Overview Of Business Structures


Overview Of Business Structures Print

There are many forms of conducting business, but the following four types are the most popular.  For an overview, see the Entity Comparison Chart.

  • Sole Proprietors – One person engaged in a business; the individual has not formed either a Corporation or an LLC.
  • Partnerships – Two or more individuals collectively engaged in a business; they have not formed either a Corporation or an LLC.
  • Corporations – Owned by shareholders and administered by a board of directors who appoint officers to manage the day-to-day operations.
  • Subchapter S-Corporations – Additional option for tax filing.
  • Limited Liability Companies (LLC) – Owned by a minimum of one member and up to an unlimited number of members.  The LLC may be managed by the member(s) or the members can appoint a manager or multiple managers to operate the LLC.

The biggest risk to the Sole Proprietor and the Partnership is that the owners have unlimited personal liability exposure for the debts of or claims against the business. If anything happens in the business, the owners are liable and third party creditors and claimants can reach the owners’ personal assets, including their home, vehicles and bank accounts, to satisfy the business obligation. Obviously, this is a tremendous risk to the owners and certainly not an incentive to engage in business in either of these forms.

Both LLCs and Corporations provide asset protection to their owners since these entities are statutory entities, meaning they are formed by complying with provisions contained in the Arizona statutes. Both LLCs and Corporations are entities separate and apart from their owners.  It is very important that the owners of these entities comply with all requirements of the statutes that govern them.  The failure to do so can result in “piercing the corporate veil,” which allows company claimants and creditors to reach the assets of the owners to satisfy company obligations.  We’ll discuss this in more detail later.   Each state has statutes that govern Corporations and LLCs, but this website is designed solely for businesses operating in Arizona so all information provided in this site will deal with Arizona laws.

Here’s a more detailed look at each form of conducting business.


Sole Proprietorships

According to the Small Business Association, the vast majority of small businesses start out as Sole Proprietors.  A Sole Proprietor business is owned by one person, usually the individual who is responsible for operating the business.  The Sole Proprietor also assumes complete responsibility for any and all of the business liabilities or debts.  In the eyes of the law and the public, the individual is the business.

Advantages of a Sole Proprietorship

  • Minimum legal restrictions.
  • Ease of formation.
  • The Sole Proprietor is in complete control of the business and may quickly make any decisions as the need arises.
  • The Sole Proprietor receives all income generated by the business and owns all the assets.
  • Profits from the business flow directly to the owner’s personal tax return.
  • The business is easy to dissolve when ready to close the business.

Disadvantages of a Sole Proprietorship

  • Sole Proprietors have unlimited liability and are legally responsible for all the debts and obligations of the business. The Sole Proprietor’s business and personal assets are at risk for any business obligation.
  • Sole Proprietors may be at a disadvantage in raising capital and are often limited to using funds from personal savings, credit cards, home equity loans or consumer loans.
  • It is often more challenging for Sole Proprietors to attract high-caliber employees or those who are motivated by the opportunity to own a part of the business.
  • Some employee benefits including the owner’s medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income).

Partnerships

In a Partnership, two or more individuals are collectively engaged in a business.  Just as with a Sole Proprietor, the law does not distinguish between the business and its owners.

Partnership Agreement: The partners should have a legal agreement, called a “Partnership Agreement,” that clearly states how the partnership will be operated and administered, such as:

  • how much time and capital each partner will contribute,
  • how decisions will be made,
  • profits will be shared,
  • disputes will be resolved,
  • how future partners will be admitted to the partnership,
  • how partners can be bought out, &
  • what steps will be taken to dissolve the partnership.

While it is challenging to think of parting ways when the business is just beginning, the smart, proactive business owners will address these important issues  as they form the business. Current statistics show that 80% of Partnerships fail.  When partners cannot agree how to handle important issues and they don’t have a Partnership Agreement, the end result may require court action to dissolve the partnership and divide the assets.  This process is incredibly expensive, time consuming and generally an overall challenging experience.

Advantages of a Partnership

  • Partnerships are relatively easy to establish.  It is incredibly important to the success of the partnership that appropriate time is invested in developing the partnership agreement.
  • With more than one owner, the ability to raise funds may be increased.
  • It has a broader management base than a Sole Proprietor.
  • The profits from the business flow directly through to the partners’ personal tax returns.
  • Prospective employees may be attracted to the incentive to become a partner.
  • The business usually will benefit from partners who have complementary skills.

Disadvantages of a Partnership

  • There is no entity protection, so the partners have unlimited liability for the actions of the other partners.
  • The profits must be shared with all partners.
  • There is a divided authority in decision making.
  • Since decisions are shared, disagreements can, and often do, occur.
  • Some employee benefits are not deductible from business income on tax returns.
  • The partnership may have a limited life – it may end upon the withdrawal or death of a partner.
  • There may be a difficulty in disposing of the partnership interests.
  • If a Partnership Agreement is not created, difficulties often arise as to how to manage the partnership, how a partner may exit the partnership and the value of the partnership’s interest.

