Understanding the Different Types of Business Organizations: An Overview
Farm Management Resources
Disclaimer: The information in this blog post is for educational purposes only. This blog post is not intended as legal or tax advice and is not legal or tax advice. Readers should consult an attorney and a tax professional prior to the formation of any business entity and while any business entity is operating.
This blog post offers a brief overview of the major types of business organizations available to small businesses. The overview is not intended to be comprehensive and does not consider every type of business organization, nor does this post comprehensively address the types of organizations listed. The author focuses on income tax considerations, liability issues, and ease of business succession. Note that each state has different rules and requirements. Different state income tax consequences may result in different states. This blog post serves as merely a starting part in discussing different options for organizing your business.
A sole proprietorship is someone who owns an unincorporated business by himself or herself. No formal steps are required to start a sole proprietorship, the person merely begins to operate the business. Income of a sole proprietorship is taxed at the individual level. The sole proprietor is personally liable for all liabilities and debts of the business and all personal assets of the sole proprietor are subject to liabilities and debts of the business. An interest in a sole proprietorship may not be transferred to the next generation, although the physical assets can be transferred. Business succession is difficult, if not impossible. Twelve percent of businesses in the United States are sole proprietorships.
A partnership is the relationship between two or more people to do engage in a trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business. No written, or even oral, agreement is required to form a partnership. If the actions of the parties indicate that a partnership exists, the law implies the partnership. Only 2% of businesses in the United States are organized as partnerships.
For income tax purposes, the income or loss of the partnership “passes through” to the owners and is taxed at only the individual level. For example, if A and B enter into 50/50 partnership, and the partnership earns a profit of $100,000 this year, A will show $50,000 on her income tax return and B will show $50,000 on his income tax return. The partnership is not taxed separately.
A limited liability partnership is a type of general partnership where every partner has limited personal liability for the debts of the partnership. Partners are not liable for negligent or intentional actions of the other partners, but are potentially liable for contractual debts depending on the state.
A corporation is a legal entity that is separate and distinct from its owners. A corporation is formed under state rules and formally registered and has a separate taxpayer ID number. Income of the corporation is taxed at the corporate level. If any income is distributed to shareholders, that income is taxed again at the individual level, giving rise to a “double tax.” However, a benefit of the corporate form of ownership is that the shareholders are not liable for the liabilities and debts of the corporation IF the corporation follows corporate formalities. Corporate formalities include a separate bank account, no commingling of shareholder and corporate monies may not be commingled with personal monies, the board of directors manages the business, and the directors and members hold regular meetings with notice and minutes. The corporation must follow state law and corporate bylaws. If corporate formalities are not followed, the court may “pierce the corporate veil” and hold shareholders personally liable for corporate responsibilities.
The typical corporation is referred to as a “C Corporation” since it is organized under Subchapter C of the Internal Revenue Code. Many small businesses are organized as “S Corporations”, referring to Subchapter S of the Internal Revenue Code. S Corporations are designed for small businesses, with limits on the number and size of shareholders. S Corporations seek to provide the limited liability of a C Corporation, but the single level taxation of a partnership. About 1/3 of business in the United States are organized as S Corporations, and about 19% as C Corporations.
Given the two levels of taxation of a C Corporation, the C Corporation should not own real estate or other appreciating assets. If appreciated assets are sold by the C Corporation, two levels of tax will be paid- one for the corporation and one for the individual when the gains are distributed. The S Corporation avoids this issue, so real estate may be held in a S Corporation, but care must be taken upon the death of a shareholder to ensure one level of taxation.
Business succession is relatively easy with a corporation. An owner can convey shares of stock during life or at death. Voting and non-voting stock can allow division between on-farm heirs and off-farm heirs.
Limited Liability Company
A limited liability company (LLC) is a business organization that combines the limited liability of a corporation with the flow-through tax characteristics of a partnership. Members (owners) of the LLC are not personally liable for the debts and liabilities of the business, so long as the business formalities are followed. However, profits and losses pass through to the members, so are taxed only at the personal level.
Limited liability companies were enabled in the 1990’s to improve upon the S Corporation’s promise of limited liability and one level of taxation. Real estate and appreciating assets may safely be held in an LLC. LLCs are increasingly popular, with 35% of United States businesses organized as LLCs.
Business succession proves to be relatively easy with a LLC, similar to corporations. Ownership “units” can be transferred during lifetime and at death. In addition, some ownership units can hold votes on the business operation and some can not have votes, enabling a division between off-farm heirs and on-farm heirs.
The Accidental Partnership
Partnerships do not require written agreements, or even oral agreements. If two or more people act like partners, the law will imply a partnership with all of the liabilities. For example, if two operators decide to purchase inputs together, market products together, or do work for each other, the arrangement begins to resemble a partnership. If an accident occurs, a court may rule that all “partners” are personally liable.
Operators who collaborate with others should consider a written agreement to clarify the relationship. In addition, all parties should confirm with their liability insurance carrier that accidents are covered by the policy.
The Magic LLC
The popularity of LLCs has led to a mythology surrounding the form of organization. Many seem to believe that creating an LLC cures any business woes. The LLC is a tool and should not be used because your neighbor has one or it is cool. Discuss your goals with your business advisors, including your attorney. An LLC may well be a good tool to further your goals, but other tools are available. An LLC does not make you a better manager, make your business more profitable or protect you from creditors.
A Note on Limited Liability
The limited liability offered by corporations and LLCs is very limited. First, any assets in the business are subject to liabilities. Second, lenders will require personal guarantees of owners for many loans, depending on the value of the collateral. Finally, if business formalities are not followed, courts will look beyond the business entity and impose personal liability on the owners.
The best way to protect the business from liability is to engage in practices to keep operations safe. In addition, every business should have liability insurance, with the owners named as co-insured. Consult with your insurance agent to make sure that your activities are covered by the policy.
No matter what business entity you use, business agreements tailor the legal arrangements to meet the family goals. Never accept a boilerplate operating agreement or business organization. Discuss your goals with your attorney and form business agreements to further those goals. Agreements can address the 5 D’s- Death, Disability, Divorce, Disaster, and Disagreements. The types of agreements include buy-sell arrangements, rights of first refusal, and limits on who may own an interest in the business. The latter agreement can ensure the business remains in the family.
A variety of different business organizations exist. When considering which business organization best fits your goals, consider income tax, liability, and business succession, among other factors. No matter what type of organization you choose, make sure that you craft business agreements to achieve your goals, and make sure that you have adequate liability insurance coverage that protects your assets. Finally, work with your attorney, tax advisor and others to make the right choices.
Jesse J. Richardson, Jr. is a Professor of Law and the Lead Land Use Attorney at the Land Use and Sustainable Development Law Clinic at the West Virginia University College of Law.