A business is formed by any one person, two people or more, who carry on a commercial enterprise to provide services, products or both, in exchange for payment from customers. A "business organization" offers a legal framework that defines the company's structure, profit dispersal and liability risk. Unlimited liability business organization types are a sole proprietorship and general partnership. Limited liability business organization types are limited liability partnership (LLP), corporation and limited liability company (LLC). You should carefully review each of the business organization types to decide which best suits your business now and in the long-term.
What Does Business Organization Mean?
A business organization is the legal set-up of your business. Each state and region has different laws for registering your business organization, so check what's required to set up your business. To decide which type of business organization suits your business, you will choose who is liable and for how much, what assets belong to the company and how they are divided. Your business organization will define whether the business is a for-profit or a non-profit. If it's for-profit, your business organization dictates how those profits will be divided. The organization will also extend to the hierarchical structure within the company, for day-to-day operations, and in regard to legal responsibility.
Part of the purpose in designating a class of business organization is to contain risk. All businesses inherently come with risk, but risk can be controlled within the parameters of its organizational structure. Consequently, each type of business organization offers pros and cons, depending on the industry or business set-up.
Business Organization Types
There are several kinds of business organizations, but they are divided into two main classes; unlimited liability and limited liability. It is essential to understand that liability in the context of a business organization means risk. For example, if a company loses a lawsuit where customers were harmed by their product and it puts them out of business, the financial burden or liability is determined by their business organization – unlimited liability or limited liability.
In an unlimited liability, the owners of the company are liable for shouldering debt, penalties and any other losses associated with their collapse. In a limited liability organization, there is a limit to how much the company owners can be held personally liable for damages and legal costs.
Unlimited Liability Business Organizations
A sole proprietorship is a sole owner of a business who is responsible for all profits, losses, assets and liabilities. Many sole proprietorships have separate operating names, but it is not required since taxes are paid through the owner's Social Security number. When someone describes themselves as “self-employed,” they’re often functioning as a sole proprietorship. It requires less paperwork to set up a sole proprietorship and in some regions, no paperwork or formal set-up is required at all.
A sole proprietor oversees all aspects of the company. They may have a full-time staff or outsource work to sub-contractors or freelancers. A sole proprietorship is less expensive to start up than some other forms of business organization. The disadvantage of a sole proprietorship is that the business owner assumes all risk and his personal assets are at stake in case of business failure, a lawsuit or other unforeseen financial disasters. Sole proprietors are therefore often at a disadvantage when it comes to raising capital for their enterprise. Lenders and investors will not only consider the feasibility of the business itself but largely base their decision to lend money on the personal credit history of the business owner.
There are two kinds of partnerships, a general partnership and a limited partnership. Like the sole proprietorship, there is no limitation on personal risk as a general partnership. In a general partnership, a group of two or more people share authority and the responsibility of risk for the company. Each partner can make choices about governance, but each also assumes their equal share of liability or more, since all partners are "jointly and severally liable." This means that should things go sideways and creditors call their debts, if one partner is unable to pay their share of the debts, the other(s) must pay up, even if they have already paid their portion. Each person involved in a general partnership is wholly liable but also empowered to act on the business’s interest.
Limited Liability Organizations
A limited partnership must have a general partner who assumes the risks and bears the burden of running the business with the legal authority to make any and all decisions. A limited partner is not able to act in a company leadership role, and their financial and legal risks in running the company are limited by a partnership contract that stipulates where their responsibilities end. Ultimately, the limited partner is an investor in the business while the general partner makes the day-to-day business decisions and assumes the personal risk for the legal and financial dealings of the company.
Limited liability partnerships (LLPs) are often the organizational type used by doctors and lawyers. These organizations allow for protection of personal assets when other partners cannot meet their share of debt or other financial burdens. Each partner is generally only liable to the extent of their investment.
When seeking to separate business risk from personal liability, corporations are the most common choice of a business organization and they are preferred by outside investors. Corporations are created by having shareholders who share in the profit of the company but are not held liable for debts or legal issues. The number of shareholders is inconsequential – there may be one or thousands. Limited liability is the major advantage of a corporation.
