Six types of business organizations

For the benefit of the business owner, I’ve listed the six types of business organizations with easy to compare pros and cons. Since small businesses change over time, it’s important to understand that what business organization you chose today will change with the business; “the tax laws and other regulations that influence the way we operate also are in constant flux" (Anthony, n.d, p. 2). Understanding the advantages and disadvantages of each business type is imperative; since the right business organization is based on individual circumstances, not a magic bullet that works for everyone and every unique situation.

All forms of business organizations fall into two groups. First, corporations where tax is assessed at the corporate level and second, pass-through entities where tax is assessed at the shareholder level. Pass-through entities do not have profits taxed to the corporation. “100% of profits (or losses) are distributed (or passed-through) to the shareholders. Each shareholder reports his or her share of profits or losses on his or her individual Form 1040" (Perez, 2009, p. 1).

“C" corporations are taxed at the corporate level. Sole proprietors, “S" corporations, and partnerships are pass-through entities and taxed at the shareholder level. Limited liability companies can be taxed at either the corporate level or the shareholder level depending on the owner’s choice of organization: sole proprietorship, partnership, “C" corporation, or “S" corporation.

Sole Proprietorship

A sole proprietorship, also known as a consultant, independent contractor, or freelancer is a business owned by a single person. Sole proprietorships are “the most common form of business organization" (Beatty, 2006, p. 755).

Pros and cons of a Sole Proprietorship

Pros

Simplicity in retirement plans

Easiest form of business to set up and dissolve

Avoids the expense of forming a partnership or corporation

Not required to file a separate tax return (although it will be on a separate schedule)

No need to register with the government (a few states and local governments require sole proprietorships to possess a business license)

Cons

You are on your own

Unlimited personal liability for all debts of the business

Limited financing options (cannot raise capital from outside investors)

Self-employment taxes of 15.3% on the first $106,800 of earnings

Business dissolves when owner dies or sells rights to business (new owner must start new sole proprietorship)

Sole proprietorship characteristics in regards to:

Liability - Good only when there’s a small risk for liability exposure. An accident at the factory, en route to a job site, or at the job site can result in loss of not only the business assets but also all personal assets.

Income taxes – Self-employment taxes for Medicare and Social Security are paid in full, as opposed to employees who pay half and the employer pays the other half. Half of the cost of self-employment taxes is deductible. Business profit is considered self-employment income and is reported on a Schedule C tax form. You receive no salary as a Schedule C business owner. If you wanted to leave money in the business with the intention of increasing inventory or saving for a new piece of equipment you may be paying higher taxes. “If you operate as a sole proprietor, those "retained" profits would be taxed at your marginal individual tax rate, which is probably more than 25%. But, if you incorporate, that $50,000 would be taxed at the lower 15% corporate rate" (Pakroo, n.d., ¶ 13). In other words, you will be taxed on all profits of the business regardless of the amount of money you withdraw from the business.

Longevity or continuity of business – The business dissolves when owner dies or sells assets and liabilities of business.

Control – Owner actively engages in management decisions and daily business activities.

Profit retention – Business profit is considered self-employment income and is reported on a Schedule C tax form. You receive no salary as a Schedule C business owner.

Convenience or burden – This is the easiest form of business to start and dissolve. However, due to the inherent risks associated with manufacturing, transporting, and installing cabinetry, the risk of overwhelming financial liability outweighs the convenience factor.

General Partnership

A general partnership is formed with two or more partners as business co-owners.

Pros and cons of a General Partnership

Pros

You have someone to assist you in business matters allowing more time away from the business

Partners provide additional financial backing as opposed to going it alone in a sole proprietorship.

Simplicity and flexibility

Cons

Loss of total control resulting in decision making being done by the team instead of by the individual

Each of the partners will have unlimited personal liability for all debts of the business

Business income and expenses reported on a separate tax return

General partnership characteristics in regards to:

Liability - Good only when there’s a small risk for liability exposure. An accident at the factory, en route to a job site, or at the job site can result in loss of not only the business assets but also all personal assets.

Income taxes – General partners in a partnership are considered self-employed. They are taxed according to the self-employment tax.

Longevity or continuity of business – Business does enjoy perpetual existence, unless specified otherwise in the partnership agreement. Partners do have the right to transfer the value of their partnership.

Control – Owners actively engages in management decisions and daily business activities.

Profit retention – If a partner decides to leave the partnership, the business could dissolve. Selling of one’s partnership interest is only allowed if the partnership agreement permits it.

