Understanding the Types of Businesses

Different types of businesses are held to different laws and regulations. Each business type has different regulations regarding, license, taxes, and even how you are to pay and compensate employees. Additionally, different business types have different types of liabilities and benefits when it comes to taxes.

For many small businesses, the best initial ownership structure is either a sole proprietorship or — if more than one owner is involved — a partnership. These make sense if you have a low likelihood of lawsuits, and are not likely to take out large sums of debt such as business loans.

Get to Know the Types of Businesses

• Sole Proprietorship

For many new small businesses, the best initial ownership structure is a sole proprietorship, but this can only be the case if the business is owned by one person. A sole proprietorship is a one-person business that is usually not required to register with the state for a business license. There is no special paperwork or documents to file in order to go into business for yourself.

A sole proprietor would need to register with their state’s tax department in order to sell tangible products to the public.

The downside of a sole proprietorship is that the business and owner are, legally speaking, one and the same. The owner is solely responsible for reporting business income and losses on their personal tax returns. The owner is personally liable for business-related debts, or court judgments which may arise from a lawsuit. The owner can be sued for liable actions against the business and would thus be held responsible for payment even if the business were no longer active. The owner is personally liable for paying sales tax for any taxable products or services.

• Partnership

A partnership is similar to a sole proprietorship except that the business is owned by two or more persons. A partnership does not have to file any specific paperwork in order to form a partnership. When you begin a business with another person, you’ve formed a partnership.

Each partner is required to include profits and losses on their portion (the percentage of the business each partner owns) on their personal tax returns.  Each partner can be held personally liable for the entire amount of any business debt, or claim. And each partner would be held responsible for any lawsuits against the business.

• Limited Partnerships

Limited partnerships are businesses which are most often operated by one person for the day to day operations of the business. A general partner, or managing partner,  manages the overall working of the business. The general partner can be help personally liable for business debts and legal claims made against the company. Unless the limited partnership has also formed an LLC or Corporation.

The business, however, is owned by another partner or partners who have invested financially into the company. Who in turn receive a percentage of profits in return for their investments.  The limited partner(s) have minimal control over the daily operations and business decisions of the company, and in return, they hold no personal liability for the business debt or legal claims made against the business.

The benefit of a Limited Partnership is the investment(s) can be used as capital to grow a business without having to take out costly loans, while the general partner maintains control over how the business operates. The downside would be that the general partner is solely responsible for debts and legal actions which may be taken against the business.

Registering for a Limited Partnership is a complicated process and should be done with the help of an expert, such as an attorney or accountant. It can be costly and is not recommended for the average small business owner.

• Private Corporation

A private corporation is a business that has registered for a business license. The business that is a legal entity created by the state whose assets and liabilities are separate from its owners. A private corporation is required to file legal documentation of “Articles of Incorporation” and then submitting those documents to the state in which the business wishes to conduct their business. It does not have to be the same state where the owners reside.

Some advantages of a corporation include limited ability of owner(s), an unlimited lifespan of the business unless otherwise stated in their articles of incorporation, ease of transfer (or sale) of ownership to another person, or entity, and it might be easier to access business loans or investors.  Disadvantages include double taxation — the corporation, as a legal entity, must pay taxes, and then shareholders also pay taxes on any dividends received.

Disadvantages of a private corporation are that of double taxation. What that means is that the corporation, the legal entity, is required to pay taxes on profits, but owners and shareholders must also pay personal taxes on any dividends received.

• S Corporation

This type of ownership brings the best of partnerships and the best of corporations together. Because the business in incorporated owners has limited liability. And, they may find it’s easier to obtain business financing.  There is no double taxation because all profits are passed directly to the owners, who then pay personal income tax, but the corporation pays no taxes.  There are restrictions on the how many owners or shareholders an S Corporation may have.

• Limited Liability Company

A Limited Liability Company or LLC for short, is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.  In an LLC the “owners” of the business are referred to as “members.” And, depending on the laws of each state, the members can be either a single owner business or a business with multiple owners made up of two or more persons, or corporations or other LLCs which own the business as a subsidiary.

An LLC is not a shareholder based corporation because LLCs are not taxed as a separate business entity. Instead, all profits and losses are passed to each member of the LLC.  Subsequently, each LLC member report profits and losses on their own federal tax returns.

The advantage of a Limited Liability Corporation is that the members are protected from personal liability for business actions and debts. Additionally, there is less paperwork and lower start-up costs to file for an LLC license. The members make all decisions regarding the distribution of both equity, and work involved, earnings and how to manage profit and losses that the business may have incurred.

Conversely, in many states when any one member leaves an LLC, the business would be dissolved and members are responsible for fulfilling legal and business obligations in order to close the business. Remaining members can choose then to start a new LLC. It may be possible to include appropriate language within the operating agreement for what to do to prolong an LLC if a member leaves.

Also, members of an LLC are required to pay self-employment taxes towards medicare and social security based upon the entire net income of the LLC.

• Nonprofit Corporations

A nonprofit corporation is when an organization is formed to carry out a charitable, educational, religious, literary, or scientific purpose. Nonprofit corporations can raise funds using either direct public, or private donations from individuals or companies, or through public grant money. Federal and state governments do not generally tax nonprofit corporations on money they take in that is related to their nonprofit purpose, because of the benefits they contribute to society. However, there are specific requirements involved for a corporation to be eligible to receive nonprofit status.

• Cooperatives

A cooperative is a business or organization owned by and operated for the benefit of those using its services. Consumer co-ops can exist to operate a food, or farm cooperative, a bookstore, or other retail businesses. Such a cooperative would allow members to have a share in the goods offered. Other cooperatives might be for the purposes of a single type of work to be represented by multiple individuals, a workers cooperative. You might see this type of business with arts and crafts workers.

Groups that receive income or incur expenditures as a collective group can be considered a cooperative. Often you may see this type of business in social clubs,

Typically, an elected board of directors and officers run the cooperative while regular members have the voting power to control the direction of the cooperative. Members can become part of the cooperative by purchasing shares, though a number of shares they hold do not affect the weight of their vote.

Cooperatives may also be considered for nonprofit status depending on the purpose of the group, however, the filing for such status is different than that of a Nonprofit Corporation.

For more information on types of businesses and how you can legally start your own business, visit the U.S. Small Business Administration.

This information is not intended as legal or tax advice. Cowdery Tax and its representatives does not offer legal or tax advice. We offer services for business bookkeeping, payroll, tax payments, and personal tax filings. We share information that is publicly available. Tax laws may change with or without notice that may alter or change the information contained in this publication.