One of the earliest and most important decisions a business owner makes is deciding on the type of structure the business will have. There are different types of business structures, each with its own characteristics; legal liability protection, tax implications, and ownership structure. Hence, a business owner ought to carefully consider the options. In this article, we will detail the different types of business structures and models, ownership structures and entities, including their characteristics and the pros and cons of each structure.
Different Types of Business
The different types of business structures include the following:
#1. Sole Proprietorship
This is the simplest and most common type of business structure. A single person owns and runs a sole proprietorship. In this type of structure, there is no legal separation between the business and the owner, meaning the owner is fully liable for any debts or legal disputes incurred by the business.
Sole proprietorships do not create a separate legal identity for the business; the owner reports the business income on their tax return. This type of business structure is relatively easy and inexpensive to establish, with few regulatory requirements.
Characteristics of a Sole Proprietorship
The characteristics of a sole proprietorship are as follows:
- Ownership of business: A sole proprietorship involves an individual managing and controlling a business, with the owner receiving profits and losses.
- Management type: The owner of a sole proprietorship manages the business, including human resources, decision-making, and overseeing activities.
- Flexibility: Sole proprietorships provide market flexibility, owner control, and quick adaptability to customer demands.
- Stability: The owner’s efficiency, capacity, and life cycle determine stability, continuity, and business growth, ensuring business success.
- Liability: A sole proprietor has unlimited liability and is personally responsible for all business debts and obligations, using personal assets for debt repayment.
- Minimum legal aspects or formalities: Sole proprietorships have minimal formalities, straightforward requirements, and minimal documentation or registration processes.
Disadvantages of a Sole Proprietorship
The disadvantages of running a sole proprietorship-type business structure are as follows:
- The owner of a sole proprietorship is personally liable for all business debts and obligations. Personal assets can be at risk if the business runs into financial trouble.
- Sole proprietorships may need help raising capital, as banks and investors often hesitate to lend to them. Hence, limiting the ability to grow and expand the business.
- The sole proprietor is solely responsible for all aspects of the business, including its successes and failures. Hence, increasing the stress and pressure on the owner.
- In a sole proprietorship type of structure, there is no legal distinction between the owner and the business.
Advantages of a Sole Proprietorship
The advantages of a sole proprietorship are as follows:
- One of the main advantages of a sole proprietorship is that it involves minimal paperwork compared to other types of business structures.
- Sole proprietors generally do not need to register with the state. Therefore, making it easier and also quicker to set up a business. However, the owner may still need to obtain a business license or permit.
- Sole proprietors have simpler tax requirements, no EIN application, and can use their Social Security number for business transactions.
- They are taxed as a pass-through entity, reporting income and losses on the owner’s tax return. Also, they may be eligible for tax deductions like the 20% tax deduction in the Tax Cuts and Jobs Act of 2017.
- A sole proprietorship type of structure grants the business owner complete control and decision-making power over a business, allowing freedom of operation and privacy
#2. Partnership
A partnership is a type of business structure where two or more people runs the business together. Each partner contributes resources and money to the business and shares profits and losses.
Partnerships can be general partnerships, where all partners have equal responsibility and liability, or limited partnerships, where there are both general and limited partners. In a limited partnership, the partners have limited liability and are not involved in the business’s day-to-day operations. The shared profits and losses of the partnership are recorded on each partner’s tax return.
Characteristics of a Partnership Business Structure
The characteristics of a partnership business structure are:
- Existence of an agreement: A partnership is an agreement between individuals for business, typically in writing, with a deed outlining terms and conditions.
- Membership: A partnership requires two individuals and a maximum of 100 partners. The partners are legally competent individuals, excluding minors, insolvents, and lunatics.
- Sharing of profit and loss: A partnership aims to share business profits in an agreed-upon ratio, with losses shared implicitly when partners agree to share gains.
- Mutual agency: A partner in a partnership acts as both principal and agent, binding each other and the firm through their actions.