When it comes to day-to-day operations, a corporation with multiple shareholders generally elects a board of directors who are responsible for hiring, firing and other aspects of the daily business. The board of directors can be subject to personal liabilities, depending on regional tax laws and their contract. Corporations dominate the business landscape and include companies like Coca-Cola, Starbucks, Toyota and many more large and medium-sized businesses. Once a corporation ceases to operate, the assets are sold off and monies are divided among the shareholders.
A corporation must either be an “S Corporation” or a “C Corporation.” An S Corporation is not taxed at the business level, which is often called a "pass-through" taxation structure. In the S structure, taxes are reported and losses absorbed at a personal level by all stakeholders. The number of shareholders cannot exceed 100, and in many cases, it’s capped at 75, and all shareholders must be American citizens or resident aliens. Conversely, the C Corporation is taxed as a business, and when there is profit-sharing, the shareholders must also declare taxes on any dividends paid out. The C Corporation model is most common.
Limited Liability Company A limited liability company or LLC has flexible tax reporting options and is similar to a corporation in that personal and business finances must be kept separate, and personal assets are protected from business liabilities. Single owner LLCs have the choice to be taxed either as a sole proprietorship or a corporation. A limited liability company is also recognized throughout the United States as a corporation. A limited liability company is allowable in all 50 states and the District of Columbia.
The difference between a corporation and a limited liability company are that an LLC can have a highly flexible management structure, making it possible to run the company more like a traditional partnership while enjoying the liability protections of an LLC. Taxes for an LLC are similar to an S Corp in that the profits are taxed at a personal level for all LLC "members." Members are similar to shareholders, but LLC stocks can be issued with several different classes and different rights, so those who hold stocks are considered members rather than shareholders.
Unlike a limited partnership, any losses suffered by an LLC can be used as deductions against income. There are a couple of drawbacks to an LLC, such as it's not recognized outside of the USA and there’s a “transferability restriction test” that means ownership interest cannot be easily transferred, as it can in corporations. This lack of transferability makes an LLC less attractive for raising external capital.
Why You Need a Business Organization
Whatever your business is, you need to understand the liability risks and how you can protect yourself. As a small company, it may not be necessary to have an organizational structure. For example, some careers, such as a freelance writer, make it unnecessary. A writer can avoid things like libel and slander, for which the burden of proof lies on the plaintiff, so operating as a sole proprietor is a cost-effective, logical choice. A doctor, however, runs the risk of malpractice and often shares an office with other professionals who want to protect themselves from that possibility.
When providing services to the public, having an office or retail space where people visit, serving food or cleaning homes and performing other off-site services, the risks of liability increase dramatically.
When you start a business, you envision a successful future, but statistics suggest that up to 80 percent of businesses fail within five years. If you have chosen a limited liability business organization, you don't have to worry about your personal assets in the event your business fails.
If you’re going into business with a friend, consider who will have authority for each aspect of the business including liability, and how profit will be divided.
Forms of Business Organization Advantages and Disadvantages
Each type of business organization has its advantages and disadvantages. The freedom and flexibility of unlimited liability business organizations such as sole proprietorships and general partnerships are appealing because they're easy to set up. But they both carry substantial personal risk that you need to carefully consider should your business not be successful. Are you willing to take the risk, or rethink your business organization and make it a limited liability company, a corporation or a limited partnership?
A limited liability setup does afford protection of your personal assets, but it's complicated. Ensure you have a lawyer and accountant to look after all the details properly. For example, incorporation can involve annual dividend payments, heightened bureaucracy and other hassles that unlimited liabilities do not.
You will base your business organization type on many factors including your products, services and the industry you're in. What’s right for you will also depend on the assets owned by the company, the potential for lawsuits in your industry and much more. It's always wise to consult with a professional such as an accountant, business lawyer, small-business advisors or small-business bureaus to help you decide the best business organization for your business. The costs of incorporating and registering your business will depend on the state or region in which you are operating.