The Different Types of Business Structures (and their Benefits and Drawbacks)
What Form of Business Ownership Structure is Best?
When starting a new business, it is important for the owner to consider not only what they must do in the present to get their company off the ground, but also for them to think about what they might want it to look like in the future. One of the best ways for a business owner to set him or herself up for success is to choose the right business structure. Although having the right product or service to sell is obviously the cornerstone of financial success in business, without considering the type of business that they plan to run, an owner might end up losing unnecessary money to taxes or even putting themselves at risk for personal financial ruin. So what are the different types of company ownership and what are their benefits and disadvantages?
Proprietorships: High Risk, (Potentially) High Reward
What is a Business Proprietorship?
The first (and simplest) type of business structure in corporate America is the proprietorship. In a proprietorship, there is no official distinction between the owners of the company and the company itself, meaning that what happens to the business happens to the owners, for better or for worse. In a proprietorship-based company, the money of the company is the money of the owners, and in a sole proprietorship there is only one owner who holds absolute financial and executive power in his or her hands. Because proprietorships do not require the filing of any official incorporation documents in order to conduct business, all businesses are proprietorships by default until they are officially made to become something else.
What Kinds of Companies are Often Proprietorships?
For reasons that we will soon discuss, proprietorships are mostly companies that are extremely small or even involve just one person working on their own. Larger companies almost never stick with the proprietary model, and rather opt for a structure more suited to a large business like a C Corporation.
What are the Benefits of a Proprietorship Business Structure?
Because this business model is the classification that companies automatically fall under without having to incorporate, starting a proprietorship is as easy as beginning to market and sell your service or product. In addition to not having to jump through hoops to begin conducting business, running a proprietorship is incredibly easy in regards to navigating the complexities of taxation; as the proprietorship-based company is indistinguishable from its owner, the income taxes of the owner are also the taxes of the proprietorship. The indirect result of this tax structure is that the company does not have to pay the corporate taxes that might bring down revenue in other cases.
What are the Downsides of a Proprietorship?
Because proprietorships are owned and run by the people (or person) who are, on paper, the same entity as the company, investors are not able to hold equity in a proprietorship. The unfortunate result is that proprietorship owners have a difficult time raising capital to fund the growth and success of their businesses. In addition, the proprietary business model is unequivocally the most dangerous one to operate under because of the unlimited liability risk associated with proprietorships; the owners of a business that is organized under this structure has absolutely zero protection against their own personal assets being taken in a situation of debt or lawsuit. As a result, although the owners of a proprietorship may be able to take all of the profits of their business for themselves, as soon as the business goes south they are at risk of losing their own personal assets including their money and even their car or house. Proprietorships are the only business type discussed in this article that do not benefit from limited liability protection.
Who is a Proprietorship Right For?
The business owners who will benefit the most from the proprietary model are those who most likely run a fairly small company, and whose risk of over-leveraging the company and going bankrupt or getting entangled in a lawsuit is very low. The benefit of holding full executive and financial control over a company is significant, but so is the loss that these owners could face if their business begins to lose money or face potential conflict.
Limited Liability Companies: Keeping Things Simple
What is an LLC?
Limited Liability Companies, more commonly known as LLC’s, are one of the more popular business structures in the United States. As the name would suggest, these companies do not face the same enormous risk of personal asset loss as proprietorships. Rather, the assets of the owners of an LLC are not in danger of losing their money or other possessions when the company gets into financial trouble. Much like the proprietary model, however, LLC’s are very basic business structures that do not have a ton of intricacies to be considered.
What Kinds of Companies are Often LLCs?
Because of the personal protections inherent to an LLC, there is a far greater number of notably large companies that have adopted this business model. One well-known Limited Liability Company is PricewaterhouseCoopers (PwC), a massive accounting and financial firm. Another LLC that has held a significant degree of public notoriety for many years is Chrysler, the American car company. Even Factor Finders is structured as a Limited Liability Company!
What are the Advantages of Choosing an LLC Business Structure?
Along with the safety and security of personal asset protections that come along with filing as an LLC, the simplicity of the LLC structure makes it a far easier type of company to set up than a corporation. This simplicity in organization brings with it a low cost of creation, as filing a company as an LLC costs only a few hundred dollars in most states. Additionally, because an LLC does not involve as much paperwork or regulation as a corporation, there is a great degree more flexibility in management decision-making for the owners of an LLC. Finally, because of the “flow through” tax structure of the LLC, any money that the company makes is considered to be personal income for the owners and will be taxed accordingly rather than facing the additional business tax that must be paid by corporations.
What are the Disadvantages of an LLC?
