When starting a business, there are a number of decisions that have to be made. In addition to issues such as hiring employees and choosing a business location, you also need to choose the type of business entity by which you will operate. This may leave you wondering which is the best entity type for your business or even asking, "What are different types of business ownership?" It can be very confusing if you aren't familiar with the different types of ownership and the advantages or disadvantages of each.
Fortunately, it doesn't have to be difficult to choose the business type that's right for your business. There are four major business formation types with which you need to concern yourself, and each one works best for certain types of businesses. Once you learn more about these different types of business entities, the best option for you and your business should become clear.
Though you may have heard about a number of different types of ownership when researching business options, there are only four primary types that you'll likely have to consider: sole proprietorships, partnerships, limited liability companies and corporations.
Types of Ownership
Each type of ownership functions differently and places you in a slightly different role within the company. There are different advantages to each business type and also specific requirements that you have to meet in some cases.
The type of business entity you create affects both your role within the company and how the company operates. Because of this, it's important to take the time to better understand each option before making your decision. Certain business types may open you up to legal and financial liabilities, though they also give you more control over the company as a whole. Others may reduce this liability but have up-front creation costs and more oversight at the state or federal level. The more complex a business entity is, the more rules you have to follow regarding what you can and can't do with the business.
Perhaps the most basic type of business entity is the sole proprietorship. It typically takes the form of a single individual in business as the sole owner of the company. In many cases, the owner of the sole proprietorship is also the only employee as well, though this doesn't have to be the case. The sole proprietorship isn't registered with a state agency and doesn't require a specific license or filing for its creation. Many self-employed individuals who provide services either in their local community or online act as sole proprietorships, as they do not create a separate formal company before beginning their work.
From a legal standpoint, there is no separation between the business and the individual running it. Finances flow through the business to the owner, and in many cases the owner doesn't even maintain separate bank accounts for business funds and personal funds. Any legal liabilities or debts taken on by the business are also held in full by the owner. If the business is sued or otherwise faces legal action, the owner is held legally responsible for the liability or debt in the case. As the business does not exist as a separate legal entity, there is no way for the owner to shift responsibility to the business itself.
While it is not strictly possible to sell a sole proprietorship because it does not exist as a separate legal entity, one might sell any assets associated with the business and allow another individual to take over operation. If the sole proprietorship is operated under your name, the new operator would have to either use his name or file a business name with the appropriate local government.
Partnerships are similar to sole proprietorships, though they are owned and managed by two or more individuals instead of one. The owners may divide duties among themselves, putting one in charge of finances while the other is in charge of day-to-day operations, for example. For a general partnership, there is no filing to create a separate company and the same legal liabilities faced in a sole proprietorship are also faced in a partnership. Contracts between the partners may shift the liability to certain members within the partnership, but there is no way to shift the liability to the business itself.
Other forms of partnerships exist, though they are less common than general partnerships. Limited partnerships are similar to limited liability companies, protecting the partners from some liability for debt and legal action. They are much more complex to create, however, and don't work well in all fields. Joint ventures are another form of partnership, though they are typically created with a specific goal or a limited time frame in mind instead of being created to operate indefinitely. There are a few other forms of partnerships available as options as well, though these are typically reserved for special cases or are only open to certain professions or operating styles.
Some businesses begin as partnerships and then evolve into more complex business entities as time goes by. In most states, it's actually possible to convert a partnership into a limited liability company by simply filing the correct paperwork and paying any required filing fees.
Limited Liability Company
Limited liability companies create a separate legal entity that can bear at least some of the liability for debt and legal action, reducing or eliminating the liability faced by the business owner or owners. The business structure is similar to a corporation, yet the business itself is much less structured than a full corporation and provides the owners with the same sort of flexibility that one sees with a general partnership. An LLC is often referred to as a hybrid business model, as it combines some of the benefits of incorporation with some of the benefits of operating a general partnership. Note that an LLC is different than a limited partnership and requires different filings to create.
While an LLC does offer protection against legal liabilities, there are still some instances where you can face liability as an owner of an LLC. Owners of an LLC (referred to as "members") are not personally responsible for an LLC's debts so long as they did not provide personal collateral or other personal guarantees to back the funding. If they did, then they may still be liable unless the funding is refinanced to remove their personal stake. If you fail to meet obligations to the company or are personally responsible for third parties losing money or inventory through interaction with the LLC, you may still be personally liable in court as a result.
An LLC is similar in some ways to a corporation, but there are some key differences. LLCs are more fluid than corporations and aren't able to take on shareholders in the traditional sense, though they can allow new members to join the company as partial owners. Because an LLC exists as a separate legal entity, the owner or owners are able to take actions that partners or sole proprietors would not be able to take, including establishing credit lines for the company and even selling the company if all owners agree.
A corporation is a business that operates as a separate legal entity than its creators. Corporations are taxed at different rates than other business types, and a corporation may have different legal rights and responsibilities, depending on the state where it is incorporated. A corporation can enter into legal agreements with individuals and other businesses, it can be sold or have others take control of it and it maintains most of the liability for its debts and legal actions itself. Corporations are governed by a board of directors or other governing body and typically do not have a single "owner" operating the business; corporations can actually sell shares of ownership to raise funds and divide ownership among a number of shareholders. While many view corporations as large companies, smaller businesses can be incorporated as well.
There are two primary forms of corporations: C corporations and S corporations. A C corporation is a "regular" corporation, with the company paying its own taxes and holding its own finances. There are no limits to the company's size, and a C corporation can have shareholders from anywhere in the world. An S corporation is a much smaller business structure, with money passing through it similar to what happens with a sole proprietorship. The corporation does not pay its own taxes; instead, those taxes must be paid by the owners who receive the money. S corporations may have no more than 100 shareholders across the entire company, and all of those shareholders must be United States citizens.
While corporations are typically for-profit businesses, the majority of nonprofit companies operate as corporations due to the fact that the company is a separate legal entity. This allows the company itself to achieve tax-exempt status without requiring individuals within the company to also have that status.
Choosing the Right Option
With so many types of business entities, how do you choose the one that's right for you and your business? The first thing that you need to do is stop and consider just what your goals are and what type of structure your business will have. Are you starting a business simply because you want to work for yourself, or are you hoping to work with a partner? Do you plan on hiring employees or bringing in others as the business grows? Will the company be funded by your personal investments, or do you want it to be self-sustaining and capable of taking on its own debts? The goals you have for your business will go a long way toward helping you choose the right business entity type.
Take the time to write out your goals and desires for your business as well as where you would like your business to be in three or five years down the road. Be as thorough as possible with this; it's not enough to say that you want the company to be successful. You need to outline a reasonable description of what you'd like the business to be doing, how many employees you'd like to have, whether you'll be expanding to new locations and any other relevant information. Once you have a grasp on what you'd like your business to look like and how you'd like it to operate, then you can start choosing a business type.
Weigh the advantages and disadvantages of different business types against the business outline you've created. Would your business be able to grow like you want as a sole proprietorship? Will you work alone, or would a partnership setup fit better into your plans? If you want to reduce your personal liability while running your company, would an LLC or a corporation be a better option as a business structure? If you choose to create a corporation, would your aspirations be better served by a C corp or an S corp?
No two businesses are alike, and the structure that works for one company may not work for another. This isn't a decision into which you should rush, so take your time and choose the business entity type that truly works best for your business.