The best type of business structure for small business operators is not always top of mind when getting started with their business.
Similarly many business owners, once they have been operating for a while, come to the realization that the entity structure they started out with was not the best one.
There may be a number of reasons for this realization such as lack of protection from lawsuits, inability to attract capital and a host of other things that hinder the best business operation.
The type of business structure that a business owner operates under can be crucial for its success. The business world is full of danger, uncertainty, and challenges. And the choice of which structure the business will operate under can make the difference between success and failure.
There are so many types of business structures it can be difficult to determine which is the best to operate under.
This article will outline 14 types of business structures to consider for operating purposes. Of course, the ultimate type of business entity that one may choose really depends upon what product or service the business offers.
What is Business Structure?
Business structure is usually defined by law. Different types of business structures are legally recognized by federal and state statutes.
Organized businesses like a corporation, a limited liability company, or partnerships are given descriptive terms by law that allow them to be legally recognized. They are defined by statute.
A more detailed description of these different structures will be given below.
The structure of a business may be determined by how the various parts of the business operate. For instance, an organization chart may show lines of authority and the duties and responsibilities of various departments and how they interrelate with each other.
In this article we cover the types of business structures that may be considered for business operations and how each of them are categorized. The advantages and disadvantages of each structure is also covered.
Why It’s Important
How a business is structured and operates is very important for several reasons. If the business is structured properly the persons operating it can shield themselves and their personal assets from personal liability.
They can also maximize favorable tax deductions, be looked at more favorably by a bank for loan purposes and a host of other benefits.
One of the most important advantages of having a proper business structure is the limitation of loss in case something drastic happens during operating the business.
For example, if the business is created under the corporation business structure and there is a terrible accident caused by a vehicle operating under the name and control of the corporation and causes an injury to persons or property damage, there will very likely be a big lawsuit.
However, because the corporation is a separate and distinct structure apart from the (shareholders) owners any judgment or damages awarded as a result of the accident could only be levied against the assets of the corporation but not the owners (shareholders) individually. This is called limited liability.
On the other hand, if the business structure and operations are started and operated by a sole individual and the same occurrence happens that individual, as well as the company, will be fully liable for all the damages and any judgment, including all of his or her personal assets.
Therefore, it is very important to know and understand which type of business structure is best for any situation and the exposures, advantages, and disadvantages of each type. In the next section, these points are covered.
Types of Business Structure
Knowing the different rules and regulations that control the set up of different types of business is important. The 14 different types of business organizations have some similarities but also distinct differences.
Become familiar with the differences and it will help to make a decision about which one may be best for your business operation.
1. Sole Proprietorship
This type of business is the simplest of the legally recognized structures for operating a business. It can be started with little or no money and usually is operated by one person. The company is usually operated in the name of the person that creates the business.
A sole proprietorship can be started by simply creating a product or service to sell, opening a bank account, getting a business license, setting up contact information, a mechanism to account for sales and collection of monies and commencing the business.
If the owner decides not to operate the business in his or her name, a name for the business can be created for the business and it can operate under what is known as a fictitious business name.
All this means is the owner decided to operate under a different name than their own personal name. For example, Jane Jones could decide to operate as a sole proprietor using the name Jane’s Coffee Shop.
In order to do so legally, she only needs to file for and obtain a fictitious business name permit from her local county or city government.
If there are no other names similar to or the same as Jane’s Coffee Shop, she will be issued a fictitious name business permit. She can then open a bank account in that name and operate the business under that name.
While the process of operating a sole proprietorship is simple and doesn’t cost much money, it is generally not the best business structure for operating a business.
The main reason is that the owner of the business is subject to unlimited liability for any claims or judgments that may occur as a result of any lawsuits, tax assessments, etc.
Under such circumstances, everything the sole proprietor owns is subject to be taken away by the judgment. That means bank accounts, property, vehicles, equipment, etc. are subject to being lost.
2. General Partnership
Where two or more people conduct activities together promoting and selling a product or service in return for money the law regards this type of activity as a general partnership. A partnership may have several people.