Although LLC’s do get to pass over the corporate tax on their income, the owners do have to pay an “employment tax” that other types of companies may not be subject to along with a “franchise tax” in certain states. LLC’s are also organizations that are at risk of being disbanded quite easily; if even one of the owners leaves the company (either by their own volition or because they have passed away), the LLC is dissolved unless the owners had previously agreed upon and filed a strategy regarding what they would do in such a situation. It is also important to keep in mind that LLC’s are not universally protected against the seizing of personal assets; as is the case with many other types of corporations, protections may be revoked if the owners of the LLC commit serious white-collar crimes.
Who is an LLC Right For?
Limited Liability Companies are best suited for businesses that do not want to have to deal with the red tape of applying for and working with corporate status. LLC companies are great for those who desire the freedom and simplicity of operation that comes with straying away from a corporate designation but still desire the safety of keeping their personal assets separate from their business holdings. Companies that want to focus on the generation of revenue through the development of their service or product and not on massive expansion or saving money from taxes should consider registering as an LLC.
Limited Liability Partnerships: Working Together with Caution
What is a LLP Business Structure?
Limited Liability Partnerships are similar to Limited Liability Companies in their protection of personal assets, but differ in the actual structure of the company. While LLCs can have executives and a chain of management that places people along a spectrum of power, Limited Liability Partnerships are managed by a group of partners (unlike an LLC, which can have one person as the leader). Although LLPs often have a managing partner, all of the partners in the firm hold equal power over their employees and have an equal say in the decision-making process. The other main difference between the LLC and LLP structure is the additional protection that LLP partners receive against the bad decisions of their colleagues; if one partner messes up badly and becomes wrapped up in a lawsuit, the other partners in the firm are not at personal financial risk.
What Kinds of Companies are Often LLPs?
Not just any company can become a Limited Liability Partnership; in many states, only individuals in certain specified fields can form an LLP. As a result, most of the companies around the country that are registered as LLPs serve in a select number of professions. Look up the restrictions in your state regarding what industries allow the formation of LLP’s.
What are the Benefits of an LLP?
Limited Liability Partnerships offer a great deal of personal protection to their owners, against corporate debt and lawsuits and also against lawsuits that go after other partners in the business. In addition to the asset safety involved with forming an LLP, the “flow through” tax system that benefits owners of an LLC is also present in the taxation of LLPs, saving the partners in the business a significant amount of money. Finally, not only does the equal power of the partners in the firm allow for a more egalitarian and democratic business system, but unlike an LLC, an LLP does not get disbanded if a partner decides to leave the company.
What are the Downsides of an LLP?
Because of the added benefits and slightly more persnickety structure of Limited Liability Partnerships, they are more difficult to form than LLCs, involving more paperwork and consequently more frustration. Additionally, because of the organization of LLPs as equal partnerships between individuals, companies cannot be the leaders or even the partners of LLPs. Finally, in some cases, LLPs are unable to do business across the nation due to regulations that keep them confined to operating within their home state.
Who is an LLP Right For?
Limited Liability Partnership status works well for companies in the aforementioned professions who want to ensure that they are as protected as possible from personal liability and who desire to work with a less “ranking-based” structure than would be best with an LLC. Law firms, medical practices, and financial firms who intend to primarily operate in-state and want to reap the benefits of personal protection and equal management should consider filing for LLP status.
So What’s the Difference between an LLC and an LLP?
In many cases, the decision between forming an LLC and LLP will be made for you; if you aren’t in an industry that your state permits to have LLPs, you don’t have to worry about deliberating between these various types of business ownership. If you are in a situation where you can pick either corporate structure, however, you will benefit from thinking about what you want your management to look like. Are you looking to form a company where one person calls the shots or where there is a council of people who are going to be collectively making decisions? Once you have decided this, you have essentially considered the main distinction between these two forms of corporate organization. Although an LLC and LLP share an identical tax burden, the way that you manage your company could impact profits and long term success, so be sure to consider this difference when making your decision.
C Corporations: Go Big or Go Home
What is a C Corporation?
C Corporation, or “C Corp,” is the default category of company that a business will fall into if it has filed as a corporation and not specifically applied for S Corporation status. Most if not all of the world’s largest and most successful businesses are C Corps, as this structure is the most conducive to fast business growth and massive corporate size. This is mainly due to the C Corp’s tax and investment policies, which provide many benefits to publicly traded companies (or companies that desire to take on a large number of investors).
What Kinds of Companies are Often C Corps?
Think of a large, successful, famous company: Maybe Apple? Berkshire Hathaway? Google? All of these companies are publicly traded C Corporations, as are the vast majority of all companies on the Fortune 500. Although this does not mean that all C Corps (or even most of them) are going to be profiting in the billions, it does prove that this structure is the one that gives companies the best chance to expand significantly in size.
What are the Benefits of a C Corp?