Corporations

A Corporation, sometimes referred to as a C-Corporation, is formed by complying with the state’s statutory requirements.  It is the most complex type of business organization.  The Corporation is considered to be a unique entity, separate and apart from those who own it. Since a Corporation is a separate entity, it can be taxed, it can be sued, and it can enter into contracts. The Corporation is owned by its shareholders who offer money and/or property in exchange for shares or stock. The shareholders elect a board of directors to oversee the major policies and decisions of the Corporation.  The board of directors appoints officers who manage the day-to-day operations of the Corporation. 

Advantages of a Corporation

  • A Corporation is a separate legal entity.
  • Shareholders have limited liability for the Corporation’s debts or judgments against the Corporation.
  • Generally, shareholders can only be held accountable for their investment in stock of the company.  However, officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.
  • Corporations can raise additional funds through the sale of stock.
  • The Corporation has a life of its own and does not dissolve when ownership changes; they remain in business until the shareholders decide to dissolve the company.
  • A Corporation may deduct the cost of benefits it provides to officers and employees.
  • A Corporation can elect S-Corporation status if certain requirements are met. This election enables company to avoid double taxation.
  • The shareholder can transfer ownership of stock, subject to any restrictions in shareholder agreements.

Disadvantages of a Corporation

  • The process of incorporation is expensive, complex and takes longer to form than other business structures.
  • Corporations are monitored by federal, state and some local agencies, and as a result require more administration and record keeping than other forms of business structures.
  • Incorporating may result in higher overall taxes and C-Corporations are subject to double taxation – once on corporate profits and again on dividends.

Subchapter S-Corporations

An S-Corporation is a general Corporation that makes a tax election to be treated as an S-Corporation.

Why elect S-Corporation status?

  • Shareholders can treat earnings and profits as distributions and have them pass through directly to their personal tax return. 
  • Shareholders are required to pay themselves a reasonable salary if they work for the company.
  • If they pay themselves a reasonable salary, shareholders can then pay themselves the profits of the company in the form of a dividend. 

The shareholder salary must meet standards of “reasonable compensation.”  This can vary by geographical region as well as occupation, but the basic rule is to pay the shareholder the same pay as the Corporation would have to pay someone to do the job. If the company fails to do this, the IRS can reclassify all of the dividends/profit as wages, and the shareholder will be liable for the payroll taxes on the total amount of compensation.

To qualify as an S-Corporation, the Corporation must meet the following criteria:

  • Be based in the United States.
  • Have only one class of stock.
  • Be limited to no more than 100 shareholders.  A husband and wife can be treated as one shareholder for this purpose.
  • The shareholders must be individuals, estates, certain exempt organizations and certain trusts.
  • Shareholders cannot be a non-resident alien.
  • There are restrictions regarding its tax year.
  • Each shareholder must consent to the S-Corporation election.

Since tax laws change with some frequency, check with your accountant for updated information and to determine if this option is a good choice for your business.


Limited Liability Company (LLC)

An LLC is formed by complying with the state’s statutory requirements.  The LLC is considered to be a unique entity, separate and apart from those who own it. Since an LLC is a separate entity, it can be taxed, it can be sued, and it can enter into contracts.  The LLC is owned by members and can be operated by one or multiple members or the members can appoint a manager or multiple managers to operate the LLC.

The LLC is a hybrid business structure and it combines the protection of Corporation and the tax efficiencies and operational flexibility of a Partnership. Formation is more complex and formal than that of a general Partnership

A single-member LLC can be taxed as a Sole Proprietor, a C-Corporation or an S-Corporation.  A multi-member LLC can be taxed as a Partnership, a C-Corporation or an S-Corporation.  If the LLC does not make any tax elections with the IRS, then the default tax classification for a single-member LLC will be taxed as a Sole Proprietor and the default tax classification for a multi-member LLC will be taxed as a Partnership.  Check with your accountant to determine which tax option is the best choice for your business.

Advantages of an LLC

  • There is limited disclosure of owner information.
  • There is limited documentation.
  • There are no public disclosure of finances or annual reporting requirements.
  • Members can create buy-sell provisions in the LLC’s operating agreement.
  • There is an ease in transfer of ownership.
  • Members do not have liability for company debts and obligations.
  • Members can assign management duties to non-members.
  • Members can create different classes of owners.

Disadvantages of an LLC

  • A large number of owners may complicate status or operations.
  • Death, bankruptcy or withdrawal of a member may cause problems for the company.

Given the various tax options, it is important to work with the company’s accountant to make the best tax election.