Want to start a business? One of the first steps is to pick its form. In this lesson, you’ll learn about the primary ways businesses are organized with examples provided along the way.
All business entities are not the same. Some provide owners a lot of flexibility in management and control and some do not. Some provide owners a significant degree of protection from liability and some do not. And some are heavily regulated, and some are not. On top of these differences is the fact that our tax code provides different tax treatments for different business entities. All of these factors should be considered when an entrepreneur is selecting the type of business entity she or he wishes to use for her or his business.
Okay, let’s take a look at the primary choices an entrepreneur has by breaking them down into two broad categories. First, we’ll take a look at unlimited liability entities, or those business organizations that don’t provide the owner or owners any protection from personal liability, such as sole proprietorships and general partnerships. Then, we’ll examine limited liability entities, which are business organizations that usually limit an owner’s liability to his or her investment in the business, such as corporations, limited liability companies, and limited partnerships.
Unlimited Liability Organizations
If you’re the only owner, you can keep it very simple and run your business as a sole proprietor. In a sole proprietorship, you are the business, as there is no legal distinction between the business and you. You’re completely personally liable for any debts, contracts, negligence, or wrongful acts done by the business. On the plus side, the business is very easy to operate, isn’t subject to a bunch of organizational regulations, and you simply report profits and losses from the business on your personal tax return. A kid’s lawn mowing service is an example of a sole proprietorship.
A general partnership is a business owned by more than one person. Partners often enter into a partnership agreement, which outlines the rights and obligations of the partners. Just like a sole proprietorship, general partners are completely responsible for the liabilities of the partnership. In fact, partners usually have joint and several liability, which means that a partner can be dinged for 100% of the partnership debts and will have to pursue his partners for their share.
On the positive side, partnerships are very flexible to manage as long as the partners agree. Also, partnership law isn’t that complex. The primary law for partnerships is the Uniform Partnership Act as enacted in each state. Partnership profits and losses are reported at the individual partner level because partnerships are considered flow-through entities, in which profits and losses flow through the entity to its owners where it is taxed. The classic example of a general partnership is a law firm.
Limited Liability Organizations
Okay, now that we’ve talked about unlimited liability entities, let’s go over some limited liability entities:
The corporation is the original limited liability entity. Most publicly traded companies, such as Apple, General Motors, and General Electric, are corporations. Corporations are highly regulated by state statutes and are rather inflexible in the manner they can be organized and managed. The shareholders (or owners) select a board of directors by election. The board then develops corporate policy and strategy. The officers of the corporation run the day-to-day operations.
Shareholder liability is limited to their investment in the corporation, which means the most shareholders can lose is their investment in the corporation. It should also be noted that there is a special type of corporation called a professional corporation where the shareholders are all members of a profession, such as lawyers in a law firm or doctors in a medical practice. There are even special liability rules regarding professional corporations, but they’re beyond the scope of this lesson.
Additionally, corporate taxation can be very complex. You’ve probably have heard of C corporations and S corporations which are federal tax designations. C corporations are basically your typical big corporations that are taxed at two levels: the corporate level and the shareholder level. In other words, Uncle Sam taxes the corporation on its income and then taxes the shareholders on the income, known as dividends, that the corporation distributes to its shareholders. An S corporation does not pay federal income tax. Instead, the income flows through to its shareholders where it is taxed. Not all corporations can elect to be S Corporations.
Limited Liability Company
A limited liability company has the flexibility of a general partnership, the limited liability of a corporation, and can elect flow-through taxation. It’s a very popular entity for these reasons. A limited liability company can consist of one or more members and can be managed by members, like a partnership, or by managers, like a corporation. Most businesses can operate as a limited liability company.
Limited partnerships are a special type of partnership consisting of a general partner and limited partners. The general partner controls the partnership, and the limited partners have no management rights. However, limited partners do share in the profits and losses of the partnership. General partners have joint and several liability for partnership obligations, but limited partners have limited liability. Profits and losses are normally eligible for flow-through tax treatment in a limited partnership. Limited partnerships are commonly used in commercial real estate investments such as hotels, malls, and residential subdivisions.
Other limited liability entities
And finally, there are two less-common limited liability organizations worth a brief mention. A limited liability partnership is a partnership where some or all of the partners have limited liability. It’s often a popular choice of partnerships of professionals, such as lawyers and accountants. A limited liability limited partnership is a limited partnership where one or more general partners have limited liability. This latter type is particularly rare.
Selecting an appropriate business organization type for a new business venture is a very important step every serious entrepreneur must take. Considerations include flexibility in management, level of regulatory complexity, tax treatment, and whether there is unlimited or limited liability. Business structures that don’t provide limited liability include sole proprietorships and general partnerships, whereas business organizations that do provide limited liability include corporations, limited liability companies, and limited partnerships.
Business Organization Vocabulary & Definitions
- Unlimited Liability Entities: Business organizations that don’t offer protection from personal liability.
- Limited Liability Entities: Business organizations that restrict the owner’s liability to their investment in the company.
- Sole Proprietorship: A business that is owned by a single person, making no legal distinction between the company and the individual.
- General Partnership: A business that is owned by two or more individuals who are directly responsible for the liabilities of their partnership.
- Corporation: A business that is largely regulated by state regulations, which limits the flexibility of how it can be set up and operated.
- Limited Liability Company: A business with the restrictions of a corporation and the flexibility of a general partnership. This type of company can be managed by members or managers.
- Limited Partnerships: A business that’s run by a single general partner and a group of limited partners. The general partner has more management rights than the limited partners.
- Limited Liability Partnership: A business where a few or all of the partners have limited liability.
- Limited Liability Limited Partnership: A business that’s set up with a limited partnership and where one or more of the general partners have limited liability.
Once you have viewed this lesson, you should be able to:
- State the difference between unlimited liability entities and limited liability entities
- Explain what a sole proprietorship is as opposed to a general partnership
- Identify the components that make up a corporation, limited liability company and limited partnership