Like a sole proprietorship, a general partnership may be created and started with little or no money. It can be operated in the names of the partners or, in the more usual circumstance, obtain a fictitious business name and operate under that name.
Each general partner has equal ability to make contracts on behalf of the partnership and can bind the partnership and other partners for debts and liabilities in their individual capacities without conferring with the other partners. This can be a disadvantage.
In addition, each partner will be equally liable for any judgment obtained from a lawsuit, even if they were not involved in creating the contract or the cause of the lawsuit.
Like the sole proprietorship, each general partner is exposed to unlimited liability. Their personal assets are exposed.
Some of the advantages of a general partnership are it may be able to generate more capital with which to operate the business. The duties and responsibilities can be divided between the partners as well, thus lessening the burden of operating the business.
Banks and other lending institutions may look more favorably on a partnership for making a business loan because there are more people to look to for repayment in case of a default.
3. Limited Partnership
A limited partnership can be created when two or more people join to operate a business.
However, in this type of partnership, there is an agreement that at least one person will act as a general partner with the duty of operating the business and having all the unlimited exposure for liability for lawsuits and other claims.
The other party to a limited partnership is called the “limited partner.” There may be more than one limited partner.
From a liability standpoint, a limited partner is protected from unlimited liability in case of a lawsuit or claim for damages. The exposure of loss to a limited partner is limited to the amount of money invested in the limited partnership.
For example, if the limited partner invested $50,000 in the limited partnership and then the limited partnership was sued for $1,000,000 and lost that case the limited partner would only lose the $50,000 originally invested. The general partner would still be liable for the entire judgment of $1.000.000.
This type of business operation allows for investment into a business operation by a limited partner with the opportunity for a rate of return on the investment made into the limited partnership and with liability limited only to the amount of investment by the limited partner.
4. Limited Liability Partnership
A Limited Liability Partnership is a special statutory business entity. It is usually limited to persons who are licensed in a professional category such as lawyers, accountants, doctors, and other licensed professionals.
It functions much the same way as a limited partnership. The partners can deliver their professional services and are given limited liability protection.
The limited liability structure gives the partners an umbrella under which their personal assets outside of the limited liability entity are protected.
5. Limited Liability Company (LLC)
A limited liability company, also known as an LLC, is a statutory type of business structure that allows one or more members to join and create a business.
The name itself is somewhat self-explanatory. The operation of this type of business allows its owners to provide goods and services and make money, while at the same time limits their liability exposure for lawsuits and other adverse claims.
The persons who own a limited liability company are referred to as members and often are referred to as managers. These terms are interchangeable. Members are often the managers as well.
The members of a limited liability company may also hire managers to run the company for them.
A limited liability company also creates tax advantages for its members depending on the internal revenue selections that are made by the members.
In any event, the income of a limited liability company usually passes through the company and is paid to the members. The members, in turn, pay taxes on that income at whatever tax bracket they may be in.
Limited liability protection and taxation advantages are two of the most important points of this type of business operation.
It is easy to set up. Set up can be done by filing a one-page document called Articles of Organization in most states. Its operational guidelines are contained in documents known as a limited liability company operating agreement.
The operating agreement provides the road map of how the company will operate.
Ownership within a limited liability company is represented by the issuance of share certificates. The certificates describe the percentage of ownership of each member.
6. C – Corporation
A corporation is probably the most widely known business. It is created by filing with the office of the Secretary of State in each state.
The document filed to create a corporation is called Articles of Incorporation. Once filed and approved by the Secretary of State the corporation is provided with an identified number under which it will always operate.
A corporation must have By-Laws that govern how it will operate and conduct its business. It must also maintain minutes of meetings on a periodic basis to report and record its activities.
Shares of stock are issued to represent ownership in a corporation. Each share of stock can vote on decisions that are made regarding the corporation.
A corporation functions through what is called a board of directors. The persons on the board of directors make policy and procedures on how the corporation operates and the board of directors operate the corporation through officers.
These officers are commonly referred to as Chief Executive Officer (CEO); President, one or more Vice Presidents and other officers as may be determined by the board of directors.
