Okay, so I’m going to jump off the road map storyline this week to discuss business types. How you organize your business can vary depending on what type of industry you’re in and what product or service you sell. Knowing the differences can help you determine what type of business is best for you.
Before we delve into this topic we need to define some of the terms that are used when it comes to business and legal jargon.
In terms of accounting, liability means anything that you owe to someone else in the name of the business. An example would be a loan that you need to repay to the bank. Essentially it is someone else’s claim to part of your business.
When it comes to defining your business type, liability involves the degree to which your personal assets are at risk in your business. This is a very important aspect when differentiated between different business types.
Not to be confused with the board game, risk is the level of uncertainty involved in a given business transaction or venture.
So now that we have all of that figured out we can actually get this show on the road. In the wonderful world of business types there are six main types of organizations: Sole Proprietorships, Partnerships, Cooperatives, Limited Liability Companies (LLC), C-Corporations, and S-Corporations. There are different variations on some of the organization types, but I’m going to be sticking to these main six for the purposes of this post to make it simple.
We’re going to start this post with the simplest and easiest to set up of all of the business types. The sole proprietorship is easily the most straightforward business type out there. Many small mom-and-pop shops are set up this way. However, with the ease of set up also comes the most liability if something were to go awry.
You see, in a sole proprietorship there is absolutely no legal difference between the business entity and the business owner. All of the assets of the business are the same as the assets of the individual. This is convenient for tax purposes and the flow of money from the business to the owner’s pocket, but this also means that if the company was to face a lawsuit, all of the business owner’s personal assets could be taken. For example, if Old Town were set up as a sole proprietorship and there was some mass food poisoning event, we could be sued by those affected and they could go after both our business assets AND our house, car, computer, television, et cetera.
This example would not be ideal as we could potentially no longer have a place to live in addition to our livelihood being taken away. The sole proprietorship possibly has the biggest opposing pros and cons of any of the business types. It has advantages in ease of set up and tax benefits, but in my opinion the risks outweigh the benefits and I wouldn’t recommend it in most circumstances.
Partnerships are one of those business types that have some sub-types. Each of these depends on the circumstances, but there are General Partnerships, Limited Partnerships, and Joint Ventures. All three of these sub-types share the general definition of what a partnership is. According to the US Small Business Administration, “A partnership is a single business where two or more people share ownership. Each partner contributes in all aspects of the business.” Now what they mean by all aspects are money, property, and time and skill.
The differences in the three sub-sets are really about the liability involved and the length of time that the partnership lasts. The cool thing about partnerships is that there can be a specific amount of time that the relationship lasts until it is dissolved. This, of course, requires detailed legal documents to outline those exact guidelines, but it is an interesting aspect of this type of business.
Overall, partnerships can be less risky because multiple people are contributing their individual capital to the business. This puts less weight on any individual owner, or partner, and spreads out liability. However, unless you set up a limited partnership, the same liability issues arise as we encountered with the sole proprietorship. I say, “unless you set up a limited partnership,” because that business organization allows the partners to shelter themselves from the pesky issue of having their personal assets be vulnerable.
The term “limited” in this context refers to limited liability for the owners of the business. It is purely legal jargon, but that simple term allows the partners to separate their personal assets from the assets of the business. In the event that the mass food poisoning were to occur, the lawsuit ruling could only go after the assets of the business. So yes, your livelihood could be taken away, but at least you would still have a place to live after it’s all said and done.
Another advantage of partnerships is the same as the Sole Proprietorship and that is single taxation. I brushed over the tax benefits of the Sole Proprietorship, but basically single taxation works like this: the business brings in revenue throughout the course of the year (hopefully), there are expenses associated with bringing in that revenue, and whatever is left over is the profit; this profit is then taxed at the end of the year. Since you’re set up as a partnership, this profit is allocated to the individual partners and they are taxed as a part of their personal taxes. The business is merely a “flow through entity” that generates the profit.
Partnerships are a really good way to set up your business because of the relative ease of set up and the ability to have it established for a specific amount of time. As long as you establish the partnership as a “Limited Partnership” you are protected from a certain amount of liability and maintain the benefits of single taxation. On the whole, I would say this could be the way for your entity if you and a friend have a hobby that you’d like to turn into business and want a nice easy set up process.
I’m not going to go into a lot of detail about cooperatives, but I will define it for you. Basically a cooperative is a group of people or businesses that get together to work toward a common purpose or goal. They have members much like a partnership, but they usually have a board of directors above them that helps steer the ship and keep things on track. The board can be made up of the member entities and can include outside individuals with experience in the given industry.
