There are several types of business entities, each designed for different situations. The primary types are as follows, along with their advantages and disadvantages.
A sole proprietorship is a business that is directly owned by a single individual. It is not incorporated, so that the sole owner is entitled to the entire net worth of the business, and is personally liable for its debts. The individual and the business are considered to be the same entity for tax purposes. The advantages of a sole proprietorship are:
- Simple to organize
- Simple tax filings
- No double taxation
- Complete control by the owner
The disadvantages of a sole proprietorship are as follows:
- Unlimited liability
- Self-employment taxes must be paid by the owner
- The only provider of equity to the business is the sole owner
In brief, the unlimited liability imposed by a sole proprietorship is usually considered to completely outweigh all other aspects of this form of ownership. Its ability to avoid double taxation can be matched by an S corporation (as described later), but the S corporation also keeps the owner from being personally liable for the obligations of the business.
A partnership is a form of business organization in which owners have unlimited personal liability for the actions of the business, though this problem can be mitigated through the use of a limited liability partnership. The owners of a partnership have invested their own funds and time in the organization, and share proportionally in any profits earned by it. There may also be limited partners in the business, who contribute funds but do not take part in day-to-day operations. A limited partner is only liable for the amount of funds he or she invested in the entity; once those funds are paid out, the limited partner has no additional liability in relation to the activities of the partnership. If there are limited partners, there must also be a designated general partner that is an active manager of the business; this individual has essentially the same liabilities as a sole proprietor.
A partnership does not pay income taxes. Instead, the partners report their share of the partnership's profit on their personal income tax returns. Because partners must pay income taxes on their shares of partnership income, they typically require some distribution of cash from the partnership in order to pay their taxes.
In those instances where a partnership recognizes a loss during its fiscal year, the share of the loss recognized by each partner in his or her personal tax return is limited to the amount of the loss that offsets each partner's basis in the partnership. If the amount of the loss is greater than this basis, the excess amount must be carried forward into a future period, where it can hopefully be offset against the future profits of the partnership.
The key advantages of a partnership are as follows:
- With many partners, a business has a much richer source of capital than would be the case for a sole proprietorship
- If there is more than one general partner, it is possible for multiple people with diverse skill sets to run a business
- No double taxation
The disadvantages of a partnership are as follows:
- The general partners have unlimited personal liability for the obligations of the partnership
- A partner’s share of the ordinary income is subject to the self-employment tax
The risk associated with a partnership arrangement works well for limited partners, since their losses are limited to their own investments in the business.
A corporation is a legal entity whose investors purchase shares of stock as evidence of their ownership in it. A corporation acts as a legal shield for its owners, so that they are generally not liable for the corporation's actions. A corporation pays all types of taxes, including income taxes, payroll taxes, sales and use taxes, and property taxes.
The advantages of the corporation are as follows:
- The shareholders of a corporation are only liable up to the amount of their investments
- A publicly-held corporation in particular can raise substantial amounts by selling shares or issuing bonds
- A shareholder can sell shares in a corporation to a third party
The disadvantages of a corporation are as follows:
- Double taxation
- The various types of income and other taxes that must be paid can add up to a substantial amount of paperwork
There are two main types of corporation, which are the C corporation and S corporation.
The default form of corporation is the C corporation, which is taxed as a separate entity. Distributions to shareholders are made in the form of dividends. The C corporation structure is heavily used, because it can be owned by an unlimited number of shareholders. This gives it an unrivaled ability to attract capital from investors.
A variation on the standard corporation model is the S corporation. An S corporation passes its income through to its owners, so that the entity itself does not pay income taxes. The owners report the income on their tax returns, thereby avoiding the double taxation that arises in a regular C corporation.
Limited Liability Company
A limited liability company (LLC) combines the features of corporations and partnerships, which makes them an ideal entity for many businesses. Their advantages are:
- The liability of investors is limited to the amount of their investments in the LLC
- An LLC can be structured so that the income earned by the business flows directly through to investors
- An LLC can be run by professional managers, rather than a general partner
- There is no limitation on the number of investors in an LLC
- An LLC can issue multiple classes of stock
The disadvantages of an LLC include:
- Each state has implemented different rules regarding how an LLC is structured and operated
- There will be annual government fees charged to maintain an LLC entity