A C-corporation provides for limited liability of its shareholder owners and the board of directors and officers. This protects their personal assets from lawsuits and claims that may be made against the corporation
The income of this type of corporation is subject to dual or double taxation, which is regarded as one of the drawbacks of a C- corporation. Dual taxation means the income of the corporation is taxed twice if the corporation declares a dividend.
A dividend is a return on investment paid directly to shareholders as a result of the successful operations of the corporation. That money is taxed the same as income to the shareholder.
Double taxation is a situation that affects C corporations. This happens when business profits are taxed at both the corporate and personal levels.
The corporation must pay income tax at the corporate rate before any profits can be paid to shareholders. Then any profits that are distributed to shareholders through dividends are subject to income tax again at the recipient's individual rate. In this way, corporate profits are subject to income taxes twice or "double taxation."
Despite this disadvantage, most corporations operate under the C-corporation structure, due to other benefits such as management's ability to raise significant capital through the sale of share certificates, more favorable treatment at financial institutions for loans, tax credit incentives and a host of other benefits that are not provided to other types of business operations.
7. Benefit Corporation
Benefit corporations are sort of like the new kid on the block. They have not been around for a long time. However, recently they have become extremely relevant within the context of “corporate social responsibility” demands placed on corporations whose sole and required mandate has always been to “maximize shareholder profits” to the exclusion of just about everything else.
Times have changed and pressure on corporations to heed the demands of consumers, community and the environment to reflect their wishes in the promotion and sales of products and services offered by corporations have caused a significant change in corporate attitudes toward “just making a profit.” For corporations to avoid backlash, damage to brands and reputations they now of corporate social responsibility programs that address the concerns and needs of the environment (greening philosophy) employees and the community within which they exist.
As a result of this concern, some corporations have changed their charters and by-laws to reflect a mission to not only make a profit but to avoid profits where those profits are at the expense of the community, the environment and/or the masses of their employees.
Out of this new philosophy and business model, the benefit corporation has arisen. A benefit corporation is a for-profit corporate structure that promotes a social responsibility mindset along with the earnings of a profit as it conducts its business. Executive decisions made by a benefit corporation board of directors and officers are not made purely in the interest of profit.
C-corporation vs. Benefit Corporation
The distinct difference is a C-corporation’s charter requires emphasis solely on generating maximum profits to its shareholders to the exclusion of other goals so long its legal. In fact, directors and officers of a C-corporation could be subject to lawsuits from shareholders if it is determined that socially responsible actions are taken in operating the corporation over a profit motivation.
A benefit corporation includes the profit motive but is tempered by the effect of how making the profit may have an adverse effect on the community, employees, environment and other stakeholders.
Effect on our environment, communities, and employees are not at the forefront of the minds of the consuming public. Therefore, benefit corporations are now a desirable and effective method through which to “do good while making a profit.”
How Is A Benefit Corporation Set Up?
At the time of this writing this article, not all states have regulations in place for the creation and recognition of a benefit corporation. However, at least 20 states have statutes that create the existence of a benefit corporation. Most other states are in the process of creating similar statutes. In general, to create a benefit corporation the organizers must meet:
The purpose of the corporation must have a significant and positive impact on society and the environment.
The operation of a benefit corporation requires decisions made to impact not only the shareholders and ultimately a profit, but the community, the environment and even concerns for employees and how they are impacted.
Benefit corporations are required to make a public benefit report on an annual or biannual basis that assesses their overall social responsibility and environmental performance. The measuring stick is usually in contrast to an existing third-party standard
If it is determined that a benefit corporation is not meeting the statutory prerequisites the corporation may be subject to a lawsuit to cease its operations and fulfilled its stated purposes.
Except for the above-noted differences, a benefit corporation is treated the same as a regular C-corporation.
8. S – Corporation
An S- Corporation is a corporation with the same attributes as a C-corporation. The difference is the Internal Revenue Service (IRS) under its corporation rules contained in Subchapter S of IRS Codes sections 1361 through 1379, makes a special allowance for corporations wishing to designate under this chapter for tax purposes. The term S corporation means a small business corporation.