- Unlimited liability: A partnership allows partners to collectively and individually repay debts and obligations using personal assets.
- Voluntary registration: Registration of a partnership is not mandatory but recommended. It has benefits like conflict resolution and dispute resolution against partners and external parties.
- Lack of continuity: A partnership lacks continuity, meaning that it can come to an end due to the death, bankruptcy, retirement, or insanity of any partner. However, if the remaining partners wish to continue the business, they can enter into a fresh agreement.
- Transfer of interest: The transfer of interest in a partnership requires the mutual consent of all partners. This means that a partner can only transfer their interest to an external party with the agreement of the other partners.
Advantages of Partnership Business Structure
The advantages of partnership business structures:
- Self-operating a business can be challenging due to financing, connections, and resources. Hence, forming a partnership can alleviate stress by gaining access to resources, financial standing, and industry connections.
- Partnering can enhance your business by providing valuable insights and past experiences. Also, it provides a well-rounded team, combining strengths to manage and grow the business effectively.
- Partnerships provide flexibility in formation, management, and decision-making with fewer strict regulations than corporations. Also, they involve multiple expert minds, resulting in better decision-making and better outcomes.
- Business partnerships offer tax-saving benefits through income splitting, passing through losses, and greater borrowing capacity. Hence, reducing individual tax brackets and providing financial flexibility.
- Partnership affairs remain private without annual financial statement filing, benefiting business partners.
Disadvantages of a Partnership
A partnership-type business of business structure has the following disadvantages
- A partnership exposes partners to unlimited liability for business activities. Thus, resulting in personal liability for debts, obligations, and legal issues.
- Partnerships face challenges in the transferability of ownership due to the need for consent from all partners. Hence, making it difficult to bring in new partners or sell the business.
- Partnerships can dissolve easily due to partner departures or disagreements, potentially causing the unexpected end of a profitable business.
- More partners in a business can complicate decision-making, decrease profits, and cause conflicts, hindering efficiency and growth.
- Partnerships face limitations in business development due to a lack of legal personality. These limitations make it difficult to own property, enter contracts, or borrow money.
#3. Corporation
A corporation is a distinct legal entity that shareholders create. Incorporating a business protects owners from being personally liable for the company’s debts or legal disputes. Corporations have a more complex structure and require drafting articles of incorporation, which include information such as the number of shares, the name, location and the purpose of the business.
There are different types of corporations, including C corporations, S corporations, and non-profit corporations. C corporations are taxed as a business entity, and owners receive profits that are taxed individually. S corporations are similar to C corporations but may only consist of up to 100 shareholders, and profits are not taxed twice. Non-profit corporations are tax-exempt and must utilize all incoming cash flow for the organization’s operations or plans.
Characteristics of a Corporation
The characteristics of a corporation are:
- Limited liability: A corporation has limited liability, allowing shareholders to avoid personal liability for debts and obligations in cases of bankruptcy.
- Ownership by shareholders: Corporation is a type of business structure where the shareholders who own fixed stock shares and voting rights are the owners of a corporation. More shares give them greater control over the company’s decisions.
- Continuity of existence: A corporation’s lifespan remains unaffected by shareholders, employees, or officers’ withdrawals or incapacity. This is because it operates independently and is defined by its state charter.
- Professional management: A corporation is typically managed by a board of directors and company officers. They oversee daily operations and make crucial decisions for shareholders, enabling efficient decision-making and specialization.
- Double taxation: Corporations face double taxation, with profits subject to income tax and dividends taxed on shareholders. However, corporations can avoid double taxation by passing income and losses directly to shareholders.
Advantages of Forming a Corporation
- Shareholders are not personally responsible for corporate debts or legal obligations, providing personal asset protection.
- Ownership of a corporation is based on stock ownership, which allows for easy transfer of ownership and continuity.