Cooperatives require a lot more legal set up than a partnership or sole proprietorship and includes Articles of Incorporation, By-Laws, Electing Board Members, and so on. One major thing that needs to be established from the beginning is what purpose the cooperative is set out to achieve and it must stay on target. If you’d like to read a little more about cooperatives and get a more detailed definition click here.
Limited Liability Companies
Limited liability companies are kind of a hybrid business type that has emerged relatively recently in the world of business. They act as a combination of a partnership and a corporation. They are really a cool legal entity and many business professors will recommend this organization type for most small businesses.
What LLCs do is provide the limited liability of a corporation, but give you some wiggle room and the tax advantages of a partnership. As I mentioned earlier, the term “limited liability” really just means that you separate your personal assets from those of the business and you still get the single taxation benefit of a partnership.
There is an important distinction between an LLC and a limited partnership and that is while a partnership has to have two or more people, an LLC can have a single owner (called a member), two or more people, or it can even be owned by other business entities. This type of organization is good because an individual owner who wants to start a business, but doesn’t want the liability of a sole proprietorship can still go into business without having to bring in a partner.
Although you get the single taxation benefit from an LLC, there is a downside. With an LLC you are required to pay an extra self-employment tax. The entity itself isn’t taxed on the profits, but you get hit with an extra 15% on the flow through tax bill. If you’re especially averse to taxes, I recommend talking to your accountant or lawyer about whether or not this is the best option for you.
Big corporations are usually organized as C-Corporations. This type of entity provides the greatest amount of liability protection and has the best chances at raising capital from its owners. The owners of C-Corps are individual shareholders that buy “stock” in the company. In the simplest terms, the more “stock” you own in the company the more weight your votes hold.
Corporate stocks can be held by an indefinite number of individuals or other businesses and the ownership can change hands an indefinite number of times. The biggest advantage of this type of fluid ownership is that the business can have an indefinite lifespan. The founder and original owner of the corporation can pass away and the business can live on as long as it continues to make money and be profitable.
However, there are some major disadvantages to C-Corps. One of the main disadvantages is double-taxation. Unlike the previously mentioned business types, corporations are recognized as individual legal entities and are taxed as such. Once the profits of the business are taxed, then the owners (shareholders) are taxed on their share of the business. This is a huge drawback because you’re essentially paying twice the tax that other business types do.
In addition, C-Corps are much more difficult to set up and require a lot more legal documentation and reporting. They have to have a board of directors, legal documentation of the business entity, accounting regulations are much more stringent, and they are tightly regulated by the IRS and SEC.
I would say most small businesses don’t need to become incorporated as a C-Corp. The extensive fees and legal requirements are really unnecessary for, say, a small restaurant in Joseph, Oregon. There are definitely entities that do need to be set up as corporations, but generally it’s better to evolve into one over time.
If you like the idea of the advantages of the LLC and the advantages of the C-Corp, then this is the business type for you! S-Corporations are an interesting breed because they give you much of the advantages of a C-Corp, but you also get the tax benefits and a little more flexible like an LLC (although there are stricter regulations than an LLC).
The major legal distinction between a C-Corp and an S-Corp are the number of shareholders allowed. The maximum number of shareholders allowed is 100 and you must apply to become recognized as an S-Corporation. The initial registration is recognized as a C-Corp, but through an application process you can get IRS recognition and gain the benefits of the S-Corp.
This is what we decided to with for Old Town through the advice of our accountant. One of the best advantages you get over with this type of organization over an LLC is that you don’t have the self-employment tax. You are still only taxed once, but the profits get passed onto the individual shareholders, but it’s recognized as a dividend and is taxed at a lower rate. We were initially going to be an LLC, but when our accountant pointed out this fact, we decided that the S-Corp was the better option.
Now there are some downsides to an S-Corp, but I believe the benefits outweigh them. You have to keep more detailed records and there is some regulation, but not nearly as strict as with a C-Corp and the tax benefits are second to none. Anyone who is tax averse should definitely consider this option as you will get the most bang for your buck. However, as I said last week, I encourage everyone to consult a professional accountant or lawyer before you incorporate. If we hadn’t, we’d be hurting a lot more in the tax department.
I realize that these descriptions are very light and I didn’t cover nearly all of the material involved. However, this is the gist of what each business type involves. I encourage you to look deeper into any business type you’re considering and the US Small Business Administration has really good resources to help you decide what business type may be right for you.