Making the right decision about the legal and corporate structure of your business is critical to your long-term success. How you establish your business will affect ownership rights, your personal liability risks, and how you can operate the business.
The following is a simple breakdown of some of the different types of business structures most commonly formed in the United States.
Corporations
To incorporate a business you must file Articles of Incorporation with your Secretary of State. All nonprofit corporations require a board of directors, officers and directors. Most corporations can also have shareholders and voting members (who usually pay dues).
Corporations are governed by a set of Bylaws, which are usually filed along with Articles of Incorporation. Corporations become a legal entity that "owns" itself. Corporations can have their own bank accounts, assets, and even secure financing.
- Advantages: Personal liability is usually limited to the amount an individual investor has invested in the corporation. Certain representatives of the corporation can sign for loans on behalf of the corporation, rather than having to personally co-sign for loans.
- Disadvantages: Corporations are subject to regulations that do not apply to other types of business structures. Incorporating can be expensive, and founding documents require specific legal language. Since no one person owns a corporation, founders can lose control if a board of directors or membership votes to change the way business is done.
Limited Liability Corporation (LLC)
To establish an LLC you must also incorporate. It is one of the simpler ways to start a business, and is becoming one of the most popular ways to structure a business.
- Advantages: The owners of an LLC are generally not personally liable for the LLC’s debts. LLCs have the choice of paying taxes as a partnership, corporation, or sole proprietorship. For individuals who do not meet the criteria for an IRS “S” corporation, this may reduce taxes.
- Disadvantages: Incorporating a business can be expensive and requires filing Articles of Incorporation with your Secretary of State. You may need an attorney to help you write your founding documents.
The Limited Liability Partnership (LLP)
An LLP is similar to a general partnership; however, in an LLP, each partner is not liable for the actions of other partners. If one partner dies, the LLP automatically ceases.
- Advantages: LLPs do not need to have a board of directors or hold meetings. The LLP is not liable for taxes because income passes through to the partners, who are individually responsible for taxes. Partners are not liable for the actions of other partners.
- Disadvantages: Many states do not recognize LLPs and those that do often limit LLPs to professionals (i.e., lawyers, accountants, architects, etc).
Sole Proprietorships
The sole proprietorship is the easiest way to form a business. It is subject to the fewest regulations of all business structures. For tax and legal purposes, the business is the owner. When the owner dies the business automatically ceases.
- Advantages: Sole proprietors own the business and everything the business owns. They maintain control over the business, and there are no legal regulations that tell a sole proprietor how they must operate their business. Starting a sole proprietorship typically only requires obtaining a business license and business name registration.
- Disadvantages: The owner of the business is liable for taxes and any legal issues that arise from operating the business. The owner may even be held personally liable in any judgments against the business. Because of liability issues, insurance premiums are high for sole proprietorships, and it is hard to get loans under the the business’ name.
Nonprofit and Charitable Organizations
There are many types of nonprofit organizations and each has its own unique filing requirements. In general, to set up a nonprofit, you must establish a board of directors and incorporate.
Nonprofit organizations are not automatically tax exempt organizations. If you wish to become tax-exempt, you must file Form 1023 with the Internal Revenue Service (IRS). Nonprofit organizations that do not have tax exempt status have to pay federal, state, and local income taxes.
Most states accept an IRS ruling of an organization’s tax exempt status, and automatically exempt the organization from state taxes as well. However, in some states, like California, you must apply separately to the state in order to be exempt from state taxes.
- Advantages and Disadvantages: The pros and cons of establishing a nonprofit vary considerably depending upon the type of organization you are creating. Tax-exempt organizations may be eligible for retail discounts, reduced postal rates, and can provide tax receipts to donors. Nonexempt organizations may not give tax receipts.
Summary: There are many ways to legally establish a small business. The easiest form of business to create is the sole proprietorship, which has the most personal liability risks. Corporations offer less exposure, but are more complicated and expensive to establish and run. LLCs are the easiest type of corporation to establish. Nonprofit organizations are corporations that may, or may not be, tax-exempt.
There are many forms of partnerships and some states do not recognize LLPs.
