Choosing the form of business is the most important decision that an entity has to make. What form of business an entity adopts would impact its future and its relation with the stakeholders. Specifically, the form of business that one selects would decide how an entity pays taxes, its legal identity and liability, cost of operations, and the formation and operational costs. Thus, it is very important to understand each form of business clearly and its pros and cons.
Forms of Businesses
Following are the forms of businesses that one can choose for their company:
The sole proprietorship is the simplest and most popular form of business. We can call it an unincorporated company. In this, an individual owns and runs the business to make profits. A point to note is that the existence of such a business depends entirely on the owner. This means the business dies if the owner dies (if there is no transfer of ownership). You may go for this form of business if you want full control of the entity and do not have enough money to start with.
The advantages of this form of business are: all profits belong to the owner, it faces very few regulations, fewer starting requirements, and it is very flexible. There is nothing with regard to sharing of trade secrets, and the owner has complete control and freedom to make decisions as per his wisdom.
The big advantage of Sole proprietorship can also become the biggest disadvantage as in this form of business, the owner is fully and completely (110%) liable for all debts and losses. There is no separate identity nor any delinking in a personal and business capacity. As long as the business is doing well, everything is OK. However, the moment the business suffers a setback, the personal standing of the owner also remains at stake and gets jeopardized.
As the word suggests, it is a business owned by two or more people. A partnership could be general and limited. In a general partnership, all partners invest the funds (money, property, and labor) and are 100% liable for all business debts, collectively as well as individually. Moreover, even if a partner invests less in the business, then also they will be fully liable for all business debts. Another feature of a general partnership is that there is no need for a formal agreement.
In contrast, limited partnerships need a formal agreement among all the partners. Such a type of partnership allows partners to limit their liability for business debts in proportion to their investment in the partnership. A point to note is that there has to be at least one general partner in a limited partnership. That one partner will be fully responsible for all the debts irrespective of his contribution percentage. And others are limited partners.
The advantages of having partnerships are: more partners means more capital sources, simple structure, flexibility in operations, and inexpensive to establish. Moreover, they can use the expertise of each other for the business in the interest of all the partners. Secondly, it also shares the risk of the business in the event of any adversity.
Its biggest disadvantages are: that partners are also 100% liable for the debt (general partnership) like sole proprietors. Further, selling the business is hard, and the partnership ceases if any partner wants to end it/exit it.
There can also be Limited Liability Partnerships or LLPs. In this, partners are not personally responsible for the operations and debt of the business. LLPs, however, are very rare as they are limited to certain specific professions, such as lawyers, finance professionals, architects, and so on.
A corporation is a separate entity in the eyes of the law, i.e., separate from the owners. It also means that the income of the corporation is taxed independently of the shareholders/owners. The taxes are as corporation income rather than personal income. The corporation distributes the remaining profits to the owners or shareholders. That profit then becomes the owner’s personal income and is subject to tax as their personal income. Compared to the earlier two forms of businesses, the biggest advantage of a corporation is its independent identity. That makes the owner quite relaxed as their liability remains limited to their contribution.
There can be three types of corporations:
C Corporation – it is the most common type of corporation. The corporation’s profits are taxed separately, while the owner’s profit is taxed separately.
S Corporation – such a corporation can have up to 100 shareholders. Moreover, these entities are like partnerships and are not subject to double taxation.
Non-Profit Corporation – these types of corporations are tax-exempt. The primary objective of such entities is not to make profits. One should not get confused between non-profit and not-for-profit organizations.
The advantages of this form of business are: the liability of the owners is limited, one can easily transfer the ownership, the business can continue indefinitely even if one or more owners dies, and no one can confiscate the personal assets of the owners to pay business debts. A very common proverb is there for this form of business: “a shareholder can come and go, but the company goes on forever.”
Its biggest disadvantages are: that starting and operating a corporation is costly, and the corporation is subject to many restrictions and complex paperwork.
Limited Liability Company (LLC)
This form of business is a combination of limited partnership and company. Under LLC, owners have limited liability and enjoy some of the benefits of a corporation. LLC has its own separate identity.
The advantages of this form of business are limits on the liability of the owners and no double tax on the profits.
Its biggest disadvantages are: that starting an LLC could be costly and involve complex paperwork, and ownership is subject to state laws.
A group of individuals owns such a business, and they operate it for mutual benefit. The individuals who are part of the group are called members. Such a type of business can be incorporated or unincorporated. Cooperative banking and credit unions are good examples of this form of business.
Examples of Forms of Businesses
Usually, a business start as sole proprietorships, and when they progress and grow bigger, they convert to corporations. eBay, for example, was a sole proprietorship initially, and later it converted to a corporation.
Hewlett-Packard (HP), on the other hand, was initially a partnership between two friends.
One of the biggest automobile makers, Chrysler, is an excellent example of a limited liability corporation (LLC).
Apple is a very good example of a corporation. Soon after the company started operations, it got incorporated. Moreover, the company continued even after the death of one of its co-founders, Steve Jobs.
Forms of Businesses – How to Choose?
Considering and keeping in mind the following points will assist you in selecting the right form of business:
Debt and Liability
Usually, small businesses and startups go for a sole proprietorship or partnership firm. And obviously takes upon them the entire liability. However, if you are in a high-risk business, or want to limit your liability, then you can go for a more formal structure. A formal structure requires more paperwork and costs more to establish.
If one wants to keep the taxes separate from the business, then one should go for a corporation form of business. And, if one does not mind filing the business profits/expenses on his own personal tax returns, then one can go for a sole proprietorship form of business.
Partners or Investors
As we know, a sole proprietorship is a single-owner form. Hence, If there is more than one investor or partner, then the first stage alternate is to go for a partnership form of business. One will have to start a partnership, an LLC, or a limited partnership in such a case.
Unlike sole proprietorships, a formal business structure makes it easier to hire more employees down the road. Though an entity can always change its business form whenever they want, it is always better to have a plan ready.
Intentions – Profit or Cause
If the primary objective is to help others and not make a profit, then one should form a non-profit business. Such businesses get tax-exempt status and require less paperwork.
Once we have answered all the above questions and decided on the business form that one wants, the next step should be to check the local and state laws. Knowing the laws fully will help one a great deal in running the business smoothly.