What is a Business Entity?
It is essential to determine an appropriate business structure while setting up a business. Running a one-man business is entirely different than managing a multi-continent business, making it important to correctly decide the type of business identity to adopt. There are many options available under the law that one can adopt while setting a new business.
Choosing the right type is important not only from the tax perspective, but also helps owners plan for future expansion. This post provides basic information about different business entities that can be registered in the US under the law and key difference between them. This should be helpful for people who are seeking to register their new business and aren’t sure about the business structure to adopt.
Types of Business Entities
1. Sole Proprietorship
It’s the simplest and easiest to setup business entity and essentially a one-man business owned and run by a single person aka owner. The owner is responsible for everything, including liabilities and loss. This type of business is very easy and inexpensive to form, while dissolving it is also fairly simple. Owners don’t have to worry much about tax aspects and formalities related to complicated bookkeeping. There are no business liabilities as they are treated as owner’s personal liabilities. A sole proprietorship business ceases to exist immediately after the death of the owner.
Since the owner is responsible for everything including profit and loss, a sole proprietorship business is disregarded for tax commitments and any income made/money lost is considered personal income/loss of the owner. This type of business is essentially a trade name assigned to an individual, while the owner’s liability for obligations of the firm has no limits.
Pros
- Easy and inexpensive to setup, also simple to dissolve
- No tax aspects in general
- Just basic booking required
- Business’s liabilities are treated as personal
Cons
- Loss and all liabilities are the owner’s responsibility
- Business ceases to exist after the death of the owner
- Liability for obligations of the firm has no limits
2. Partnership
A partnership is an association of 2 or more partners who can be individual persons, corporations as well as other types of partnerships. These partners are responsible for managing their business, work as co-owners and are personally responsible for running the business, profit/loss and liabilities. The partners make a formal agreement to share profit and losses while entering a partnership.
Businesses based on a partnership are also required to file returns to the government, which serves the purpose of reporting profit and loss as well as their allocation to partners. Partner’s liability is joint therefore; any partner can pay all the debts, regardless of his/her contribution towards the partnership or allocation of profit/loss. The three main types of partnerships include general partnership, limited partnership and joint venture.
Pros
- Inexpensive to form
- Joint liability
- Partnership is not liable to pay taxes
Cons
- Taxation process is somewhat complex
- Ceases to exist when a partner dies or certain criteria are met
General Partnership
General partnership assumes equal partnership and is the most basic form of business partnership. Partners share all the liability and management unless specified otherwise. Partnerships with a limited liability are known as limited partnerships in which one of more partners manage a business and are liable (personally) for any debts. However, there also might exist one or more partners with a limited liability who contribute capital and in return, share the profit without running the business themselves. They are not liable for obligations of the partnership beyond their individual contribution.
Limited Partnership
Limited personal liability is also possible for general partners if a general partnership elects to do so by registering such election with the Secretary of State. This makes the partners responsible according to their contribution. Although pros and cons of general partnership are pretty similar to those of a sole proprietorship, things change a bit when partners have limited personal liability.
Joint Venture
Usually a time-based partnership, a joint venture is comprised of two or more individuals who can work together until completion of a project after which the partnership gets dissolved. Although the partnership is dissolved after completion, it can be extended for a specified time period. However, partners can opt to continue working together even after the partnership dissolves, but they have to register as general partners in order to continue working together.
3. Corporation
A business corporation is registered under the state laws as a legal entity to conduct specified transactions or business. Corporations are subdivided into two different types from a functional perspective i.e. business corporations and non-profit organizations. The difference between them is pretty obvious as objective of a business corporation is to earn profit while a non-profit entity is established to advance a specific objective, which isn’t necessarily returning a profit. Examples of non-profit organizations include charities, educational and welfare and benevolent organizations.
Domestic and Foreign Corporations
Both business and non-profit corporations can be registered either as a domestic or foreign entity. Domestic corporations are established under the US state laws, while foreign corporations are incorporated under laws of another country or state.
Business Corporation vs Partnership
A business corporation is essentially incorporating a new legal person that is separate from its real owner’s aka shareholders. Although a corporation exists separately from the directors, shareholders and employees, it’s still treated as a person by the law. What differentiates a corporation from a partnership is the level of complexity involved in incorporating and running a corporation business. All the partners are personally responsible for a partnership and its liabilities, but in case or a corporation, it continues business until legally dissolved, regardless of status of the shareholders.
While it depends on state laws, most corporations are allowed to have only one owner, director and officer. Shareholders are the owners of a corporation who can elect directors to represent their own interests and set business’s policies. The elected directors can appoint other officers who are responsible for managing business operations.
When it comes to formalities, corporations have to follow much more of them compared to any partnership. These formalities include shareholders-directors annual meeting and board approval of important matters. Shareholders cannot take corporation’s funds directly without first documenting the reason, while a board resolution is also required for such transactions.
Taxation is another area where things are a lot more complex for corporations. A business corporation can elect to be treated as a partnership for tax purposes (and not pay taxes itself) aka S corporation as well as elect to be treated as a C corporation i.e. a taxable entity. In case of an S corporation, shareholders can pass profits through to their own personal tax return and treat them as distributions.
Pros
- Separate from shareholders etc.
- Treated as a separate person under the law
- Have the same rights/responsibilities as a person
- Can make contracts
- Shareholders and directors have specific roles
- Limited shareholder liability
- Centralized management
- Ownership interests can be transferred
- Can continue functioning until the law dissolves them
Cons
- Difficult to setup
- Much more complex tax processes
- A lot of formalities to follow
- Shareholders cannot take funds directly
4. Limited Liability Company (LLC)
An LLC is essentially a hybrid of a business corporation and a partnership and is allowed in most states. This allows LLCs to run with a limited personal liability and enables them to access profit/loss to individuals, resulting in a more flexible business structure. Better flexibility means LLCs are suitable for a variety of purposes and can be as simple and complex as its members want.
An LLC can have members with and without limited liability, while it can also have limited liability for its members as that of a corporation. This means that depending on the state laws, the members can run it like a corporation as well as a general partnership. Some states require LLCs to specify a time period after which it will dissolve automatically, while others require them to dissolve in case a member dies or meets some other calamity. However, in this case the remaining members can still vote to continue.
As far as taxation is concerned, an LLC is more like a limited liability corporation that is operated and taxed like a partnership. An LLC becomes a corporation and taxed accordingly if it meets more than two requirements that characterize a corporation i.e. centralized management, continuity of life, ownership interests transfer and limited liability of assets. The pros and cons of an LLC depend on the structure of a business and can be a hybrid of a corporate business and partnership.
Conclusion
Considering different business entities and choosing the most appropriate one according to your business structure is very important when setting up a new business. A sole proprietorship makes no distinction between personal and business life and is suitable for people who are ready to take all the risks (and reap all the benefits). Partnerships have similar inherent risks, but can result in larger capital and human resources. The partnership agreement should clearly state how to proceed if disagreement arises or a partner dies, goes bankrupt etc.
A business corporation has its own set of advantages, including operation as a separate entity, but it’s also much more difficult to setup and subject to more formalities and compliances. An LLC is very flexible and is suitable for a variety of businesses that can choose to have limited liability, managers and elected to be taxed as a partnership or as a corporation.