private company. In this structure, the corporation can have a maximum of 100 owners.
Private companies restrict how capital can be raised and limit the owner's transfer of ownership. A public company can offer the public to subscribe to the equity or debt they issue. The ownership can also be transferred easily among owners.
Note
The ownership of a private company is closely held, so the private company cannot issue its equity or debt to the public. The transfer of ownership is also restricted.
3. Nonprofit corporation
Generally, corporations are formed to create profits, except for nonprofit corporations. This organization is formed to foster public benefit through charity. These could include educational, religious, and public hospitals.
As these corporations aid the public, they receive a tax exemption from the IRS.
4. B Corp
A B Corp, also known as a benefit corporation, supports the Triple Bottom Line theory whereby the corporation works toward social, economic, and environmental benefits. These corporations work with profit as their motive.
They work towards creating a better society by supporting the three facets of Corporate Social Responsibility (CSR).
In October 2022, R&A Bailey & Co, the famous Baileys Irish Cream Liqueur producer, was awarded the status of a B Corp. They have strived to achieve sustainability by implementing the Society 2030: Spirit of Progress Plan.
Limited Liability Company
A limited liability company (LLC) combines the features of two business structures - partnerships and corporations.
As a partnership, the owners receive the profits in their accounts and are taxed at personal rates. As the income is only taxed once, the overall taxes are reduced. It works similarly to an S Corporation.
As a corporation, the owners enjoy limited liability. The owners are entitled to manage the company and are not personally responsible for any downturn. Only the corporate assets will be used to pay off a debt.
At incorporation, an LLC must have at least one owner, and there is no limit to how many owners it can have. The owners are more commonly addressed as a member.
This structure can have many and any members, including individuals, corporations, foreign organizations, and other LLCs. Additionally, it is permitted to have just one owner. These are referred to as single-member LLCs.
The features closely complement that of an S Corporation. One of the critical features of an S Corp is the maximum limit on the owners,i.e., they can only possess up to 100 owners. However, an LLC can be owned by unlimited members.
Often, small business owners prefer forming this structure because the process is quick, and they can benefit from the advantages of forming a corporation. The owners must create an Operating Agreement and Article of Organization, which must be filed with the Secretary of State.
An LLC is a private company with restrictions on raising capital from the public. The other methods they can use to raise funds are to undertake loans, acquire government funding or attract new owners.
It could be possible that the IRS could classify a domestic LLC as a partnership or a disregarded entity. An LLC with at least two members can be classified as a partnership for income tax purposes.
Single-member LLCs could be classified as disregarded entities, i.e., the business is not a separate legal entity. This could be avoided by filling out Form 8832, whereby the owners can elect the preferred business form.
Summary
Here is a quick summary and comparative table for the different types of business structures. Before incorporating a business, evaluating the different structures based on their features, advantages, and disadvantages is advised.
In the table below, you can see the key differences for each structure. In addition to the major differences among the set, the table mentions the features of the various business structures.
| Particulars | Sole Proprietorship | Partnership | C Corp | S Corp | Limited Liability Company (LLC) |
|---|---|---|---|---|---|
| Ownership | One | Two or more | One or More | One or more. Maximum: 100 | One or more |
| Liability | Unlimited | Unlimited | Limited | Limited | Limited |
| Formation Cost And Process | Simple | Easier than Corporations | Intensive | Intensive | Easier than Corporations |
| Ability To Raise Capital | Difficult | Easy | Easiest | Easiest | Easiest |
| Taxation | Through the owners | Through the owners | Double taxation | Through the owners | Through the owners |
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