Convenience or burden – Like a sole proprietorship, general partnerships can be created without formalities. However, due to the inherent risks associated with manufacturing, transporting, and installing cabinetry, the risk of overwhelming financial liability outweighs the convenience factor.

Limited Partnership

A limited partnership is a partnership formed by two or more people having at least one general partner and one limited partner.

Pros and cons of a Limited Partnership

Pros

Limited liability for limited partner

Easy to form

Perpetual existence – business continues as partners come and go

Only one partner is required to be a general partner

Cons

Selling of one’s partnership interest is only allowed if the partnership agreement permits it.

Reinvested profits are taxed at the owners’ highest marginal tax rate

Sharing profits with others

Greater expense to form than a general partnership

General partners liable for debt

Limited partnership characteristics in regards to:

Liability - When choosing a form of business, the major legal consideration is limited liability protection. The business owner(s) are only liable for the capital they have invested and not their personal property.

Income taxes – Reinvested profits are taxed at the owners’ highest marginal tax rate resulting in the possibility of paying more in taxes than in a corporation.

Longevity or continuity of business –Business does enjoy perpetual existence, unless specified otherwise in the partnership agreement. Partners do have the right to transfer the value of their partnership.

Control – Management is separate from shareholders. Managers don’t have any ownership responsibilities and shareholders don’t take on any management responsibilities. This separation keeps liabilities from poor management decisions from depleting shareholder's personal assets.

Profit retention – Selling of one’s partnership interest is only allowed if the partnership agreement permits it.

Convenience or burden – Control of the business by the general partner restricts power of the limited partners. This business entity would be a good choice for a silent partner who is merely assisting in funding the business as opposed to having a hands-on involvement.

“C" Corporation

Pros and cons of a “C" Corporation

Pros

Limited liability

Greater flexibility than a “S" corporation

Multiple classes of stock

No restrictions on eligible owners

Some states have no corporate tax

Section 179 expensing election considerably lucrative (“S" corporations are limited to just one amount)

Unlimited number and type of shareholders – beneficial when planning a stock offering or requiring many investors

Ease of selling or transferring stock

Some states require no disclosure of corporate owners

$50,000 of group term-life insurance coverage tax free to the employee

Tax-free accident and health insurance to the employee

Perpetual existence – business can continue without their founders

May elect to use a fiscal instead of a calendar tax year (ability to shift income between taxable years)

Cons

Double taxation - profits taxed at the corporate level and dividends at the shareholders level

Greatest startup cost (incorporation fees, etc.)

Greatest cost of filing yearly-required paperwork (taxes, business license, etc.)

“C" corporation characteristics in regards to:

Liability - When choosing a form of business, the major legal consideration is limited liability protection. The business owner(s) are only liable for the capital they have invested and not their personal property.

Income taxes – Your salary is deductible as a business expense and shareholders’ dividends are taxed at a 15% “qualified dividends" tax rate. Perez states:

The lowest tax bracket for a C-Corp is the 15% bracket that goes from zero to $50,000. It may be possible to manage your small business finances so that your corporation will never pay more than 15% in taxes. (2009, p.3 ¶ 2)

Longevity or continuity of business – Relative ease of transferring shares and adding shareholders means selling your business, bringing in a new business partner, or transferring ownership to your children is easier than with a partnership or sole proprietorship.

Control – Management is separate from shareholders. Managers don’t have any ownership responsibilities and shareholders don’t take on any management responsibilities. This separation keeps liabilities from poor management decisions from depleting shareholder's personal assets.

Profit retention – Only “C" corporations can split profits between dividends and retained earnings. Perez states:

The ability to choose when and how much you are taxed by controlling when and how much money is distributed is a crucial tax advantage for C-Corporations. This means that there is more flexibility with a C-Corporation to pick your tax rate than there is with the other options. (2009, p. 3 ¶ 9)

“C" corporations retain losses, and the losses offset the following year’s income. Using another form of business would result in the loss reducing the shareholder’s income. “Pass-through" business losses result in a tax break for the year of the loss, while “C" corporations losses result in a future tax break for the company.

Convenience or burden – There is greater startup costs associated with a “C" corporation, but for a highly profitable business this is the best option.

“S" Corporation

An “S" corporation is a “C" corporation that has elected for “S" corporation tax status. With an “S" corporation, you receive the limited liability of a corporate shareholder with the benefit of paying taxes as a sole proprietor or partner.