Under the IRS Subchapter S rules, a corporation may elect to be regarded differently than a C-corporation. This type of business entity can elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. This avoids the dual or double taxation treatment and each shareholder who received income is taxed within the individual tax bracket they fall into under normal IRS taxation rules.
In order to be recognized as an S corporation, the entity must meet the following criteria:
- No more than 100 shareholders
- All shareholders must be individuals with the exception of various tax-exempt organizations, estates, and trusts
- It must not have nonresident aliens as a shareholder, and
- The S corporation may have only one class of stock.
Like a C corporation, the S corporation provides limited liability protection and is operated through its board of directors, officers and employees.
9. Closed Corporation
A close corporation is a small corporation that has made an election to operate as a corporation but under special rules governing its operation. It is less formal than a C corporation and an S corporation.
In many respects, a close corporation, in its operations, is like a partnership. This often is a benefit to the shareholders because of the informal and flexible rules that apply to it.
In general, a close corporation is limited to no more than 30 to 35 shareholders. It also cannot offer to sell its shares of stock to the public. A written shareholder agreement is usually required in order to recognize the business as a close corporation and govern how it operates.
Unlike a C corporation, a close corporation is not held to the requirement of having a formal annual meeting. Another difference is the fact that the shareholders really can be active in the management of the company and can override the board of directors and in effect run the company.
Election to operate as a close corporation is usually required to be stated within the Articles of Incorporation of the corporation when the close corporation is organized within the state of its incorporation.
In my home state of California an election to organize as a close corporation is done by using the clause “ All of this Corporation’s issued shares of all classes shall be held of record by not more than 35 persons, and this Corporation is a close corporation.
The shares are also subject to a restriction on resale by both the shareholder agreement and state law. If a shareholder wants to sell his or her shares of stock within a close corporation, there is usually a requirement that the shares must first be offered to an existing shareholder who has a right of first refusal before she shares can be sold to an outsider.
Like the C and S corporation, a close corporation offers the protection of limited liability to its shareholders.
10. Nonprofit Corporation
Depending on the intent and goal of the business organizers the best business structure may be to organize and operate the business entity as a nonprofit corporation. Federal and state regulations allow for the formation and operation of this type of business.
A nonprofit organization is a business that has been granted tax-exempt status by the International Revenue Service (IRS) because it furthers a social, religious, charitable, educational, literary, public safety or cruelty-prevention cause or purpose. The main point is a nonprofit organization must be organized and operated for a recognized public benefit.
The service for the public benefit may be in the form of products or services. It may also be a combination of these two nonprofit categories.
One of the big advantages of a nonprofit corporation is the fact that under the IRS code any monies provided to the company are exempt from payment of taxes. It also allows for any money given as a donation to the nonprofit to qualify for a tax deduction for benefit of the person who gave the donation.
In order to qualify for nonprofit status, the nonprofit company must file for nontax status under IRS Code section 501 (c) (3). Once approved, the nonprofit can operate as a non-taxable entity and solicit donations from individuals and businesses.
A nonprofit organization is barred from making money. It can earn an income so long as the income is reasonably related to its mission and purpose. If money is earned on the sale of goods or services that are not reasonably related to its mission or purpose, the nonprofit corporation may be subject to income taxes the same as a regular corporation and will be required to pay taxes.
Nonprofit 501(c) (3) corporations cannot be involved with political activities. They cannot engage in endorsements of candidates or promotion of political views through the media and similar communication avenues. If they do, they are subject to having their nonprofit status revoked by the IRS.
11. Cooperative
A cooperative, also known as a co-op, is a business entity that may be for-profit or nonprofit depending on the mission and vision of those that create it. While it has similarities to a corporation, it differs because it has members instead of shareholders. A cooperative’s members run it. They have the authority.
There are generally two types of cooperatives. They are consumer cooperatives and worker cooperatives.
A consumer cooperative is owned by consumers and managed for their group purposes and common needs of the consumer cooperatives members. An example is a credit union or a food-co-op.
A worker cooperative is a cooperative that is owned and self-managed by its workers. This control may mean a firm where every worker-owner participates decision making in a democratic fashion, or it may refer to one in which management is elected by every worker-owner who each have one vote.