- Corporations can raise funds by selling shares of stock, making it easier to obtain capital for business growth
- A corporation is recognized as a separate legal entity from its owners, offering protection and legal standing.
Disadvantages of Forming a Corporation
- Maintaining a corporation requires following formalities and regulations, such as creating bylaws, holding annual meetings, and keeping board minutes. This can be time-consuming and involve additional costs.
- Depending on the corporation structure, corporate profits may be subject to corporate income tax at the corporate level and then taxed again when distributed as dividends to shareholders.
- Corporations are subject to state and federal regulations, including requirements for issuing stock, distributions of earnings, and financial reporting. Compliance with these regulations can take time and effort.
#4. Limited Liability Company (LLC)
An LLC is a relatively new business structure that combines a partnership’s pass-through taxation benefits with a corporation’s limited liability benefits. An LLC offers flexibility in management and taxation, and owners are known as members. LLCs are not taxed as separate entities, and the profits and losses are passed through to the members, who report them on their tax returns. LLCs provide limited liability protection to their members, meaning their assets are generally protected from business debts and liabilities.
Characteristics of an LLC
- Separate legal existence: An LLC has a separate legal existence, allowing contracts, property ownership, and legal actions while separating debts and liabilities from owners’ assets.
- Limited liability: LLCs offer limited liability protection for members, limiting their responsibility for company debts and liabilities to their investment in the company.
- Flexibility in taxation: LLCs are typically treated as “pass-through” entities, reporting profits and losses to members. They can also be taxed as corporations if that is advantageous.
- Simplicity in operation: LLCs have simpler operational requirements, less burdensome recordkeeping, and fewer annual meetings than corporations.
- Few restrictions on ownership and management: LLCs have fewer ownership and management restrictions. They can have multiple members, and can choose member-managed or manager-managed management.
- Flexibility in profit distribution: LLCs offer flexibility in profit distribution, allowing members to determine distribution based on factors like work contributions or performance.
- Simplified formation: Forming an LLC is simpler and less formal than forming a corporation. Although they still require the filing of articles of organization.
Advantages of an LLC
The advantages of an LLC include:
- One of the primary advantages of an LLC is pass-through taxation. This means the LLC does not pay taxes at the business entity level.
- An LLC’s main advantage is its limited liability protection for its owners. This means that the owner’s assets are protected from debts and lawsuits against the business.
- An LLC offers flexibility, allowing owners to manage as members or appointed managers, compared to rigid corporate structures with a board.
- Forming an LLC boosts a business’s credibility and trust by providing a professional image and registering with the state. Conducting business under a separate legal entity’s name enhances its perception.
- LLCs have fewer state compliance requirements and formalities, reducing paperwork and administrative hassles for owners and making it easier to form and maintain.
- LLC members can deduct operating losses from regular income, offsetting personal income tax liability.
Disadvantages of an LLC
The disadvantages of an LLC include:
- Forming and maintaining an LLC costs more than sole proprietorships or general partnerships, with initial and ongoing fees varying by state.
- LLC ownership transfer is harder than that of corporations, as shareholders can sell shares, and all members must approve adding or altering members.
- LLC taxes are complex and may include additional taxes like capital values or franchise taxes for members who work for the company.
- An LLC may be treated as a corporation in international countries, potentially impacting taxation and requiring additional or different treatment.
- LLC establishments may require significant filing fees, including publishing a letter of intent in a newspaper, varying by city and state.
- LLCs may not appeal to investors due to structure and governance differences
- An LLC needs more jurisdiction in litigation out of state due to state-specific business laws, which is potentially disadvantageous for their case.
#5. Cooperative Business Structure
A cooperative is a business that is fully owned and operated for the benefit of its members. Cooperatives sell shares to cooperative members, who have a say in the operations and also the direction of the cooperative. Cooperatives have specific requirements, such as creating bylaws, having a membership application, and having a board of directors. Organizations that focus on serving a particular member group and aiming to benefit them rather than external stakeholders frequently use them.