The main reason for the unlimited growth potential of C Corps is the fact that they are not limited in regards to the number of investors who can become shareholders in the company. This is why so many of the world’s largest corporations are registered as C Corps; as they never hit a wall where they can no longer bring on more investors, they end up having a countless number of people holding shares which add up to billions of dollars in value. In addition, C Corporations have the benefit of being able to pay less taxes when putting their revenue back into the company than LLCs and S Corporations, meaning that a cycle of growth can emerge that is conducive to corporate expansion. Finally, because of the fact that incorporating a company separates its owners as individuals from the the company, C Corps can continue to exist even if all of the original owners are gone and have been replaced without necessitating any form of agreement prior to their leaving.
What are the Downsides of a C Corp?
Unlike proprietorships, LLC’s, or LLP’s, C Corps are subject to “double taxation,” meaning that they must pay both a corporate tax and a personal income tax on the same money. Additionally, as owners of a corporation, those who are in control of a C Corporation must organize multiple officially recorded meetings per year to ensure that the legality and transparency of the company’s work is upheld. On top of the time consuming process of adhering to these standards, the financial and legal minutiae of C Corps can become quite difficult to keep track of in a way that the aforementioned business types are not.
Who is a C Corp Right For?
Companies that plan on increasing their size significantly, hope to go public, or simply want to take on a larger number of investors should consider filing for C Corporation status. Although C Corps do have to pay more taxes (in some cases) and jump through more hoops than other types of companies, any owner who desires to crack the fortune 500, 1000, or even 2000 is going to have to take a very serious look at either founding or converting to a C Corp company.
S Corporations: Small Businesses, Large Benefits
What is an S Corporation?
S Corporations and C Corporations share much in common regarding structure and corporate status, but they also differ greatly in regulation and taxation. While a C Corporation can be humungous in size and promotes fast growth, S Corps tend to be smaller businesses that are focused on becoming successful without necessarily becoming massive. A company must apply for S Corp status (whereas C Corps are the default type of corporation), and once this status has been granted they are restricted to a cap of 100 owners. Because S Corporations could otherwise become tools that are manipulated by larger companies, an S Corp can only have its special status if its owners are individuals, not other companies of any kind.
What Kinds of Companies are often S Corps?
Because the S Corporation designation is engineered to help promote small business, most of the companies that hold S Corp status are small businesses that are not hoping to grow significantly in size (at least not in the near future). Many small businesses that want the benefits of being filed as a corporation without having to pay C Corp taxes are registered as S Corps.
What are the Benefits of an S Corp?
Companies that are registered as S Corps are able to ensure their own safety slightly more than many other types of corporations in that they are able to claim losses personally in taxation and therefore pay less when things are going poorly. Additionally, unlike a C Corporation, S Corporations do not have to pay corporate tax and rather use the same “flow through” structure as LLCs and LLPs.
What are the Downsides of an S Corp?
Because of the special treatment of companies that choose to apply for S Corporation status, the government is more particular in setting strict guidelines for S Corps than for any other type of corporation. This has multiple effects: first of all, S Corps must divvy up their profits according to percentage of ownership, unlike LLCs who have the freedom to choose who gets how much. In addition to this, S Corp businesses will experience punishments if they attempt to manipulate their balance sheets, even in legal ways. Third, as is the case with C Corporations, S Corporations are quite complicated both legally and financially and require much attention from hired professionals to ensure that nothing illegal or unwise is occurring. Finally, S Corps must hold the same tedious meetings and file the same tedious reports as C Corps to ensure that they are being as open about their practices and accounting books as possible.
Who is an S Corp Right For?
Any company that wants to benefit from the structure of being a corporation and knows that they are not planning on going public or significantly increasing their size in the near future should see S Corp status as a very solid option for their business. Although some of the necessary proceedings that come with filing and existing as an S Corporation may take up time and potentially money, the benefits that a company can take advantage of once they have applied as an S Corp and gained this status could very well outweigh the costs by a significant margin. For companies that see the costs and open ended nature of existing as a C Corp as unnecessary but the structure and tax cuts discussed above to be enticing, becoming an S Corp can be a very beneficial and lucrative move.
So What’s the Difference between an S Corporation and a C Corporation?
S Corporations and C Corporations may share a somewhat similar corporate structure, but the way a business will function as a C Corp is a far cry from how it will operate as a S Corp. Not only is an S Corp designed to benefit small businesses, but it is also far less costly with regards to taxation. This means that someone who wants to run a profitable business with relatively low risk and cost and is not concerned with making the Forbes list is probably better suited to opening an S Corp. On the other hand, the C Corp has higher taxation costs but also benefits that can be scaled. The way that a C Corporation has the possibility for unlimited growth is the core difference between it and its smaller S Corporation cousins. In this way, these two corporate structures are distinct enough that a business owner who chooses one over the other could be either helping his business reach its goals or hindering its forward progress. In short, when looking at a C Corporation vs an S Corporation, you should think about the following things: is it worth it to pay an extra corporate tax? How big do I want my business to grow? Do I want to take on lots of extra investors, or keep a small number of owners? With these things in mind, you should be able to make the right decision in choosing your business structure.