Pros and cons of an “S" Corporation

Pros

Limited liability

Pass-through of losses - corporate losses can pass through to shareholders unlike in a “C" corporation (no double taxation)

No federal income taxes

No shareholder FICA tax on net income (unlike self-employment taxes of 15.3% on the first $106,800 of earnings for a sole proprietorship)

Perpetual existence – business can continue without their founders

Simpler than a “C" corporation

Cons

Subject to some of the same requirements of “C" corporations (keep corporate minutes, hold shareholders and directors meetings, allow votes on major corporate decisions by shareholders)

Must maintain financial exclusivity between private and corporate holdings to avoid personal financial liability

State corporate income tax return may need to be filed

Must have at least one shareholder

Limited to a maximum of 100 shareholders (no foreign shareholders)

All shareholders must agree to the election of “S" corporation status

There can only be issuance of common shares which can limit capital raising efforts

All gains and losses must be passed through to the shareholder's stock stake in the company proportionately

Annual state franchise fee or tax

Less flexibility than a “C" corporation

Must use calendar year for tax reporting purposes (few exceptions)

“S" corporation characteristics in regards to:

Liability - When choosing a form of business, the major legal consideration is limited liability protection. The business owner(s) are only liable for the capital they have invested and not their personal property.

Income taxes – The IRS expects the managing shareholder to be paid ‘reasonable compensation’ along with profit distribution. You may be inclined to pay yourself more as profits and less as salary to reduce payroll taxes, but the IRS is aware of that accounting practice. You must pay yourself what you would expect to be paid working for someone else.

Longevity or continuity of business – Relative ease of transferring shares and adding shareholders; means selling your business, bringing in a new business partner, or transferring ownership to your children is easier than with a partnership or sole proprietorship.

Control – Owner(s) actively engages in management decisions and daily business activities.

Profit retention – Shareholders pay taxes at their individual tax rates on all profits of the “S" corporation since it isn’t a taxable entity. Likewise all loses are the responsibility of the shareholder, but these can be deducted against the shareholder’s other income.

Convenience or burden – The legal and accounting costs of starting an “S" corporation are similar to those of a “C" corporation. They must meet much of the same requirements of “C" corporations, which in turn raise legal and tax service costs. Keeping corporate minutes, holding shareholders and directors meetings, and allowing votes on major corporate decisions by shareholders, add to the complexity and cost of running an “S" corporation. The limited tax benefits when compared to a “C" corporation along with the aforementioned negatives make this entity a poor choice for this business.

Limited Liability Company

A limited liability company (LLC) is a hybrid between a partnership and corporation.

Pros and cons of a Limited Liability Company

Pros

Limited liability

Hybrid between a partnership and corporation

Owners can report their share of profits or losses on their individual tax returns

Can utilize pass-through taxation (if the owners decide to treat the LLC as a sole proprietorship or a partnership)

Distribution of earnings among members is flexible - profits and losses don’t have to be distributed in proportion to ownership

Can be managed by owner or outside manager

Can be single owner (a few states require more than one owner)

Cons

Generally required by state law to have written operating agreements - rights and duties of the members much like a partnership agreement

Limited tax benefits versus sole proprietorship or general partnership

No perpetual existence (most states require the operating agreements of an LLC to set a limit to the company’s existence.)

Requirements must be met to sell ownership interests

Limited liability company characteristics in regards to:

Liability - When choosing a form of business, the major legal consideration is limited liability protection. The business owner(s) being liable for the capital they have invested and not their personal property.

Income taxes – LLC’s aren’t subject to the double taxation of “C" corporations or paying federal taxes prior to the distribution of money to the owners. Taxes at the state and local levels may be required of the LLC. Company members report their share of profits on their personal federal tax returns. Single-owner LLC’s are treated as sole proprietorships by the IRS.

Longevity or continuity of business –

Most LLC’s will dissolve upon the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member, collectively known as the events of dissolution. This can create problems for certain businesses because of the lack of stability it provides. To combat this instability, the operating agreement may provide the remaining members with voting rights that allow them to continue the LLC. Usually these rights do not cause the LLC to take on continuity of life, but careful wording of the provision must be used to avoid corporate taxation. An LLC may have continuity of life provided it has decentralized management and no free transferability of interests. (n.d.,¶ 10)

Control – Management is separate from shareholders. Managers don’t have any ownership responsibilities and shareholders don’t take on any management responsibilities. This separation keeps liabilities from poor management decisions from depleting shareholder's personal assets.