Characteristics of a Cooperative Business Structure
The characteristics include the following:
- Democratic control: Co-operatives are managed by a committee elected by members at annual general meetings, closely monitored, and preserve democracy through membership education, frequent meetings, and member involvement in committees.
- Voluntary and open membership: Cooperatives welcome all individuals, regardless of gender, social status, race, or religion, and offer membership without discrimination. Members control policies and decisions.
- Member economic participation: Cooperative members contribute equitably, democratically control capital, and distribute economic benefits proportionally based on participation level.
- Autonomy and independence: Cooperatives are self-help organizations controlled by members who make decisions independently.
- Education, training, and information: Cooperatives offer education, training, and information to members, representatives, managers, and employees for cooperative development.
- Cooperation among cooperatives: Cooperatives collaborate across local, national, regional, as well as international structures for effective service.
- Concern for community: Cooperatives promote sustainable community development through member-approved policies, considering social and economic impacts.
Type of Business Owner
Several types of business ownership structures exist, such as sole proprietorships, partnerships, limited liability companies (LLCs), and corporations. The simplest type of business is a sole proprietorship, which has no legal distinction between the owner and the company. It is easy to form, has low startup costs, and lacks personal liability protection. Unlike sole proprietorship, where there is one owner, partnerships are types of business structures with two or more owners, general partners, and limited partners. The LLC type of business structure doesn’t have one owner either; there are multiple owners. They combine limited liability protection with flexible tax treatment, making them popular for small businesses.
Corporations are legal entities that shareholders own and a board of directors oversees, providing shareholders with limited liability protection. Larger companies and those looking to raise capital through stock sales frequently use them because of their more complicated formation and governance requirements.
Type of Business Model
A business model refers to a company’s plan for making a profit. It outlines the products or services the business plans to sell, its target market, and anticipated expenses. There are many different types of business models, including:
- Subscription: This type of business model involves offering a product or service that requires ongoing payment, usually in return for a fixed duration of benefit. Examples include software subscriptions and monthly subscription box deliveries
- Cash machine: This is a type of business model that focuses on quickly converting cash into goods and services and then back into cash. Companies with low profit margins use it but have a disruptive market position.
- Hidden revenue: In this type of business model, users don’t have to pay for the services offered, but the company earns revenue from other sources, such as advertising
- Razor and blade: This type of business model involves selling one item at a low price (the “razor”) and another associated item at a premium price (the “blade”). Examples include printers and ink cartridges.
- Agency-based: This model involves hiring an outside firm to complete a specific task. Examples include advertising agencies and design firms.
- Online educational: This model targets the educational industry and provides access to educational resources through flat course fees or subscriptions.
- E-commerce: This type of business model connects buyers and sellers through an online platform. It includes various types such as B2B, B2C, C2C, and C2B.
- Retailers and manufacturers: These are the primary types of business models. Here, manufacturers produce and may sell their goods, while retailers buy goods to resell to the public
Factors to Consider When Selecting a Type of Business Structure
Several factors must be considered when selecting the most suitable type of business structure. They include:
- Investment needs: Consider the investment required for the smooth running of the business. It is important to align the requirements with the capacity of the company.
- Nature of business: Consider the business’s nature, products/services, industry/market sector, and goals to ensure the structure aligns with the enterprise’s requirements.
- Taxes: Business structures impact tax burden; sole proprietors, partnership owners, and S corporation owners categorize income as personal, C corporation income separate.
- Liability: Determine the appropriate level of liability protection you’ll need for your personal assets.
- Flexibility: Consider the future needs and growth potential of your business. Some structures may need to be improved in raising funds or adding new members.
- Control: Choose the appropriate business structure based on desired control levels.
- Ownership Structure: Consider the number of owners and how ownership will be transferred. The type of business structure will determine if there will be one owner or multiple.
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