Cooperatives are not prevalent but are an optional form of business organization when considering different types of business structures.
12. Unincorporated Association
Several people get together and they start an organization for a particular purpose. It can for the public benefit or for a defined group of people. They don’t bother to go and create a legal business entity by filing documents and following the statutes or regulations governing the creation of various businesses. Nevertheless, they continue, and they conduct business.
Under such circumstances, they will often be regarded by the law as an Unincorporated Association. The association is usually run by a committee and may last only for a short period of time or a very long period. The members of the unincorporated association do not have unlimited liability and may be liable individually and collectively for claims made against the association.
Where this type of association has been created and is operating for a profit, it is generally treated as a partnership for legal and tax purposes.
Some states have created special statutes to define and create unincorporated associations. In California for example, an unincorporated association is defined as an “unincorporated group of two or more persons joined by mutual consent for a common lawful purpose, whether organized for profit or not.” Corp Code §18035. Such an association can hold property in its name and make profits from goods and services sold.
If the purpose of the association is to benefit the public and does not include earning a profit, the association’s members have formed an unincorporated nonprofit association. Cal. Corp Code 18020 A nonprofit association may carry on a business for profit and apply any profit that results from the business activity to any activity in which it may lawfully engage. Corp Code 18020 (b) People form nonprofit unincorporated associations all the time; often without being aware of it.
13. Franchise
A franchise is a special type of business entity. It is a system where a person buys the rights to open and operate a business using a business plan or system provided by another and often larger corporation.
The franchise contract requires the buyer of the franchise to follow the formula that is provided by the company selling the franchise. It’s sort of like a business in a box. You buy it and it’s already set up for you. What you must do to be successful is to follow the guidelines within the contract.
The person who purchases the franchise is called a franchisee. The company that sells the franchise is called the franchisor. A typical example is McDonald’s Hamburger chain. It sells franchises. The franchisee is required to attend training at what is referred to as “hamburger university.” Afterward, the franchisee operates the restaurant in accordance with the rules and regulations outlined within the franchise contract and usually, if followed as required, the restaurant will be successful.
Franchising can a great choice for a business. The franchisee is provided with an opportunity to run a business with an already established business system that has been proven to be profitable to some degree. Therefore, the buyer of a franchise usually can start out with a head start in running a successful business, although this does not always turn out to be the case. Many franchises fail for several reasons. A franchise is one of the most popular business choices for entrepreneurs.
14. Joint Venture
A joint venture is a strategic alliance where two or more parties, usually businesses, form a partnership to share markets, intellectual property, assets, knowledge, and, of course, profits.
Usually, a joint venture has a limited life span because it is normally created for a specific purpose and a given time period after which the entity is dissolved.
Joint ventures are very useful for situations where businesses who would not be able to handle a project or produce a series of products on their own can join forces together and produce the products or complete the project by pooling their resources and experiences together to mutually gain what each of them need but otherwise would not be able to but for their joint efforts.
This type of business structure can be especially favorable for a smaller business to scale up and increase their profitability. In addition, since there is no transfer of ownership in the deal, each business can maintain its individual autonomy and can still have limited liability if it is a corporation or limited liability company.
Which type of business structure is best for your business?
The whole purpose of this article is to provide you, the reader, with knowledge of several types of business structure. With a better understanding of what is available for the creation of a business entity, the better choices can be made for which type of business entity best fits your situation.
Which is the business choice for any particular way to conduct a business depends on a number of factors such as whether it’s a small startup, the products or services offered, the exposure from potential claims and lawsuits, the mission and vision of the business owner, the amount of available capital and a number of other circumstances.
Making the choice of which type of business entity one should create is an important decision and it is strongly suggested that such a decision should not be taken lightly. Getting good legal advice from an experienced business lawyer should be one of the first steps taken when considering the best structure for your business.
Hopefully, the explanation of these 14 types of entity structures has been helpful to you.
To get a free consultation regarding which business structure might be the best for your business get in touch with us. We will arrange a time to consult with you via phone. No fees or obligations.
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