Profit retention – An owner’s distributive share is in proportion to the percentage interest that they have in the business.

Convenience or burden –

Owing to a complex history that involves painful interaction between IRS regulations and state laws, the specific provisions of state laws vary greatly. An effort to remedy this confusion – the Uniform Limited Liability Company Act – has not at this point been widely accepted and, in fact, has been heavily criticized. Before forming an LLC, you should carefully review the laws in your particular state. (Beatty, 2006, p.765 ¶ 5)

Memorandum of report findings

Due to the risk of a lawsuit for accidents, bad decisions, or property damage, you should consider a form of organization that offers limited liability protection. Sole proprietorships and general partnerships are not acceptable business entities when there is a high risk of accidents or mistakes, due to the unlimited liability of the business owner. One accident in a company vehicle or a faulty installation at a customer’s home, could bankrupt the business owner.

Limited partnerships have limited liability that is a necessity in these highly litigious times. To remove yourself from liability you also must remove yourself from managing the business. All business decisions and profits are no longer yours alone. Disagreements between the general and limited partners can adversely affect any size business but are exceptionally toxic to a small business.

A limited liability company, in most states, can be owned and operated by an individual. However, with that control, limited tax benefits are realized versus a sole proprietorship or general partnership. Most states also require the operating agreements of an LLC to set a limit to the company’s existence, preventing long-term family ownership of the business.

“S" corporations are required to perform much of the same corporation responsibilities of a “C" corporation. All gains and losses must be passed through to the shareholder's stock stake in the company proportionately. There are minimal deductions and other accounting options available to move profits to minimize taxable income with an “S" corporation. The advantages over a “C" corporation are simpler organization at a cost of reduced accounting options.

My choice for this business is the “C" corporation. Once beyond the initial startup cost, this business type will have the potential to save your business a lot of taxable income over any other business entity.

A great example of the immediate advantage of becoming a “C" corporation revolves around the fiscal year. Individuals and “S" corporations report their taxable income based on the calendar year. This doesn’t allow an opportunity to shift income between years. “C" corporations can end their fiscal year at the end of any month. The first tax return of your “C" corporation will most likely be less than a full year.

Near the end of your personal fiscal year (December 31), you move some of your taxable income to your “C" corporation by using it for expenses like advertising. In January, your corporation pays you back. Then, toward the end of the “C" corporation’s fiscal year, you move some of its net profits out by paying yourself. This back and forth income shifting can go on for a long time. Sometimes income is never taxed.

One of the benefits of a corporation is having it provide lucrative employee benefits that are deductible by the corporation and tax free to the employees. Medical, life insurance, education, childcare, and retirement plans are just a few of the types of benefits available. On a side-by-side comparison, the tax-free status of some of these plans is much less generous for people owning more than 2% of “S" corporation stock (Kerstetter, 2009). “C" corporations can usually provide the tax-free fringe benefits provided to employees and to owners.

I also recommend looking into incorporating in Delaware or Nevada because of the business-friendly laws in those states. With the idea of expanding your market geographically and by adding a second factory in another state incorporating as a “C" corporation has the potential to lower your state tax amount. Businesses that operate in multiple states usually pay taxes in both their home state and the other states where they hold property, have employees, sell products, or provide services. Many small “C" corporations spend a large portion of their profit through salaries and tax-free fringe benefits. The typically small business profit that is leftover means less state income tax.

A “C" corporation also allows for American citizens or foreign citizens to invest in your business. With no restrictions on the amount of stock or type, you can raise money exclusively from another country where you may have a considerable following with your specialty products. You may decide to keep the business in your family by keeping a controllable stake in the company owned by family.

The last benefit of a “C" corporation I will elaborate on is reinvested profit. The profit of an “S" corporation, partnership, or sole proprietorship is allocated to the business owner and taxed on their personal tax return. Money that may be used for reinvesting into the business is taxed at the business owner’s highest marginal tax rate. Combining federal and state income taxes the top marginal tax rate for a small business owner can be forty or fifty percent. This may be $20,000 in income taxes on a reinvestment of $50,000 of profit in the business.

However, the first $50,000 of a “C" corporation’s profit is typically taxed at 15%. This could be less than $10,000 in tax on profit that is being reinvested.

With all the aforementioned benefits, I couldn’t recommend any business entity but a “C" corporation for a highly profitable small business.