Types of Business Organizations
Three principal types of organizations have developed as ways of owning and operating business enterprise.
In general, business entity or organizations are:
- Sole proprietorship
Let us discuss these concepts starting with the simplest form of business organization, the single or sole proprietorship.
A sole proprietorship is a business wholly owned by a single individual. It is the easiest and the least expensive way to start a business and is often associated with small storekeepers, service shops, and professional people such as doctors, lawyers, or accountants. The sole proprietorship is the most common form of business organization and is relatively free from legal complexities.
One major disadvantage of sole proprietorship is unlimited liability since the owner and the business are regarded as the same, from a legal standpoint.
A partnership is a legal association of two or more individuals called partners and who are co-owners of a business for profit. Like proprietorships, they are easy to form. This type of business organization is based upon a written agreement that details the various interests and right of the partners and it is advisable to get legal advice and document each person’s rights and responsibilities.
There are three main kinds of partnerships
- General partnership
- Limited partnership
- Master limited partnership
A business that is owned and operated by 2 or more persons where each individual has a right as a co-owner and is liable for the business’s debts. Each partner reports his share of the partnership profits or losses on his individual tax return. The partnership itself is not responsible for any tax liabilities.
A partnership must secure a Federal Employee Identification number from the Internal Revenue Service (IRS) using special forms.
Each partner reports his share of partnership profits or losses on his individual tax return and pays the tax on those profits. The partnership itself does not pay any taxes on its tax return.
In a Limited Partnership, one or more partners run the business as General Partners and the remaining partners are passive investors who become limited partners and are personally liable only for the amount of their investments. They are called limited partners because they cannot be sued for more money than they have invested in the business.
Limited Partnerships are commonly used for real-estate syndication.
Master Limited Partnership
Master Limited Partnerships are similar to Corporations trading partnership units on listed stock exchanges. They have many advantages that are similar to Corporations e.g. Limited liability, unlimited life, and transferable ownership. In addition, they have the added advantage if 90% of their income is from passive sources (e.g. rental income), then they pay no corporate taxes since the profits are paid to the stockholders who are taxed at individual rates.
The Corporation is the most dominant form of business organization in our society. A Corporation is a legally chartered enterprise with most legal rights of a person including the right to conduct business, own, sell and transfer property, make contracts, borrow money, sue and be sued, and pay taxes. Since the Corporation exists as a separate entity apart from an individual, it is legally responsible for its actions and debts.
The modern Corporation evolved in the beginning of this century when large sums of money were required to build railroads and steel mills and the like and no one individual or partnership could hope to raise. The solution was to sell shares to numerous investors (shareholders) who in turn would get a cut of the profits in exchange for their money. To protect these investors associated with such large undertakings, their liability was limited to the amount of their investment.
Since this seemed to be such a good solution, Corporations became a vibrant part of our nation’s economy. As rules and regulations evolved as to what a Corporation could or could not do, Corporations acquired most of the legal rights as those of people in that it could receive, own sell and transfer property, make contracts, borrow money, sue and be sued and pay taxes.
The strength of a Corporation is that its ownership and management are separate. In theory, the owners may get rid of the Managers if they vote to do so. Conversely, because the shares of the company known as stock can sold to someone else, the Company’s ownership can change drastically, while the management stays the same. The Corporation’s unlimited life span coupled with its ability to raise money gives it the potential for significant growth.
A Company does not have to be large to incorporate. In fact, most corporations, like most businesses, are relatively small, and most small corporations are privately held.
Some of the disadvantages of Corporations are that incorporated businesses suffer from higher taxes than unincorporated businesses. In addition, shareholders must pay income tax on their share of the Company’s profit that they receive as dividends. This means that corporate profits are taxed twice.
There are several different types of Corporation based on various distinctions, the first of which is to determine if it is a public, quasi-public or Private Corporation. Federal or state governments form Public Corporations for a specific public purpose such as making student loans, building dams, running local school districts etc. Quasi-public Corporations are public utilities, local phones, water, and natural gas. Private Corporations are companies owned by individuals or other companies and their investors buy stock in the open market. This gives private corporations access to large amounts of capital.
Public and private corporations can be for-profit or non-profit corporations. For-profit corporations are formed to earn money for their owners. Non-profit Corporations have other goals such as those targeted by charitable, educational, or fraternal organizations. No stockholder shares in the profits or losses and they are exempt from corporate income taxes.
Professional Corporations are set up by businesses whose shareholders offer professional services (legal, medical, engineering, etc.) and can set up beneficial pension and insurance packages.Limited Liability Companies (LLCs as they are called) combine the advantages of S Corporations and limited partnerships, without having to abide by the restrictions of either. LLCs allow companies to pay taxes like partnerships and have the advantage of protection from liabilities beyond their investments. Moreover, LLCs can have over 35 investors or shareholders (with a minimum of 2 shareholders). Participation in management is not restricted, but its life span is limited to 30 years.
Subchapter S Corporation
Subchapter S Corporation, also known as an S Corporation is a cross between a partnership and a corporation. However, many states do not recognize a Subchapter S selection for state tax purposes and will tax the corporation as a regular corporation.
The flexibility of these corporations makes them popular with small-and medium-sized businesses. Subchapter S allows profits or losses to travel directly through the corporation to you and to the shareholders. If you earn other income during the first year and the corporation has a loss, you may deduct against the other income, possibly wiping out your tax liability completely subject to the limitations of Internal Revenue Service tax regulations.
Subchapter S corporations elect not to be taxed as corporations; instead, the shareholders of a Subchapter S corporation include their proportionate shares of the corporate profits and losses in their individual gross incomes. Subchapter S corporations are excellent devices to allow small businesses to avoid double taxation. If your company does produce a substantial profit, forming a Subchapter S Corporation would be wise, because the profits will be added to your personal income and taxed at an individual rate. These taxes may be lower than the regular corporate rate on that income.
To qualify under Subchapter S, the corporation must be a domestic corporation and must not be a member of an affiliated group. Some of the other restrictions include that it must not have more than 35 shareholders – all of who are either individuals or estates. Subchapter S corporations can have an unlimited amount of passive income from rents, royalties, and interest. For more information on the rules that apply to a Subchapter S corporation, contact your local IRS office.
Limited Liability Company
Limited Liability Companies (LLCs as they are called) combine the advantages of S Corporations and limited partnerships, without having to abide by the restrictions of either. LLCs allow companies to pay taxes like partnerships and have the advantage of protection from liabilities beyond their investments. Moreover, LLCs can have over 35 investors or shareholders (with a minimum of 2 shareholders). Participation in management is not restricted, but its life span is limited to 30 years.