Business Organization Definition
Before starting a business, one of the many decisions you will need to make is what kind of business organization you will create. This decision should be based on factors like the number of people who will be involved, whether or not your primary focus is to make profit, business risk and how much financing you will need to get started.
A business organization is any entity that aims to conduct a commercial enterprise by providing goods or services to customers. There are several ways to organize a business, from a sole proprietorship to a corporation.
In the United States, there are six types of business organizations, each with its own strengths and weaknesses:
- Sole proprietorship
- Limited liability company
- Nonprofit corporation
Before choosing one of these legal forms of business ownership, keep in mind that the easier it is to create, the less separated it is from your personal finances. Many small businesses begin as a sole proprietorship, partnership or LLC in the early years and then incorporate later.
A sole proprietorship is the easiest way to set up a business. In fact, according to the federal government, you're automatically deemed a sole proprietorship if you do business without registering as any other type of structure.
With a sole proprietorship, you and your business are one and the same. Your business assets and debts are considered to be your personal assets and debts as well. This means that if your business runs into financial difficulties, you can be held personally liable for any liabilities. Raising money can be difficult since you can't sell shares in your business, and banks are often skeptical of sole proprietorships.
A sole proprietorship is often a good choice for a low-risk business where it's unlikely that your business will accumulate debt or will be sued. With a sole proprietorship, you're still able to get a trade name, which makes it a good option for testing out a business idea before selecting another type of structure.
If you're going into business with one or more other people, a partnership is the easiest organization to set up. There are two kinds of partnerships from which to choose: limited partnerships and limited liability partnerships. Like sole proprietorships, a partnership is a good way to start a business quickly before adopting a more formal organization model.
In a limited partnership, one partner has unlimited liability and is known as the general partner, while the other partners have limited liability. In most LPs, the general partner also has the most control of the company, which is specified in a written partnership agreement. Profits from the partnership are paid through personal tax returns, and the general partner is considered self-employed for Medicare and Social Security contributions.
In a limited liability partnership, every partner has limited liability, so they are all protected from being personally responsible for company debts. They are also protected from the actions of the other partners. This is a common organization for professionals like lawyers and accountants.
Forming a limited liability company gives you some of the benefits of a corporation without any of the hassles. An LLC is usually a good option if you're starting a medium- to high-risk business or if you own significant personal assets that you don't want to become entangled with your business entity.
Owning an LLC usually protects you from personal liability, so assets like your house, car and savings aren't up for grabs in the event of a business lawsuit or bankruptcy. The profits your LLC makes or its losses are reported through your personal income tax return without corporate taxes being applied.
As the owner of an LLC, however, you are deemed to be self-employed, so you have to pay self-employment tax contributions for Medicare and Social Security. In many states, LLCs have a limited life expectancy. Unless there's a written agreement for transferring ownership, an LLC often needs to be dissolved and re-formed if there is a change in ownership.
A corporation, or C corp, is an independent legal entity that is completely separate from its owners. Corporations can be taxed on their profits and can be held legally liable for debts or breaking laws and in lawsuits. Owners, called shareholders, can sell or give up shares without interrupting the company's daily operations.
Because of the complete separation between owners and the company, starting a corporation is a good option if you are starting a higher-risk business. Corporations can raise money by selling shares in the business. Only a corporation can sell shares publicly on the stock market after issuing an initial public offering.
Forming a corporation costs more in fees, and there is more paperwork involved. Your corporation will be required by law to keep extensive records of its operations. Corporations are taxed on the profits they make. When that profit is shared among the shareholders – known as dividends – they may have to pay taxes again on their personal tax returns.
An S corporation, or S corp, is similar to a C corp except that it is designed to eliminate the double taxation that shareholders can suffer. Profits and losses can be passed to the owners' personal income taxes without having corporate tax applied. This, however, is a federal government policy, and not all states treat an S corp the same way for tax purposes. Some states may tax an S corp when profits exceed a specified threshold, while other states will tax it the same way that it would a C corp.
You have to apply to the IRS to form an S corp, and each state may have its own restrictions. The federal government requires that there are no more than 100 shareholders, and they must all be U.S. citizens. This can be a good choice if you want to create a corporation but have no intentions of expanding beyond a small- or medium-sized business.
A B corp, or benefit corporation, is for companies that perform a benefit to society in addition to making a profit. They are taxed the same as a C corp but have different rules in their accountability and transparency to the government. There are third-company services that offer certification for B corps, but in states where B corp status is available, these certifications are not a requirement.
A close corporation is similar to a B corp except that it doesn't need a board of directors. A close corporation is often better suited for a small group of shareholders. In most states, close corporations are not allowed to offer public shares.
A nonprofit corporation is for organizations doing charity, education, literary, scientific or religious work. The focus of these organizations isn't to make a profit but to serve the public good. They often rely on donations instead of selling goods or services, and profit, if any, at the end of the year is incidental.
Nonprofit corporations can receive tax-exempt status from the IRS and state governments so they do not have to pay state or federal income taxes on profits. These organizations are often referred to as 501(c)(3) corporations from the IRS code used to grant them tax-exempt status.
A cooperative is a business or other organization that is owned by the same people it is designed to serve. Profits earned by a cooperative are shared among its user-owners. Examples of cooperatives range from farms to artist studios to credit unions.
Like a corporation, a cooperative is run by an elected board of directors who are elected by the user-owners. User-members can join a cooperative by buying shares. Unlike a corporation, however, the weight of their votes does not depend on the number of shares they own.